“The market is a pendulum that forever swings between unsustainable optimism and unjustified pessimism.” – Benjamin Graham
March was quite the interesting month for investors. After a poor start to the year in January and February, the equity markets posted positive gains for the month, with the emerging markets the lone exception. The bond index, on the other hand, continued its downtrend as interest rates continued to rise. The dollar and commodities both posted strong, positive gains for the month.
All data as of 04/01/2022, Source: Wells Fargo Investment Institute. [Wells Fargo Investment Institute, Inc. is a registered investment advisor and wholly-owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.]
Breaking from our usual format, instead of starting with a look at the stock market this month we wanted to begin with a discussion of the current economic landscape, as we see it. Understanding that we cannot predict what will happen in the next few months, let alone the rest of the year, we think it is important to look at what issues the markets are facing as we enter the second quarter of the year. Hopefully, we can give you an understanding of what we are looking at as we make investment decisions for our clients.
The Big Picture
There are three ways to think about the economy. First is what we experience in our day-to-day life. This point of view differs from person to person and very much depends on what is going on in your life. Next is the mainstream viewpoint, which you can see or read about in the traditional news. Finally, there is the stock market’s understanding of the economy.
We think it’s important to understand that the mainstream view does not necessarily line up with how the stock market sees things. Right now, this distinction is best summarized by Joe Duarte at Stockcharts.com:
Mainstream View of Current Situation in the Economy
- Runaway inflation is the central influence
- The Federal Reserve will raise interest rates aggressively until 2024
- The Economy will tank
- The stock market will crash
The Stock Market’s View
- Inflation is a thing to consider, but not the only thing
- The Fed won’t be able to raise rates too many times
- The Fed will be lowering rates in a hurry before too long
- The market moves the economy and lower rates lead to higher stock price
Interesting dichotomy of thought, amiright?
Neither of these points of view, in our opinion, is exactly correct. There are so many unknowns at this time that it is impossible to really have a firm grasp on the economic implications over the coming 6 – 12 months. Energy costs are a great example.
Usually, the cure for higher prices is higher prices. Said another way, high oil prices would lead to more production to meet the demand and make money at the higher prices. The rebalancing of supply/demand – which could lead to overproduction – would lead to lower prices. We are not, however, in normal times.
The Dallas Fed Energy Survey is telling us is that the production increases might not happen. Why?
- A plurality (41%) of executives think WTI in the $80-99 range would get US producers “back into growth mode.”
- Some think $100+ oil prices would generate new growth, but 29% think price doesn’t matter.
- Over half (59%) believe investor pressure to maintain “capital discipline” is the primary reason producers are restraining growth despite high oil prices.
Put in simple terms, the cost to produce a profitable barrel of oil in the United States is $56, oil is currently around $100, and new substantial new production isn’t happening. This suggests the normal supply/demand dynamic isn’t happening this time around.
Add to the oil production/energy cost issues the supply chain disruptions and uncertainty associated with the Russia-Ukraine war. Or the supply chain issues from Covid that are still occurring in China and other global manufacturing hubs.
Hard to come to any firm conclusions about where the world is heading with that as the background.
Clearly there is a lot going on in the world as well as the financial markets. The situation is fluid, with no obvious direction. Things can, and probably will, change in unexpected ways in the coming months and years. Having a set point of view seems to be the wrong approach. Moving forward, there are four main areas we will continue to look at in the coming months and years to inform our investment decisions:
War between Russia and Ukraine: Now in its second month, no resolution to the conflict seems apparent at this time. Acknowledging the horror of what is happening on the ground, the effects on the global economy are just starting. We agree with Blackrock’s Larr Fink that this conflict has put an end to globalization as we know it. A reformulation of the global economic structure away from the current, more globalized system, to something more regionalized is now underway. There will be winners and losers – companies, sectors, countries. Looking back in 5 or 10 years what happens will probably seem pretty obvious. In real time it is important to get an unfiltered understanding of what is actually happening.
Covid-19: While the pandemic stage is optimistically behind us, the effects of covid-19 are not. People are still getting sick, albeit at much lower rates, and people are still dying. There is a new variant floating around both Europe and the United States. While our hope is that the pandemic has turned into an endemic, continuing to monitor the situation is important. An uptick in new cases could have negative consequences on the economy as well as the markets.
