There's no place like home There's no place like home http://www.federatedinvestors.com/texPool/static/images/texpool/texpool-logo-amp.png http://www.federatedinvestors.com/texPool/daf\images\insights\article\road-yellow-brick-small.jpg November 8 2022 September 23 2022

There's no place like home

Investors seeking shelter from stormy markets.

Published September 23 2022

Poor Dorothy. Back in the epic 1939 movie “The Wizard of Oz,” she had a lot of stress in her dream. All she wanted to do was go home. The massive millennial generation can relate. The run-up in home prices to record highs, still rising mortgage rates that already have doubled this year and a dearth of supply are putting homebuying out of reach (more below). Housing affordability is stuck near all-time lows. Residential building activity has plunged. A lack of supplies, developable land and in some cases, workers are making it difficult for homebuilders to complete projects. This isn’t good for record-high rents (or inflation), either. At this writing, the S&P 500 is revisiting its mid-June 3,666 low and the 10-year Treasury yield is at a 12-year high. Now investors believe the Fed’s hawkishness. Piper Sandler’s proprietary gauge of global short rates has surged to a new cycle high, suggesting further macro weakening into 2023. In financial markets, every major asset class (outside of cash) is being challenged, with sentiment and positioning at bearish extremes and the major averages at bottom-defining support. There’s little evidence yet of exhaustion or imminent bullish risk reversal. Supply may be one reason. Investors pumped $4.2 trillion into equities over the last few years. They only started cutting back in Q2 and have taken $32 billion out of equity funds over the last five weeks.

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Still, the global allocation to stocks is at an all-time low, according to Bank of America’s weekly fund manager survey, with the U.S. a big overweight relative to Europe and the rest of the world. Indeed, Europe is a mess. The energy crisis is certain to intensify as winter settles in. The situation is creating policy schizophrenia, with countries such as Germany and the U.K. cutting taxes and offering energy subsidies to consumers even as their central banks enact outsized policy rate increases. In the U.S., markets are running from inflation worries back to global recession worries. The Fed is now projecting the jobless rate to rise seven-tenths of a point next year, an increase historically associated with recession. A string of declining Conference Board leading indicators, which fell a seventh straight month in August, are sounding recession warnings, too. U.S. recessions on average see -20% EPS declines, though declines tend to be less in recessions amid high inflation (-11% in ’70s). A silver lining? With wages climbing at their fastest rate since the ’70s and labor representing 40% of S&P expenses, margins are being pressured and forward earnings have been trending down. This is likely to continue, a potential catalyst for further market declines. The second year of a presidency historically is the weakest of the four and this year fits that pattern, with the S&P down 24% year-to-date. The good news is that, since 1942, stocks have risen an average 31% a year out from the midterm-year bottom and have not declined in the 12 months following midterm elections. However, Strategas Research shares high-inflation midterm years in ’74 and ’78 cut rallies short. Hmm.

Things may not be as bad as they seem. Even before the Fed meeting, September’s Michigan survey showed expected inflation 12 months and five years out at mid-2021 lows and in line with historical ranges. Deflating Treasury yields by inflation expectations, which Powell indicated is his preferred method for measuring real yields, would put real yields around a positive 1% across the curve, a clear sign policy already is restrictive. Surging U.S. bond yields arguably indicate a lot of this newfound Fed hawkishness is priced in, and there are signs markets are starting to sniff out positives. The copper/gold ratio, which troughed in mid-July has been rising since. Historically its movement aligns with forward macro conditions. Elsewhere, Citi’s G10 economic surprise index has turned up, JP Morgan says the percentage of countries that have significantly downgraded growth has fallen by half from a month ago and this morning’s flash manufacturing PMI (more below) surprised. Yardeni Group also says the pace of worsening EPS forward estimates has slowed. All less bad.  Dorothy eventually woke up in a shack, but her stress was gone because she was home. Sadly, the ruby slippers were gone with the dream. Since I was 12, I have felt I could rock those shoes, for sure in a black cocktail dress. Wonder where I can get a pair? Jimmy Choos?

