'Good news,' 'Bad news' and 'Not news'
A better back-half looms for equity investors. Getting there could be rocky.
Well, we are six weeks into 2022 and already many of us are wishing it were over, or at least that we were in the back half when we suspect most of the bad news out there will be behind us and markets can resume their march toward our increasingly ambitious-sounding year-end target of 5,300 on the S&P 500. So, perhaps now is a good time to review where we are and where we could be heading by going through the news.
First, the “Not news”
Several important market-moving forces already have been heavily highlighted and, in our view, can now be added to the “not news” category:
- Inflation is running higher than most expected. Last week’s prints once again came in above expectations, with core numbers running at 7%+ year-over-year. This week’s PPI results were no better. Importantly, what started as a commodity price surge has broadened to supermarket bills, gas tank refills, housing rents and rising wages.
- Earnings are coming in strong, though guidance around margins has been softer. Several companies from JPMorgan early on to Coca-Cola, McDonald’s and Honeywell indicated that while earnings are solid, cost pressures are rising and in the near term cannot be fully offset with price increases. The best numbers coming in have tended to be in the commodity sectors and especially in energy, where operating costs are relatively fixed and margins expand dramatically with higher commodity prices.
- The Fed is behind the eight ball and is playing catch-up. Last December, the consensus for 2022 was barely two rate hikes; we are now at six and climbing. Everyone, including the Fed, is acknowledging short rates need to rise to take some steam out of the booming economy and try to get the genie of inflation expectations back inside the bottle. When St. Louis Fed President James Bullard last week first suggested a 50 basis-point hike in March, markets plummeted. This Monday, the voting member of the policy committee reiterated his idea and stocks stumbled but didn’t collapse, a sign markets have begun to pencil this in for March.
- The discount rate on risk assets is rising from historic lows. That means the multiples on forward earnings and cash flows of equity assets is declining from historic highs. The pain has been most felt in the longest of duration financial assets, tech companies with no earnings that previously were being valued on multiples of revenues. Investment strategists who have focused on this segment of the marketplace have seen their funds and ETFs fall 50% or more in today’s new valuation-sensitive market. Other financial assets that we’ve long included in the list of potential “bubble assets” (Bitcoin, SPACs, meme stocks) are similarly down 50%+. The broader stock market also has dropped 9% or so from its December peak, and within the market, common indexes of growth stocks are down more, 12% to 15%.
- Volatility is back with a vengeance. The so-called fear gauge, the VIX, has nearly doubled and the bond market’s companion measure of volatility, the MOVE index, has doubled from mid-2021 lows.
- Russia is on the verge of invading Ukraine. This has pushed the price of oil above $90 and climbing. We’re treated daily to the latest on the Ukraine-Russia feud, but with the tank unfriendly spring thaw just a few weeks away and 130,000 Russian troops deployed all along Ukraine’s northern, eastern and southern borders, the markets are primed for an imminent invasion. Oil has spiked on this news.
- Spreads have widened modestly, mostly in the weakest, high-yield areas of the market. Even so, the widening is still well within the range of a normal price pullback, with the high yield markets down 5 to 7%. Concern, but no real panic yet.
This “Not news” list is important because while their headlines drive the day-to-day news cycle, it’s fair to assume much of this already is incorporated into the current values being assigned to financial assets. That’s why the news that’s coming, both good and bad, is what really matters.
Ever the optimist, I prefer if you don’t mind, heading first to the “bad news.” That will allow me to end on a happier note.
The “Bad news”
The “bad news” is that all the above will, in our view, likely trend worse in the months ahead:
- Inflation looks sticky to us. We have oil, the first-order culprit, heading higher near term, into the $120s, with or without the Ukraine problem. The current global supply backdrop is still driven by exploration and drilling decisions made three to five years ago when “oil” was a dirty word with investors, government, and yes, even shareholders and management teams. This can’t be fixed nearly as quickly amid rising global demand as the two-year- long Covid epidemic finally comes to an end. Future rent increases are almost built in given the sharp run-up in underlying real estate prices, and labor remains in very short supply, promoting further wage gains. So, though we believe inflationary pressures have peaked, we still have them running at closer to 4% in the back half of 2022 and 3% next year.
- Earnings, we'd guess, could come in soft in Q1 before strengthening in the back half. The peak of cost pressures is being felt now, and much of the quarter has been impacted as well by the negative effects of the omicron wave. Supply chain issues are still problematic. So, we are not looking toward earnings to “save us” as we head into spring.
- The Fed is so far behind, it really can’t afford to turn dovish anytime soon. Chair Powell’s Fed realizes it has made an historic mistake, which was to assume the artificial Covid recession was even remotely similar to the financial crisis-induced Great Recession of 2008-2009. This assumption led to the decision to continue to stimulate well beyond the crisis point in the economy. With the overly stimulative fiscal policies coming out of the new Congress, we suddenly have runaway inflation and the Fed in retreat. Knowing this now, the Fed probably is anxious to correct its error as swiftly as the markets will let it. So, as the markets adjust to the notion of one or more 50 basis-point hikes this spring, the Fed likely will follow this lead and maybe even suggest more. That means the near-term outlook is probably for Fed hike expectations to continue to ratchet higher.
- Look for the 10-year Treasury yield to rise further, perhaps to 2.5%. This will continue to pressure multiples on long-duration financial assets, i.e., growth stocks. And in bubble land, remember that the tech bubble burst in 2000 didn’t end till some of the most flagrant bubble assets had declined a full 90% from their peaks.
