Wentz Weekly Insights
Volatility Increases As Fed Raises Rates, Markets Finish Week Flat(ish)
There was a lot of news to unpack last week which was evident in the market’s day to day moves and the volatility index which traded in its highest range this year of 25 to 37, however when all was said and done the S&P 500 declined just 0.24% for the week, reflecting the lack of conviction. The big event of the week was the Federal Open Market Committee (FOMC) meeting, its policy decision, and post-meeting press conference.
As expected, the FOMC agreed to raise interest rates a half percentage point and officially announced the start to shrinking its balance sheet. It was the first time since 2000 that rates were increased by more than 25 basis points. That was baked into expectation and more half point increases are expected going forward.
Regarding quantitative tightening, the Fed said it would begin reducing its balance sheet June 1 at a rate of $47.5 billion per month. This may have been lower than what was expected, and a lower start than we expected, but the Fed said it would double that pace and increase the runoff to $95 billion per month by September 1, more in line with ours and the markets expectations. The initial runoff pace will include $30 billion per month in Treasuries and $17.5 billion per month in mortgage-backed securities (and doubling each of those figures September 1). The Fed’s balance sheet is approximately $9 trillion, up from $4 trillion before the pandemic. With a runoff rate of $95 billion per month at its peak, the Fed will shrink its balance sheet at a pace of over $1.1 trillion per year.
Fed Chairman Jerome Powell opened his press conference by speaking directly to the American people. He highlighted the strength of the U.S. economy and the labor market, but first spoke about inflation being too high and how the Fed would move “expeditiously” to bring it back down and how important it was to bring down to enjoy a “sustained period of strong labor market conditions that benefit all.”
But the big question for Jerome Powell was what the Fed’s path of policy looks like moving forward. That answer came in the second question of the press conference where Powell acknowledged that a 75 basis point increase in rates is something the Fed was not actively considering. Immediately stocks moved higher. Going into the meeting the probability was increasing that the Fed would engage in such increases after several Fed speeches made mention of it. The fear was the Fed is so far “behind the curve” that it would need to raise rates to a more restrictive stance much faster which posed a higher risk to the economic activity in doing so. Powell shot down those thoughts. However, he did say additional 50 basis point increases are on the table for the next couple meetings.
The Fed came across as feeling very comfortable it would be able to engineer a “soft landing” or tightening policy enough to bring inflation back to its target without slowing the economy into a recession. It is also in a position where it needs to avoid losing credibility. After over two years of easy money and a 40% increase in money supply, inflation turned into a persistent issue, despite the Fed saying it would be transitory. Since the beginning of the year the Fed has transitioned from the “transitory” argument to saying it would move “expeditiously” to bring back down. Credibility is the first tool it has to do this – since inflation expectations play a major part in future inflation, the market’s belief the Fed can bring prices under control is an important factor.
While stocks soared after the announcement, having its best day since early 2020, the very next day stocks experienced one of their worst days since. As the news was digested overnight, investors realized the same things as before the meeting – the Fed is moving to a more restrictive stance and assets are re-pricing to reflect this. While we are approaching oversold levels, we are also approaching key support levels. If those are broken, we could see further downside.
As with everything, it is all relative. Although the S&P 500 is 14.4% below its highs from the beginning of the year, it is still 22% above its levels right before the pandemic, while the 10-year yield is 3.12% and up from 1.51% when the year began, it is still below the historical average and back to the levels it was at the end of 2018. As equity and fixed income markets continue to re-price for this environment, continue to expect this high volatility and lack of conviction in the markets.
Week in Review:
Markets experienced yet another volatile session last Monday to open the week. Headlines were slower Monday with the lack of earnings before the bell, but yields were in focus after the 10-year Treasury yield hit 3.0% for the first time since 2018, a phycological level with no significance. Technicals in the market continue to deteriorate with stocks and bonds making new lows. Stocks drifted lower through the day but in the last hour of trading saw a sharp reversal. After being down as much as 1.7% at 3:00, the NASDAQ reversed course and all within the last hour was able to close higher by 1.63%.
After the late day rally on Monday, stocks opened relatively flat on Tuesday. Headlines were quiet as the FOMC meeting began and markets wait in anticipation for the policy announcement on Wednesday. There was a bias toward value stocks again as growth underperformed. The S&P 500 gained 0.48% on the day.
