What Could Go Right?
Mark Luschini, Chief Investment Strategist
Much has been written, including in many of our publications, about the unusual degree of macroeconomic uncertainty that is serving to batter markets and render near-term prognostications futile.
The factors that are most unsettling include: inflation at a 40- year high, a Federal Reserve abruptly turning stingy, a global growth slowdown induced by the spillover from the war in Ukraine and China’s stringent “zero-tolerance” COVID
policy, and the ubiquitous rise in interest rates that is beginning to infringe on business activity. Collectively, these have served to induce volatility and pressure stock prices even as the economy, and corporate profit growth, are expected to
remain positive through the year, if not beyond.
Reasons for Some Optimism
Despite these issues, there are reasons to remain reasonably optimistic about the economy and stock market. Certainly, we are not Pollyanna, as these topics will likely remain prominent in processing our forecasts for the economy and markets for some
time to come. However, we believe it could be helpful for investors to think about what could go right. After all, by many measures, the economy is still expanding. The job market is strong, wages are percolating, and savings are abundant. Those are
usually the ingredients for personal consumption—the principal driver of U.S. economic activity, to be quite healthy.
First and foremost, we believe the U.S. could avoid a recession over the coming year. Clearly, the level of domestic activity has downshifted from last year’s remarkable pace, but it could remain at or above trend. The unemployment rate has fallen
to near historic levels and the tightness of the labor market has pushed wage gains to levels last seen a decade ago.
Households saw a sizable increase in net worth from the rise in stock prices and home values. Excess savings that were accrued during the peak of the pandemic— when many industries were closed—are not exhausted. Meanwhile, businesses express
that capital expenditure plans are in force, which will further promote a positive impulse for growth to ensue.
Headline inflation might come down. The boom in spending on capital goods, such as computer equipment, clothing, furnishings, and accessories, is fading and with it the spike in inflation that came as a result. While shelter and services inflation (occurring
in travel, restaurants, other leisure activities) are high and rising, they are unlikely to reach the double-digit levels of capital goods inflation. Consequently, as goods inflation recedes toward its long-term trend near zero, overall inflation
will subside. That is not to say inflation will be eradicated. Rather, it could gradually fall from recent highs, perhaps beginning as soon as in the next several months. This could, in turn, allow the Federal Reserve to address the tightening of
monetary policy in a more deliberate and less-aggressive fashion. Market participants would likely welcome the relief of monetary policy that is not so restrictive it thwarts economic growth.
Other Positive Signs
What else could go right? The war in Ukraine might reach a negotiated settlement that relieves the geopolitical uncertainty that would accompany further dislocations or outright escalation in the conflict.
Regarding China, the adoption of more efficacious treatments of the COVID outbreak and/or the application of less-stringent lockdowns associated with it, could boost activity.
In addition, Chinese officials have been increasingly vocal about implementing more meaningful measures to stimulate the economy, not only to offset the impairment caused by locking down populations that represent nearly 40% of its economy, but to reflate
the economy into a steadier state in advance of the 20th National Party Congress this fall.
While interest rates have increased, they are hardly biting at today’s levels. In fact, many central banks around the world have not only withdrawn their uber-easy monetary settings, but have begun to tighten policy, which should stem rates from
moving substantially higher. If policymakers don’t cut the throttle completely, economic growth can coexist with interest rates where they are, or even modestly higher.
What does it mean for investors if some, or all, of these things go right? It should allow economic growth to remain positive for the foreseeable future and the backdrop for corporate profits to remain sound. While volatility will remain a fixture given
the unlikely retraction of all the things that could go wrong, the advance in stock prices that should follow if a couple things go right reinforces our view that investors should not be underweight stocks in a multi-asset portfolio.
Guy LeBas, Chief Fixed Income Strategist
Inflation is a perennial topic in notes focused on fixed income. No wonder: Inflation is, even in normal times, a major source of risk and return.
The topic has certainly appeared in many Investment Strategy Group reports in the past year. In the May 2021 Investment Perspectives,
we pointed out that monthly inflation had likely peaked, but inflation had a long tail that would drag out into 2022. In a November 2021 report, The Supply Chain: Major Themes for Fixed Income Investing, we clarified some of the sources of this inflation.
Now, well into 2022, it is obvious that spring 2021 was indeed the moment of most acute pressures, but the tail has been both longer and fatter than we anticipated. For fixed income investors, the biggest problem is that hedging inflation risk with conventional
tools like Treasury Inflation- Protected Securities (TIPS) is just too expensive.
Chart 1: Acute Inflation Pressures Peaked in Spring 2021, But Have Had a Very Long Tail
How TIPS Work
TIPS are notes that have a principal that adjusts for changes in inflation. The mechanism is called the “index ratio,” which starts at 1.0 and then increases based on changes in the Consumer Price Index (CPI). As a hypothetical example, imagine
2-year TIPS that have a 1% coupon and in year one, the CPI increases 4%. The total return on the notes after one year will then be about 5% (1% coupon plus 1.04x index ratio). For longer-term TIPS, however, the arithmetic becomes path dependent. Imagine
in year two that the CPI falls -2% and the note matures. An investor who purchased the note at the after year one will actually have a -1.0% return to maturity.