- All the above probably causes a final spike higher in volatility. Although we don’t see, even remotely, a financial crisis of the kind that caused the VIX to hit the 70s in March of 2020, a further rise into the low 40s could be in the cards.
- And all of THAT could drive credit spreads higher, too. While the yield gap between comparable-maturity corporate and government bonds has been relatively well behaved, rising concerns about negative wealth effects and the economic outlook are likely to pressure credit spreads higher, even if a spread blowout seems unlikely.
Adding everything up, our view at Federated Hermes is that while a lot of bad news has already been priced in, there is clearly potential for another down leg as most of the news incrementally gets even worse. For this reason, our PRISM® committee several days ago took another 10% out of our equity overweight in our asset-allocation models on the rally back to 4,600 on the S&P. We put those funds into cash, raising the latter position to 5%. Our hope is we can redeploy should the present market correction extend toward the 15-20% level, which we think is likely. Please note that while we have scaled back our equity overweight, we are still recommending an overweight. That’s because of…
The “Good news”
Now, for the “good news.” Though the near-term outlook is darkening, we already are well into the present correction and importantly, by the back half of the year, the outlook should brighten considerably. Here’s a few of the good news stories we think we will be printing by midyear:
- Due to the interplay between the Fed and the asset markets, forthcoming policy hikes should take some steam out of consumer demand, helping diminish inflationary pressures. The more the market corrects, and the more real estate markets soften, the greater the negative wealth effect should soften demand. This self-correcting force is one reason not to get too bearish; the lower stocks go near term, the more the price action helps the Fed stick the soft landing it is aiming for.
- If it comes, the Ukraine invasion should end quickly, and its impact on oil markets should subside. I know this is a bold assessment with 130,000 Russian troops on Ukraine’s borders. But given the importance of Russian oil and gas to Germany’s economy, and the importance to Russia’s economy of its exports to Germany, it seems likely that even with a possible Russian occupation of some sort, some accommodation between Russia and the West will be forthcoming. It is in neither party’s interest not to seek one.
- Economic and financial system fundamentals are as solid as they’ve ever been heading into a soft patch. Consumer balance sheets are flush with cash and consumer debt levels remain low. Ditto the corporate sector. And most importantly, the banking system is, if anything, under-levered and over-capitalized. These kinds of rock-solid fundamentals make it very difficult for a stock market correction, even one of 20%, to unravel the economy—the transmission mechanisms are simply not there. And similarly, with bond yields so crazily low, remember that even 250 basis points of hikes only gets the short rate to … 250 basis points. Over the long run, it’s hard to see rates at such historically low levels seriously damaging the underlying economy.
- Margins should recover with a lag in back half of the year. In all inflationary cycles, it is very common for margins to initially get squeezed as costs rise unexpectedly and companies’ reaction to them takes time to unfold. For one thing, many products and services are priced under longer-term contracts, which only gradually come up for renewal. For another, companies typically will hold the powder till they’re sure the new price levels are going to stick. And remember, margin guidance at this stage is very public and can negatively impact the very sensitive price and wage negotiations underway with customers, suppliers and workers. All said, by the back half of the year, markets should be buoyed by rising indications that the worst of the margin pressure is over and the earnings outlook is solid.
- Inflation, though high, should begin to fade. Readers of this space know we’ve been inflation bears for over a year now. But now that markets and the Fed finally have woken up to the idea that inflation is hardly as transitory as they’d thought, our guess is the worst may be over. As noted earlier, most of the near-term risks cited above will themselves soften economic demand, helping with inflation. Supply chain problems should gradually ease, and already may have peaked. Capacity increases that last year began to be put in place throughout the global economy finally will start coming through.
- The risk of further fiscal overspend will be seen by markets as increasingly in the rearview mirror. As the midterm elections loom, and with voter angst about inflation coming through in every poll, the likelihood of a Republican sweep in the fall should rise. With that, the odds of yet another multi-trillion-dollar spending bill, fueling yet more unneeded consumer demand, will fade to zero. Good riddance.
- Buying power in the market has remained strong throughout the sell-off. Incredibly, even with the long list of near-term negatives, buyers continue to enter the market with every incremental pullback. We see this as very positive news, restraining the speed of the drawdown and keeping investors relatively calm. Although our guess is this latent buying optimism itself makes a final climactic drawdown almost necessary, the market’s present buyers effectively are conducting a rear-guard action, allowing the broader indexes to retreat in an orderly fashion toward a more sustainable valuation and technical base. That’s a very big positive that other historic corrections couldn’t always count on.
- Solid secular bulls can handle 20% corrections, and actually need them to clear the decks. As our regular readers know, we believe we are in the third great long-term secular bull market in the last 100 years. Our studies of the previous two (the 20+ year post WWII bull, and the post 1973-74 oil embargo bull that took the market up to its highs in early 2000) suggests secular bulls have experienced a dozen corrections of 20% or more and survived. It’s almost as if the bull occasionally needs this kind of price action to clear the decks of the weak hands and renew its advance.
So, though there’s a lot of bad news out there, a good hunk of it is not news at all at this point. And most of the rest, though it carries the potential to pull markets lower still, should begin to fade by midyear. Our recommendation in the meantime is to strap on your seatbelt, hold a little extra cash aside and prepare to add back to equities should the correction extend. There’s good news coming, just over the next hill or two. Hang in there.