Inflation: When most of us think of commodity inflation we think of the price of gasoline. What we need to think about is the cost of raw materials across all segments of the economy. Food prices are up in part because fertilizer expenses have exploded, but also because the cost of labor and shipping have increased. Same can be said for other industries, including housing.
Labor and Productivity: There is a lot of focus on wage increases lately, which is certainly justifiable. What has been missing in the conversation, however, is worker productivity and that we are literally running out of workers in this country. If either the size of the workforce or the productivity of the workforce (or both) stalls out, so will economic growth.
Stock Market at an Inflection Point
If we simply look at the chart of the S&P 500 and pretend that everything else doesn’t exist, the charts are looking good … maybe not for the rest of the year, but for now. Historically, 2022 is working out very much like the typical year in many ways.
As we started at the top of this post, March was a good month for the stock market. Looking at the S&P 500 Index, we had a powerful rally off the 4150 level, around 13% off the all-time highs achieved early this year. Not a great feeling for investors.
We do need to keep in mind, however, this bull market started in March 2020 from a low of 2191 for the index. That is a heck of a two-year run. Moreover, this correction, if completed, would not only be very short lived, but also not very deep.
Is it likely that the market bottomed during the first half of March? Was the rebound the start of a new bull market leg higher or a part of a topping process for the stock market?
We believe that how the market reacts in April will tell us where the stock market is headed for the intermediate term.
Here’s why: Chart #4 is a daily chart of the S&P 500. It is a positive for the stock market that the rally from the 4150 level moved back up to the February highs of just below 4600. What we are focused in on now is how the market reacts in the coming weeks. Holding the 50-Day Moving Average would be ideal. Holding the 200-Day Moving Average would be a good sign as well. More likely, in our opinion, and maybe better for the market, would be a retest of the 4150 lows. There would be more pain in the immediate but positive moving forward.
What we are not discounting is a break below the 4150 level, given the current global environment. Charts are great at providing a filtered view of the world where the only thing that matters is supply and demand. In reality, markets are impacted by what is happening in the world. War in Europe, higher interest rates, inflation, supply chain issues, and COVID are all a part of reality.
Back to the chart. If there is a break below the February-March lows we would expect to see more downside. For the S&P 500, we would be looking at 3822 and 3518 as areas of support. Not the end of the world for investors, but not a barrel of monkeys kind of fun either.
The Bond Market
The bond market is in the middle of a major move higher for interest rates as the Federal Reserve has indicated a hawkish rate hike policy as a way to combat persistently high inflation. The 10-year Treasury, which was yielding below 1.2% just 8 months ago closed the month of March at 2.327% (Chart #5). Just as significant, the spread between the 2-year and 10-year Treasury has flattened out significantly (Chart #6). The possible impact of this situation for investors could be significant.
What is interesting about the (lack of a) yield curve today is that it implies the market believes the Fed’s policymakers will follow through with a very aggressive Fed policy. For those with cash in a check or savings account getting little, if any, interest, this could be a positive. For the general economy, however, higher rates and a flat yield curve could become problematic.
Let’s take mortgages as an example. Mortgage applications are now down 40% from a year ago, and rates on a conforming 30-year mortgage hit 5% in early April. Some see this as a positive as it should cool down the housing market (source). It also has the potential to be a negative for jobs and corporate earnings if it cools down the building of new housing. For the home buyer, the move from around 3% to 5% on a 30-year mortgage over the last 12 months would increase the payment on $200,000 loan by more than $230 per month. That’s discretionary income the home owner won’t have to spend in other parts of the economy.
March was all about the pendulum for the stock market swinging back from pessimism to optimism. April could be more of the same or reversal in thought. In our opinion, this month is looking to be very important for both the stock market and the bond market.
With the first quarter now in the books for corporations, earnings reports will start to flow in the very near future. Maybe more important than what reporting companies tell us about the first three months of the year, is what they say regarding the future. What we are interested in hearing is how businesses across the various sectors are managing through these “interesting” times. We want to hear about what issues they find problematic moving forward, the changes they are making to deal with issues that arise, as well as their thoughts on consumer behavior.
For now we remain cautiously optimistic on the markets, but could be very quick to change our opinion if the economic background changes.
On behalf of Magellan Financial we would like to thank you for taking the time out of your busy day to take in our thoughts and opinions. If you found this helpful, please forward it on to others. If you have any questions on the materials presented, would like to be added to our email list, or would like our help with your investments, we can be contacted at 610-437-5650 or via email.
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