Solutions are in process for a number of the problems the market wants to see solved.
Markets have sold off precipitously since the start of 2022. Year-to-date, the S&P 500 is down 17%, and the tech-driven Nasdaq is down 26% — both at or beyond a supposed “bear market” (data from S&P Global).
In this note, we review the “whys” of the recent market decline, and where stabilization may occur.
What is driving the market?
Usually, it’s the “micro” – things like the earnings and outlook for specific companies. Less often, like today, it’s the “macro”, driven by monetary policy in flux.
In this backdrop, when we understand how these monetary policy changes affect markets it becomes much less stressful to track declining markets and our crystal ball becomes clearer.
Now, what is driving that?
We sometimes go through the “5 Whys” exercise to understand root causes, many of which tend to get overlooked in markets. For example:
- Why are markets crashing? Because 10yr bond yields rose from 1.5% to 3% in a short timeframe, leading to risk-off portfolio management.
- Why did bond yields rise? Because of a mixture of inflation expectations and thoughts around sales from the Federal Reserve bond portfolio.
- Why is inflation elevated? Excess stimulus, lack of Oil & Gas extraction investment, and war are material issues, as is a tight labor market.
Without digging into the branches of questions 4 & 5, when we look at 3) above we believe the elements stoking inflation are at very least not worsening. We have a powerful ally agreeing with us in this regard, which we will discuss shortly below.
Inflation is fizzling? A quick look at how and why:
A) Excess stimulus is over and a lot of inventory is about to go on clearance rack
This is the easiest of the “disinflationary” drivers to prove. Stimulus brought excess demand for things like appliances and stationary bikes, and rocketing inventory levels suggest this is tapped out.
Exhibit B:
“We like the fact that our inventory is up because so much of it is needed to be in stock on our side counters, but a 32% increase is higher than we want. We’ll work through most or all of the excess inventory over the next couple of quarters.” – Doug McMillion, CEO, WalMart earnings call.
While we anticipated a post-stimulus slowdown in these categories, and we expected the consumers to continue refocusing their spending away from goods and services, we didn’t anticipate the magnitude of that shift. As I mentioned earlier, this led us to carry too much inventory, particularly in bulky categories, including kitchen appliances, TVs, and outdoor furniture.“ – Brian Cornell, CEO, Target earnings call.
If only those covid consumers could have waited a bit to buy the grill and TV they might have gotten a steal later this year, but that’s America.
B) The price of crude has leveled out, and gasoline may shortly follow
Recall this market is driven first by the amount of oil available, and second by how much is being pushed through refineries. The red line suggests the amount of oil is stable. Watch the blue line as refineries are out of maintenance season
Further to the red line above, domestic oil & gas production remains extremely profitable, leading private producers to invest in production even while public producers focus on return of cash and ESG narratives:
C) War
War primarily affects the markets for rocket launchers, wheat, neon, European natural gas, and petroleum to poorer countries.
For the purposes of US markets, the primary issue is whether Russian petroleum production starts to decline due to lack of expertise and components, as we have seen Venezuela or Mexico.
This may be a factor in 2023 but right now BP, Halliburton et al are “in process of wind-down”, meaning no new equipment, meaning not much impact for maybe as much as a year. Down the road, bear in mind Russia, like its North Korean neighbor can buy an awful lot through the resale market of countries ambivalent to sanctions.
D) Tight labor market is loosening
Government data is rear-looking so we have anecdotes to forecast from, but so far 2022 looks a bit like early 2001, as the technology sector is shedding positions. This trend is early but Techcrunch shares with us the following:
Reluctantly, we’re writing a tech layoffs roundup for the third week in a row, because once again, there have been reductions across stages and sectors. Over the past month, public and private tech companies have been announcing mass layoffs. Employees from Section4, Carvana, DataRobot, Mural, Robinhood, On Deck, Thrasio, MainStreet and Netflix have been impacted by the workforce reductions. Some bigger companies are instituting hiring freezes, such as Twitter and Meta, or announcing a shift in strategy, such as Uber.
Techcrunch
A Powerful Ally
So who is the powerful ally that agrees with us?
Our ally is the best forecaster available – the bond market. Bond signals should also be picked up by certain sectors of the stock market, which could offer some relief. Bond yields have stabilized for now. If inflation were running away, bond yields should run with them.
Below is a look at what 5- and 10-year bonds yield every day so far in May:
This settling period comes after yields effectively doubled in just two months:
So far so good. But what about a recession?
Notice the 5-year yield and the 10-year yield above are about the same. This is evidence of a very “flat” curve and means the market is increasingly cautious. However, it’s hard to suggest the bond market knows with much clarity how much the economy will grow in 2023.
Yet it’s not the recession we are concerned about. The concern is the Federal Reserve will be deaf to the recession. In this regard, we are already seeing evidence of awareness, from Atlanta Fed Chairman Raphael Bostic:
Of note, Bostic echoes a number of the points in this article from his May 10 interview here: https://www.axios.com/2022/05/10/feds-bostic-supply-chains-labor
How do we apply these lessons to markets?
First, if you have been reading the deluge of negative articles or making emotional investment decisions, consider stopping that activity.
Second, if you agree there is reason to stay in markets, but are not ready to be aggressive, invest “short”. Think of stocks in terms of their “duration”. Bond investors know that bonds have duration, meaning you get payments for 5 years, 15 years etc. Long duration bonds require more faith, so are more volatile.
Stocks also have duration. For example:
- Bank of Butterfield in Bermuda pays a 5% dividend yield and repurchases stock. Butterfield is a near geyser of cash to shareholders right now. Butterfield is short duration.
- Affirm is a tech-oriented lender that hopes to become profitable under certain creative metrics at the end of 2023. Affirm is long duration, requiring faith in the stock and patience for cash flows.
In a higher rate environment, there is simply less interest in long duration. Why wait if you get paid more for your existing cash today? Buy cash coming to you, not a story that may or may not play out in 2024.
Back to Butterfield, it trades at 7x forward earnings. It is not an outlier – a number in the financial sector trade at single digit earnings multiples. Looking at Butterfield like a bond, its “earnings yield” would be 1/7 or approximately 14%. That’s not a bad return, whether the Fed Funds rates is at 1% or 2%.
Situations like this are where we are spending our time on behalf of investors and clients at jhh wealth.
Disclosure
This information should not be relied upon as investment advice, research, or a recommendation by jhh wealth, llc regarding (i) funds, (ii) the use of suitability of the model portfolios or (iii) any security in particular. Only an investor and their financial advisors know enough about their circumstances to make an investment decision.
The information presented here is not specific to any individual’s personal circumstances.
To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.