Worst equity returns in half a century
And the storm might not be over.
The first half of the year was brutal. With the highest inflation in four decades and the Federal Reserve’s belated but aggressive reversal of uber-generous monetary policy accommodation to combat it, investors have been scrambling for cover. As a result, the S&P 500 plunged 20.6% on a price-only basis and by 20% on a total-return basis, its worst first-half performance since 1970. Benchmark 10-year Treasury yields more than doubled, from 1.5% at the start the year to an 11-year high at 3.5% a fortnight ago, before rallying back to 3.01% yesterday, as bond vigilantes are beginning to consider the growing risk of recession.
Tactical allocation changes Regrettably, we believe there’s more bad news over the next few months. So when stocks staged their third counter-trend rally over the past four months during the back half of June, we again opted to sell into strength. Domestic large-cap growth stocks surged more than 10% over the past two weeks, so this past Monday, Federated Hermes asset-allocation committee increased our underweight in this sector from 2% to 4%. We moved those funds into cash, increasing that allocation from a 3% overweight to a 5% overweight. That 8% total cash allocation is the largest we’ve had in 20 years, and our plan is to keep some dry powder available to reposition back into stocks at the appropriate time, perhaps later this year. Importantly, we maintained our 4% overweight in domestic large-cap value stocks, which outperformed growth stocks by an enormous 15.2% in this year’s first half.
What’s the problem? Nominal CPI inflation is running at a 40-year high of 8.6% in May, and given its persistent nature, it may take several years—and a possible recession—before it returns to a level at which monetary policymakers are comfortable. They completed the Fed’s bond-buying taper in March and hiked the fed funds rate by a quarter point in March, a half point in May and three-quarters of a point in June. We expect them to raise the target range by the latter amount at their July 27 policy-setting meeting.
Which brings us to the uncertain crossroads of the Fed’s annual Jackson Hole, Wyo., monetary policy symposium at the end of August. If inflation remains stubbornly high, then the Fed likely will continue to raise rates at an aggressive pace. But if inflation begins to ease, it may signal plans to downshift to half-point hikes starting at its September policy-setting meeting. Regardless, the fed funds rate could be at or above 4% by this time next year. The Fed also is beginning to passively shrink its $9 trillion balance sheet by a third over the next three years, which equates to an additional annual tightening of about 25 basis points.
Upcoming earnings season a challenge The second-quarter corporate profit season starts in two weeks, and FactSet is expecting a 4% year-over-year (y/y) increase, down from a 6.6% expected gain at the beginning of the quarter. That compares with an outsized 88% y/y gain in the second quarter of 2021, which will be the toughest earnings comparison in the pandemic recovery cycle. Management guidance for the second quarter has been running at more than a two-to-one negative pace in recent weeks, a trend we expect to accelerate during the reporting season. Comparisons will start to get easier in the second half, as third and fourth quarter growth falls to y/y gains of 39% and 27%, respectively.
Target warning To be sure, the West Coast port backlog has improved, from a record 106 ships stuck at sea at the beginning of the year to less than 20 ships at midyear. But Target, for example, has twice warned about reduced profits in the past three months, as the merchandise finally arriving in its stores was ordered a year ago. The problem is that customer preferences have shifted, and they are also pushing back on higher retail prices. The personal savings rate plummeted from nearly 27% in March 2021 to just off a 13-year low of 5.4% in May 2022, and the Michigan Consumer Sentiment Index plunged to a record low in June.
Target is aggressively cutting prices to reduce a bloated inventory, which is slowing revenue and earnings growth. Target’s profit margins are under pressure, too, due to higher commodity, transportation and labor costs. Across industries, worker productivity is at a 75-year low at -7.3% in the first quarter of this year. Rather than a one-off, we believe that Target’s experience will be the rule rather than the exception for many companies during earnings season, accompanied by cautious management guidance due to a lack of visibility. In our view, Wall Street has not yet fully grasped this reality but will in coming weeks.
Trimming EPS estimates Given our concerns, we have cut our full-year S&P EPS estimate again by $10 in 2022 to $220 (verses $209.54 in 2021, implying a 5% y/y increase). We also reduced our 2023 estimate from $250 to $230 and cut our 2024 estimate from $270 to $250. Reflecting the spike in inflation and the Fed’s hawkish policy turn, we lowered our P/E multiple expectations and cut our full-year S&P target prices to 3,900 this year and to 4,000 in 2023.
More down-side risk We believe the S&P’s 8.5% rally to 3,946 from June 17 to 28 ignores our concerns. At a minimum, we expect stocks to correct by some 11% in coming months to 3,500. But if that technical level fails to hold, we believe that the S&P could continue to decline to 3,200, which would be 19% lower than Monday’s level (and 33% below its cycle peak at 4,818 in early January). By late summer or early fall, we may receive some much-needed clarity on several of our concerns: peak inflation, peak Fed hawkishness, peak corporate profits and peak recession.
Midterm elections a positive catalyst? Stocks may trade at about 14 times forward earnings by Labor Day—down 40% from 23 times at the end of last year—at which point many investors will begin to look to the critically important midterm elections on Nov. 8. Investors love divided government, and President Biden’s plunging poll numbers suggest that the political pendulum may swing to the right in the House of Representatives.
Keep the defense on the field Because equity investors much prefer gridlock in Washington to our current fiscal policies, this confluence of events could fuel a powerful fourth-quarter rally that spills into the first half of 2023. So we continue to advise investors to hunker down, seek to preserve capital and deploy a defensive investment strategy now, with a large overweight in cash and a modest equity overweight concentrated in relatively cheaper, less risky value stocks that provide the opportunity for higher dividend yield support.