For the first time since March, the S&P rallied for four straight days through Thursday. Rally days over the past few weeks have shown a shift from funds out of energy, commodities, industrial and cyclical sectors due to recession fears. Those fund flows shifted back towards growth and the most beaten down areas. In a recessionary or no-growth world, companies that can provide any semblance of top-line revenue expansion, such as necessary software and other business products in secular bull markets (cloud expansion, artificial intelligence, data analytics), catch a bit of a bid.
Yesterday saw a slight reversal where cyclical sectors posted overly generous returns, led by energy and metal stocks. Another China stimulus plan was announced, adding a further supply/demand layer to the hard commodities equation. Industrial metals have been in tight supply for months when China was closed in various Zero-Covid locations. Now that they are re-opening and throwing cash at the economy, there is no question demand will rise in their country going forward. Aluminum, steel, copper, energy and gas stocks were the largest advancers on the day.
Not to be outdone, technology (mostly semiconductor stocks that have been suppressed this year) and consumer discretionary companies saw outsized gains as well. Defensive havens, dividend payers and slow growth sectors like Utilities, REIT’s and Consumer Staples were basically flat. In total, the S&P gained 1.5% and the Nasdaq advanced 2.3%. It was a strong action following another new low in major indices a few weeks ago. While there exists a potentially stronger summer rally, these are still bear market bounces until inflation is clearly beaten and central banks stop aggressively attacking growth.
In other relevant news this week, Fed minutes were released Wednesday afternoon but proved to be a nothing burger. While the notes released were as hawkish as they were immediately following the June meeting and a 75bps rate hike, they are also backward looking. Since then, we have seen a massive collapse in anything economically sensitive. Natural gas, cotton, soybeans, wheat, nickel, copper, corn, along with many others are down over 20% in just the past month. If inflation ingredients continue to decline, the Fed can slow their pace of rate hikes. Even home rental rates are turning around.
As always, this Fed will be data dependent. Their predictive powers are not great to begin with. Even in June, they noted “The staff continued to project that GDP growth would rebound in the 2nd quarter and remain solid over the remainder of the year.” As Jim Meyer noted, most Q2 GDP estimates are for another quarterly decline, not a rebound. This miscalculation explains why commodities, energy and anything economically sensitive has struggled since the last Fed meeting. Chair Powell and his cohorts may be setting up an overshoot on tightening. A slower economy is rapidly upon us. That’s good for inflation bears and data dependent forecasters. The data changes, so can the tightening time line. They do not necessarily need to force a recession to get inflation in check.
Quantitative tightening has only just begun (The Fed is letting bonds mature from here instead of reinvesting, therefore lowering the size of the balance sheet and reducing money supply). The 2012 QT cycle ended prematurely after leading into a manufacturing recession. The 2018 QT cycle brought a 20% equity correction and the Fed stopped early as well. Now, stocks are already down 20% before QT even started. I’ll take the under on their plan this time around too.
Intermediate and long-term rates have already come back down to ~3%, almost across the board. Currently 10- and 5-year rates are inverted. Knowing there is a lag effect to fed rate increases, they should not be in any rush to invert the yield curve with respect to Fed Funds getting above 3%. Nor should they keep pulling back liquidity if jobs and wage data reverse strongly.
A continual drop in commodities will go a long way in forcing inflation and interest rates lower. While inflation is still enemy #1, a recession is slowly creeping up the list of concerns. A clear and defined downtrend to wage gains, CPI and PCE will flip the switch from ultra-aggressive tightening to a more neutral stance. That alone could provide a relief rally on a global basis for equities.
Today’s payroll report and next Friday’s CPI will go a long way in determining how hawkish the committee will be on July 27th when they announce their next rate hike and open forum discussion. As Jim has noted, this also follows a slew of earnings reports. Certainly, a lot of data to consume before making any rash judgments.
Fed minutes showed that officials are clearly worried about inflation “expectations”. If consumers are convinced that inflation is here to stay, it becomes a self-fulfilling prophecy and hard to turn around. That is a major reason for the aggressive 75bps hikes. They needed to rebuild confidence in their ability to control this situation. Since then, it has been quite clear the strategy is working. Growth has obviously slowed. Inventories are rapidly rising. Prices for goods are dropping but services are holding up. Supply chains are still in repair-mode stemming from China Covid lockdowns, but are in much better shape than last year. The aforementioned commodities are collapsing. Wheat, corn and soybeans are back below where they were prior to the Russian invasion of Ukraine:
The last important data point this week came out this morning (after this writing). Recessions start with job losses, not gains. Certainly not job gains in the ~400k range like we have been seeing recently. Since the Fed’s dual mandate also includes full employment, all eyes will be on June’s update. Wage gains are also going to be closely watched. In effect, a bad report (less job growth and lower wages) will be good for stocks as it means we’re closer to the end of tighter monetary conditions.
The first crack has begun to show its head with the number of part-time workers starting to rise. Previous negative turns pointed to economic slowdowns. How aggressive will the Fed be if inflation and the job market are clearly worsening?
Our plan remains the same. Identify world-class operators with high free cash flows, quality balance sheets, leadership product lines and above market growth. Many are below fair value. The equal weight S&P 500 is somewhat cheap at 14x earnings. However, it will take a line of sight towards the end of this Fed tightening cycle before comfortably putting our offensive team back on the field. Patience…we’re getting closer.
Netflix’s Stranger Things fans will recognize Maya Hawke’s name as she turns 24 today and is also the daughter of Ethan Hawke and Uma Thurman. Another famous family, Will and Jada Pinkett Smith, celebrate the 24th birthday of Jaden Smith. Kevin Bacon is 64 and Wolfgang Puck is 73 today.
James Vogt, 610-260-2214