Positives

  • Less bad The S&P Global flash manufacturing PMI advanced in September, with a reading indicative of solid growth in Q3. The service PMI rebounded, as well, as did the composite of the two.
  • Consumer still strong Real income growth typically is the main driver of real spending growth, and there are many reasons, from continued job gains to cost-of-living agreements on government transfer programs, to expect real income growth to be fairly strong through next year. Goldman Sachs is forecasting 3.5% real income growth in 2023 on a Q4/Q4 basis, with all income quintiles improving.
  • Confidence on sale That’s the conclusion from Leuthold Group, citing as evidence consumer sentiment near record lows, small business attitudes at recession-like levels and more CEOs than ever suspecting the U.S. is either in, or soon will be in, a recession. Could make for a nice trend reversal in this range-bound market.

Negatives

  • Housing’s in recession Particularly the single-family market, where August existing sales fell a seventh straight month, a rise in housing starts was all due to condos and permits dropped sharply. September builder confidence hit its lowest level since May 2020, with diminishing buyer traffic at financial crisis lows.
  • Workers still strong Initial jobless claims remain pinned to the floor, with the latest 4-week moving average at its lowest level since June. A lot was made of the Fed’s projection for the jobless rate to rise seven-tenths of a point next year but at 4.4%, the headline level would still be historically in line with a growing economy. A labor market that remains stubbornly tight leaves the Fed with a big inflation fight.
  • Disinflation? Costco and FedEx are warning of disinflation, the latest Manheim Used Car index shows used car prices falling at a 50% annualized rate and since 1948, whenever the percentage of ISM respondents reporting lower prices exceeded 10%, PPI tanked. It was 27% in August.

What else

War is inflationary With the U.S. in Cold War 2.0, a new framework is needed for most investors (the vast majority of whom weren’t in the markets when the Berlin Wall fell in 1989), Strategas says. Deglobalization has implications for inflation, interest rates, stock P/Es and geopolitical volatility. One example: defense stocks are quietly outperforming again as tensions with Russia and China ramp up.

More signs of risk aversion After an extremely strong year, IPOs are on pace to be slower than even the Great Recession years of 2008 and 2009. M&A activity also has hit the brakes, with the current quarter shaping up to be the weakest since Q2 2020, when capital market activity was shut down.

Hopefully, this is not the tip of the iceberg The Labor Department has identified $45.6 billion in fraudulent pandemic unemployment benefits. That’s almost 10% of the total Covid relief spending across all categories.

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DISCLOSURES

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Past performance is no guarantee of future results.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

Citigroup Economic Surprise Index: A gauge that measures how regularly scheduled reports on the economy compare to the consensus of Wall Street forecasts.

Consumer Price Index (CPI): A measure of inflation at the retail level.

Diversification and asset allocation do not assure a profit nor protect against loss.

Gross Domestic Product (GDP) is a broad measure of the economy that measures the retail value of goods and services produced in a country.

Investing in IPOs involves special risks such as limited liquidity and increased volatility.

Manheim Used Vehicle Index: An independent measurement of prices based on monthly sales of used vehicles in the U.S.

Price-earnings multiples (P/E) reflect the ratio of stock prices to per-share common earnings. The lower the number, the lower the price of stocks relative to earnings.

Producer Price Index (PPI): A measure of inflation at the wholesale level.

Purchasing Managers’ Index (PMI) is an index of the prevailing direction of economic trends in the manufacturing and service sectors.

S&P 500 Index: An unmanaged capitalization-weighted index of 500 stocks designated to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Indexes are unmanaged and investments cannot be made in an index.

Stocks are subject to risks and fluctuate in value.

The Institute of Supply Management (ISM) manufacturing index is a composite, forward-looking index derived from a monthly survey of U.S. businesses.

The Conference Board's Composite Index of Leading Economic Indicators is published monthly and is used to predict the direction of the economy's movements in the months to come.

The University of Michigan Consumer Sentiment Index is a measure of consumer confidence based on a monthly telephone survey by the University of Michigan that gathers information on consumer expectations regarding the overall economy.

Yield Curve: Graph showing the comparative yields of securities in a particular class according to maturity. Securities on the long end of the yield curve have longer maturities.

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