Table 1: TIPS Returns: A Hypothetical
Complicating matters further is that long-term TIPS have priced in an expected rate of inflation. A breakeven is the inflation rate at which the return on a TIPS is equal to the yield on a fixed-coupon Treasury of the same maturity. For example, a 10-year
TIPS has a yield at the time of authorship of -0.10%, while a 10-year coupon Treasury has a yield of 2.85%. For the return on those two to be equal, inflation would have to average about 2.95% over the next 10 years for returns to “break even.”
Economists tend to view break-evens as market forecasts of inflation, but fixed income investors should view break-evens as the cost of hedging against inflation.
Chart 2: Changes in Inflation Expectations Drive TIPS Returns More Than Actual Inflation
When To Invest in TIPS
The natural extension, if an asset owner expects 10-year inflation to be above 2.95%, they should buy TIPS, as the return at maturity will be greater than a coupon Treasury.
But, in the intermediate term, the inflation rate is rarely the primary driver of TIPS. Since 2000, changes in inflation expectations have explained 68% of the relative performance of TIPS, while actual inflation is not even a statistically significant
driver of TIPS relative returns.
TIPS have delivered. So, a better way to formulate the analysis is that investors could buy TIPS if they expect inflation expectations will increase and could avoid TIPS if the opposite. Even getting the timing of TIPS investment relative to coupon Treasuries
correct is no guarantee of positive returns. So far in 2022, with the year-over-year CPI hovering around its highest level since the 1980s, the Bloomberg U.S. TIPS index has delivered a negative total return of -4.8%. That’s a lot better than
the bond market aggregate at -8.9%, but it is hardly satisfying.
If nothing else, TIPS’ 2022 performance is perhaps the biggest example of why TIPS do a good job of hedging tomorrow’s inflation—but not today’s.
Market in May: Rates, Midterms, and the Economy
Gregory M. Drahuschak, Market Strategist
Despite its reputation as a generally good month for stocks, last month produced the second-worst April results for the S&P 500 in the past 72 years. With the 4.2% drop on the final trading day of April, the Nasdaq Composite Index was down 21.16%
for its worst start to a year on record. As usual, the market had to contend with various issues, but none was more influential than concern about how far the Federal Reserve Open Market Committee (FOMC) would go to adjust credit conditions.
Eyes on the Fed
The March 16, 2022, FOMC meeting confirmed what the market had expected when it moved the Fed fund target range up 25 basis points to 0.5%. By saying that “ongoing increases in the target range will be appropriate,” the FOMC began speculation
about how high interest rates might go and how fast they might get there. This prompted consideration of the possibility of multiple 50-basis-point rate hikes this year and maybe even a 75-basis-point increase before 2022 ends.
Rapidly rising interest rates, or the fear of them, never have coexisted well with stocks, and for most of last month they certainly did not as the S&P 500 sank back to its March lows. The market slide was further exacerbated by talk of a possible
recession. Although what appeared to be only temporary factors weighed on GDP growth, the negative 1.4% GDP drop further prompted slowdown worries.
This all led to general investment sentiment falling sharply, as the American Association of Individual Investors’ April 21 weekly survey showed the lowest percentage of bullish investors in many years. Two weeks later, the bearish percentage at
59.4% was the highest since March 2009 when the economy was in the throes of the Great Recession.
While the equity market obsessed over Federal Reserve policy, corporate earnings continued rising.
The 2022 S&P 500 earnings estimate has risen for the last 14 consecutive weeks to a record $228.17, 9.26% above the initial estimate and 41.8% above the initial estimate for 2021. Overall earnings performance, however, is held back by the fact that
the three sectors expect to produce the best year-over-year percentage earnings change together are only 14.7% of the S&P 500 total market capitalization. In contrast, the Technology sector on its own is 27.4% of the index.
The market’s performance in April underscored that relying upon seasonal patterns can be a mistake. Nonetheless, as May dawns, the “sell in May and go away” axiom undoubtedly will be resurrected. Data assembled by CFRA-Standard &
Poor’s show that the price return for the S&P 500 from November through April has recorded the highest average price change of any rolling six-month period.
Chart 3: Expected 2022 Earnings Percentage Changes
The data also show that May through October often produces a weaker equity market than the other six months of most years. The May-through-October underperformance is more pronounced during midterm election years.
Although the second and third quarters of midterm elections years on average have the poorest market performance of all quarters of the entire presidential election cycle, they have tended to set the stage for three of the best quarters of the four-year
cycle that often extends well into the first half of the pre-election year.
As May begins, however, the S&P 500 faces some technical issues that could weigh on the index. A recent break of the February 24, 2022, interim low at 4,114.65 suggested that the market might need one final move lower to provide the base for a notable
Chart 4: S&P 500 Large Cap Index, as of April 29, 2022
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