Markets opened in wait and see mode Wednesday ahead of the Fed’s decision. Stocks were flattish at the open, but after the Fed’s decision to raise rates half a percentage point and particularly after Chairman Powell’s press conference, took a sharp move higher. The reason was a less hawkish message during Powell’s remarks than what Fed members were indicating leading up to the meeting, specifically, Powell said 75 basis point increases are off the table right now. In addition, the balance sheet will shrink at half the pace that was expected for the next three months before increasing to the expected pace by September. All indices rose about 3%, with the S&P 500 having its best day since May 2020, while yields moved lower with the 10-year falling to 2.92%. Although stocks were much higher, the internals were not as strong as we would typically see on a +3% day.
Investors digested much of the Fed statement and comments overnight and ended up selling in Thursday’s trading over the realization nothing has changed – the Fed is transitioning to doing everything it can to bring inflation back under control and financial conditions will continue to tighten, whether its 50 or 75 basis point increases. Separately, the Bank of England announced a 75 basis point increase in rates as it battles inflation as well. Data in the U.S. showed U.S. worker productivity saw its steepest decline since 1947 due to a decline in output and a large increase in hours worked, while costs increased at a higher pace. The selloff in U.S. stocks was broad, but mostly driven by growth sectors like consumer discretionary and information technology, which fell 5.8% and 4.9% respectively, while defensive sectors such as utilities and consumer staples held up better, falling just 1.07% and 1.89%, respectively. The NASDAQ lost 4.99% while the S&P 500 was down 3.56% as the 10-year yield rose back over 3% to 3.04%.
Another headline producing event Friday morning was the release of the Department of Labor’s April employment report. Data showed 428,000 job gains in the month, bringing the total unemployed to 5.7 million and right around pre-pandemic levels, and a 5.5% year-over-year increase in wages, both near expectations. In fact, in was a very in-line report with one of the only disappointments being a drop in the labor force. That was not enough to spark a rally though as we already know the labor market is strong and reinforced the idea the Fed will stay on path. The issue continues to be high inflation. Stocks moved lower again with the S&P 500 down 0.57%. When all was said and done, after seeing some of the sharpest daily moves since 2020, the S&P 500 declined just 0.2% for the week. However it was the fifth consecutive week of declines, a streak that hasn’t been seen since 2011. The 10-year Treasury yield rose from 2.89% to finish the week at 3.12%. Oil rose about $5/barrel to finish at $109.77/barrel as more European nations agree to a ban on Russian energy. The major indices finished the week as follows: S&P 500 -0.21%, Dow -0.24%, Russell 2000 -1.32%, NASDAQ -1.54%.
Recent Economic Data
- The PMI manufacturing index suggests manufacturing activity improved in April compared to March, as the index moved up to 59.2 from 58.8 in March. Remember a reading above 50 indicates expanding conditions. The increase was due to growth in output while lead times lengthened further with material and capacity shortages leading to sharper price increases. Firms remain upbeat about the outlook, but still have concerns about inflation and geopolitics which drove the expectations on the outlook to the lowest level in six months.
- The ISM manufacturing index was 55.4, down from 57.1 in March and the lowest level since coming out of the recession. There was a lot of comments on labor – “Progress slowed in solving labor shortage problems at all tiers of the supply chain,” with a higher rate of quits compared to prior months. Supply chain and pricing issues continue to be the main concern. Demand expanded, but at a lower rate than last month.
- Construction spending rose 0.1% in March, below the expected 0.8% increase. March spend was 1.7% higher than a year ago. Spending on private construction rose 0.2%, with spending on residential up 1.0% but spending on nonresidential down 1.2%. Spending on public construction was down 0.2%.
- The number of job openings and number of people quitting their jobs rose to the highest rate in the data series for March. There were 11.5 million job openings on the last day of March, rising slightly from February. Separations edged higher as well, with quits reaching 4.5 million for a new record high, reflecting American’s willingness and ability to leave previous jobs for a better paying job.
- The U.S. trade deficit surged in March to another record high level of $109.8 billion, crushing the previous record of $89.8 billion in February. The increase was due to imports rising 10.3% to $351.5 billion, while exports rose a lesser 5.6% to $241.7 billion in the month. The wider deficit is a drag on U.S. GDP where net exports (exports minus imports) is an input. Through the first quarter of 2022, the deficit is 42% larger than the same period a year ago.
