We Remain Vigilant Bulls

Mark Luschini, Chief Investment Strategist

Among the many variables we watch to help prognosticate the general direction of the economy and stock prices, the Institute for Supply Management’s Purchasing Managers’ Index (PMI) is one of the most important.

Let me interject by saying no single data point, or collection of data, is infallible. After all, the economy is dynamic. Markets are reacting to not what we know today, but rather what the future is likely to hold. That creates a non-trivial amount of forecasting error since many things can change rapidly.

The Importance of PMI Data

Having said that, the monthly PMI readings—a large survey of U.S. manufacturers—have historically done a good job of explaining trends in the economy, corporate earnings, and that which normally follows the aforementioned trend, namely stock prices.

Specifically, the manufacturing survey is much more sensitive to shifts in business activity than its counterpart known as the Services PMI. A smaller portion of the economy than services industries (which encompass areas such as travel, leisure, health care, professional businesses, and utilities), manufacturing represents less than 15% of GDP. It tends to be very cyclical and more responsive to economic ebbs and flows. The survey itself seeks to quantify growth trends in business activity and its monthly release makes the report’s delivery very timely.

Some of the questions asked of corporate purchasing managers pertain to the company’s new orders, hiring plans, supply-chain efficiency, and employment conditions. When one compares these reports month-over- month over a long time, a pattern often emerges. What makes that pattern appealing for forecasting efficacy is that by advancing the data a quarter or two, its high correlation with earnings and the stock market tends to provide a roadmap for their direction. Once again, not precise to the right of the decimal, but a reasonable guide.

What does the ISM manufacturing PMI tell us today? It has clearly passed the point of having accelerated from the pandemic-induced recession to a peak that likely occurred about a year ago. The most recent report has slipped to a level that while still indicative of an economic expansion, does reflect a loss of momentum in factory activity. However, it is not consistent with readings we would expect to see if we were in, or nearing, a recession. Of course, we knew earnings growth was likely to be lower this year when compared with 2021 and the economy was unlikely to match the rapid pace of growth posted last year.

Dealing with the Challenges

Indeed, that is the reason our forecast for the performance of the stock market was more pedestrian this year. To start this year, equities have experienced a deep correction. Drawdowns in the stock market occur from time to time even in a non-recessionary environment. The avoidance of a recession over the next year typically suggests investors could do well not to abandon their commitment to equities, thoughtfully allocated to stocks in proportion to a prudent risk budget.

The same PMI can lend a playbook for sectoral allocations as well. We have been advocating investors consider a balance between those areas benefitting from the ubiquitous commodity shortages, such as Energy and Materials. In addition, we have favored high-quality, defensive growth stocks in industries such as Health Care, Technology, and Utilities.

The stock market is likely to remain volatile and challenging, but the data that helps to inform our view as to what lies ahead suggests the outlook favors cautious optimism. To repeat a refrain from a previous issue of this publication, investors should maintain equity exposure in a diversified and balanced portfolio. We will closely monitor the ISM and other variables for a warning that warrants adopting a different stance. Stay tuned.

A Turn Towards Slowing

Guy LeBas, Chief Fixed Income Strategist

Inflation has been, far and away, the most concerning element of the economy for the fixed income markets. From late 2021 into 2022, the (historically boring) monthly Consumer Price Index release has taken on greater attention than the (historically volatile) monthly manufacturing index and jobs releases. That shift in attention seems only natural when inflation data have been on an unusual path. However, last month brought with it a notable shift in the underlying concern of elevated inflation to that of risks to downside economic growth.

Within the fixed income markets, there are a handful of concerning signals that now point to a high probability of a slowdown in late 2022/early 2023. A simple model of two major signals suggests a 39% probability of recession in the next 12 months, although in our view a recession would likely be modest. It’s also worth noting that this simplistic model does issue false positives, particularly in the wake of recent recessions.

Signal 1: Short-Term Interest Rates

Pricing in the short-term interest rate (STIR) market provides the best evidence of market expectations for economic activity in the short term. While there are a range of traded STIR instruments, from Fed funds futures to overnight index swaps (OIS), the important thing to know about these instruments is that they essentially trade based on expectations for where overnight interest rates will be in the future. As such, we can use prices from these markets to understand what sophisticated investors think the Fed will do, and we know that the Fed will react to economic data, which in turn means these markets price economic expectations.