- There were 200,000 jobless claims in the week ended April 30, up 19k from the week prior, with the four-week average at 188,000. Continuing claims was 1.384 million, an all-time low, with the four-week average at 1.417 million, also an all-time low.
- U.S. worker productivity decreased at an annual rate of 7.5% in the first quarter of 2022 for the largest quarterly decline since 1947. The large decline was due to a 2.4% drop in output combined with a 5.5% increase in hours worked. At the same time, unit labor costs increased 11.6% due to a 3.2% increase in compensation and the 7.5% decline in productivity. Productivity is 0.6% lower from a year ago, but is 2.6% above the level before the pandemic. The measure of worker productivity can be volatile from quarter to quarter and it will take some time to tell how the trend has changed due to Covid, but early data suggests that growth potential of the economy is weaker than it was pre-Covid. Recall productivity is a major driver of longer-term economic growth.
- Employment in the U.S. increased by 428,000 in April, slightly ahead of the 400,000 consensus estimate, while the headline unemployment rate remained at 3.6%. The number of unemployed fell slightly to 5.94 million and is near the pre-pandemic levels of 5.7 million. The size of the labor force fell about 400k in the month, after several months of improving, bringing the labor force participation rate to 62.2% from 62.4% and still 1.2% below pre-pandemic levels. Job gains was widespread with the Covid sensitive sectors like leisure and hospitality, and transportation and warehousing continuing to see the most job gains. The U-6 unemployment rate, which is a more broad and accurate measure of unemployment as it includes discouraged workers, those “marginally attached,” and those working part-time, was 7.0%. The number of hours worked increased 0.4% to a new high and moving above pre-Covid levels. Finally, average hourly earnings rose 0.3% in April, and is 5.5% higher than a year ago. However, real wages, adjusted for inflation, are down 3.0% from a year ago.
- Data storage and hard disk drive manufacturer Western Digital moved higher last week after activist investor Elliott Management disclosed a 6% stake, or approximately $1 billion, in the company and called for it to separate its hard disk drive business from its NAND flash memory business. Elliott Management says the company has underperformed “as a direct result of the challenges of operating two vastly different businesses.”
- Uber became the latest company to address a hiring slowdown in its business. In an emailed letter to its staff, Uber said it would treat hiring as a privilege and be deliberate on adding headcount as the economic situation going forward will “require a different approach.” The company also said it would cut spending on marketing and incentives and focus on achieving profitability on a free cash flow basis.
Did You Know…?
Readily Available Cash:
Between 2019 and 2021 Americans built a larger financial buffer, mainly because of the billions in stimulus, but also due to the decline in spending and increase in savings as many things were closed due to COVID. According to the Federal Reserve, American households had an extra $4.2 trillion of readily available cash at the end of 2021 compared to the end of 2019. Savings increased 39%, or from $10.6 trillion to $14.7 trillion. The largest portion of the increase was in checking deposits and physical cash, which increased to $3.9 trillion from $1 trillion, while the remainder of the increase was from time deposits and short-term investments. In addition, about two-thirds of the increase was accumulated by the highest 20% earnings, and 28% by the top 1%.
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The Week Ahead
After two weeks of a heavy calendar between earnings reports, economic data, and other events, the calendar begins to slow down this week. We are past the peak in first quarter earnings report, but there is still a large portion of the S&P 500 left to report. Highlights this week include AMC Entertainment, Palantir, Simon Property Group, Tyson Foods on Monday, Coinbase, Electronic Arts, Occidental Petroleum on Tuesday, Disney, Rivian Automotive, Toyota on Wednesday, US Foods on Thursday, and Honda on Friday. The highlight on the economic calendar is the inflation report on Wednesday where economists estimate a 0.2% monthly (8.1% year-over-year) increase in prices, after surging 1.2% in March. The lower pace will be driven by energy prices leveling out after surging in the first quarter. Also on the calendar is jobless claims and the producer price index Thursday, followed by import and export prices and consumer sentiment on Friday. Elsewhere, as usual after a FOMC meeting, there will be many Fed members speaking publicly this week. It is also the time of year for many Investor Days, annual shareholder meetings, along with several conferences, including an EV conference – FT Future of the Car Summit.