Chart 1: Pricing in STIR Markets Plus 6m Widening in HY Spreads Imply39% Chance of Recession in Next 12mths, Highest Since 2020

Not surprisingly, STIR markets are pricing in a bunch of rate hikes in the near future. More specifically, as of May 31, the modal outcome is for a 0.50% rate hike in each of June and July, plus a roughly even chance of 0.25% and 0.50% in each of September and November. That pricing largely echoes Fed officials’ comments about how they want to fight inflation, but it is after that point in which pricing has changed recently. Markets are now pricing a roughly 50% chance of a Fed rate cut in mid-2023. And when does the Fed cut rates? When economic growth is slowing, or the economy is contracting. In other words, the most notable change in STIR pricing has nothing to do with inflation, but rather with the chances of slowing growth or contraction in 2023. If that STIR inversion deepens and becomes evident in Treasury yield curve spreads as well, it could represent a significant downshift in economic expectations.

Signal 2: High-Yield Bond Spreads

Performance in credit markets is also concerning for future economic growth. Our position on investment-grade bonds and, for those with an appropriate risk budget, high-yield corporate bonds has been generally positive in 2022 based on strong fundamentals. Many measures of corporate leverage, for example, are near their all-time best. However, that has not kept holders of credit from growing skittish and selling.

On a rolling six-month basis, high-yield spreads have widened +1.72%. While it is hardly the only metric to use, historically, high-yield spread widening of this magnitude correlates with a 17% chance of recession in the next 12 months. On its own, that number should not sound too threatening, but does represent about 80% higher probability of recession than in “normal” times and a material increase from last month’s reading.

Summary

Although it is far from certain at this juncture, two major fixed income market indicators are pointing to a higher probability of slowing economic growth in late 2022 into 2023. More concretely, pricing in the short-term interest rate markets and in the high-yield credit markets suggest a higher-than-average chance of recession in the coming 12 months. The good news is that, to the extent any slowdown or recession is engineered by the Fed’s efforts to ease the recent spurt of inflation, it should bring some positive along with it too.

Summertime And The Livin’ Is Expensive

Gregory M. Drahuschak, Market Strategist

Last month’s contribution to Investment Perspectives ended by suggesting that technical issues could weigh on the market and necessitate an additional move lower before establishing a base for a solid rebound.

A move lower through most of May accompanied recession or bear market concerns that dominated the financial press. At one point in May, the S&P 500 year-to-date was down more than 19% with only 1932, 1940, and 1970 having worse starts to a year. As a result, sentiment expressed by the American Association of Individual Investors (AAII) survey had a significantly negative bias. Although extremely negative sentiment often marks a positive turn in market fortunes, it was not enough to influence the market until it combined with a significantly oversold technical condition to produce a late-month selling reprieve that by May 27 brought the S&P 500 to a modest gain for the month.

When Drama Ensues

It is important to remember that sentiment can shift quickly and dramatically, as it did two years ago.

Depressed sentiment was present in March 2020. After setting a new high on February 19, 2020, the S&P 500 was in a bear market 22 days later before eventually bottoming on March 23, 35.4% below its all-time intraday high. Five months later, however, it had recovered its entire loss. Succumbing to the notion that a bear market and an enduringly bad economy are synonymous was costly. By January 4, 2022, the S&P 500 was 42% above its February 19, 2020, high.

If the S&P 500 dips into a classic bear status (20% or more below the recent closing high at 4,796.56), we doubt it will be sustained. The negative 1.5% print in the estimate of first-quarter GDP renewed worry that a recession might be on the horizon. A record U.S. trade deficit, less government spending, and a decline in inventory levels conspired to produce the negative number, but consumer spending and business investment were strong in the first quarter. The Atlanta Federal Reserve’s GDPNow, which is a running estimate of real GDP growth, pointed to a rebound in second-quarter GDP to a positive 1.8%. The Congressional Budget Office estimated that real GDP will grow 3.1% this year.

Inflation Still a Concern

Inflation at 40-year highs is likely to continue to be one of the market’s biggest concerns. In mid-May, 85% of the S&P 500 companies that at that time had conducted earnings calls for the first quarter cited “inflation” during the call. According to FactSet, this was the highest percentage of S&P 500 companies citing “inflation” on earnings calls since at least 2010.

Earnings continued to be a positive, but companies that reported a positive earnings surprise on average had a negative reaction in their stock.

Table 1: S&P 500 Percentage Changes

Summer months usually are quiet, but in the 72 years of 1950 through 2021, the S&P 500 has ended higher 40, 43, and 41 times, respectively, in June, July, and August. In 2017 through last year, the S&P 500 posted a monthly loss only in August 2019.

As May ended, the market seemed to be comfortable with comments from the most recent Federal Open Market Committee meeting that pointed toward 50-basis-point rate hikes in June and July with a potential pause afterwards.

Of all the many factors that might sway the market, technical conditions again might be the most important as the late-May rally took the S&P 500 to the lower end of a range of resistance.

Continued negative sentiment and oversold conditions might be enough to give the market an additional boost in June. A break on volume below the mid-May S&P 500 low (3,810.32), however, would prompt concern about a potentially deeper decline. 

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