US Strategy Weekly: Rip Off the Band-Aid!

Our view has been that based upon fundamentals, the equity market begins to find value at the SPX 3850 level. A head and shoulders top formation also implied a downside target of SPX 3800. As a result, SPX 3850 has been our 2022 target for the year. However, now that the SPX is trading below this level, it may be wise to wait for two things to materialize before substantially adding to portfolios. The first factor would be a solid 90% up-volume day that is accompanied by volume that is well above average. This would be an important sign that panic selling is exhausted and that buyers with conviction have reentered the marketplace. Second, we would wait for the results of the Federal Reserve June meeting since this announcement could be a market-moving event.

The recent down leg in prices was triggered by the “bad news” found in last week’s May CPI report coupled with the fear of higher interest rates and a possible recession. In our opinion, it was naïve to think inflation had “peaked” in May. For one thing, any inflation rate above the long-term average of 3.4% is destructive to an economy and the stock market. Moreover, a deceleration in the pace of inflation is not the same as saying the problem is solved. For another, next month’s June CPI report is also likely to be disappointing given the current environment. With crude oil currently at $122, up 65% year over year, with headline PPI up 10.8% year-over-year, with housing and rents (42% of the CPI weighting) on the rise given the recent 16.7% year-over-year gain in single-family median home prices, and with the world facing a probable food shortage this summer due to Russia’s invasion of Ukraine, it is difficult to see how inflation is going to abate significantly in the near-term.  

Policy Error

Many investors are worried that the Fed will make a policy mistake in the coming months; however, in our view, the policy mistakes have already been made. Maintaining easy monetary and fiscal policies during the post-pandemic expansion was an Econ 101 textbook recipe for inflation. This may explain why it is important for the Federal Reserve to be a non-partisan independent body that is not driven by political bias or pressures. We are not saying Chairman Powell was being political last year, but he did repeat the administration’s view that inflation would be transitory. This proved erroneous. Regardless, the FOMC has the responsibility to balance the risks of inflation and unemployment and be unimpeded in using its tools of quantitative easing and interest rates to maintain a level-handed strategy. They did not address inflation in 2021. Remember: monetary and fiscal policy mistakes were made well before Russia invaded Ukraine in February of this year.

100 Means Business

In sum, the Fed is way behind the curve in terms of fighting inflation, and equally important, they have lost the confidence of investors. It is time to admit they were wrong and very late regarding inflation and announce a 100-basis point rate hike. Markets have already sent a “lack of faith” message to the Fed by discounting a 75-basis point fed funds rate hike this week; a 100-basis point move may be a shock to markets, but it could also restore investors’ confidence and signal the world that the Fed is serious about taming inflation. The only caveat to a 100-basis point hike would be the responsibility the Fed has to not upset the fixed income markets and to protect the liquidity in these markets. Yet, all things considered, it is time to rip off the band-aid.

Many fear that an increase in interest rates will trigger a recession but we believe a recession is now inevitable. History has shown that when inflation reaches levels as high as today, the end result has always been a recession. This should not be a surprise since inflation requires the Fed to raise interest rates multiple times, or until it significantly reduces consumption. In fact, in the period between 1973 and 1983, there were three recessions in ten years. See page 4. Most of this was due to the multiple tightening cycles enacted by the Fed. In that cycle, headline CPI peaked at 14.6% in March 1980 and the inflationary trend finally turned when Fed Chairman Paul Volcker raised the fed funds rate to 14% in May 1981. See page 6.

Unfortunately, the price moves seen in crude oil, the CPI and the PPI are at or near the peaks seen in 1982. The good news is that neither core CPI nor core PPI is at similar levels. This could be a silver lining for the current cycle in terms of curbing inflation — if the Fed acts quickly and decisively.

Halfway through a recession

In a recent report (“Halfway Through a Recession,” May 3, 2022) we questioned whether or not we are already in a recession. A recession is measured as a minimum of two consecutive quarters of negative GDP growth and is confirmed by the National Bureau of Economic Research (NBER) usually after the fact. As a result, it is not unusual to not know if the economy is undergoing a recession until it is over, or at least half over. However, being in a recession is the good news. Stock markets tend to bottom in the middle of a recession, and this would put the current market weakness in a different light.

What makes us feel a recession will appear sooner rather than later is that higher interest rates are apt to slow the already decelerating housing and auto markets. The average interest rate for a standard 30-year fixed mortgage is now 5.87%, which is an increase of 36 basis points from one week ago. Rates are apt to go even higher and therefore, housing and auto activity, two important segments of the economy, may slow quickly. Moreover, the US is a consumption-driven economy, and the household sector has seen real purchasing power turn negative this year due to soaring inflation.

Meanwhile, consumer sentiment is floundering. June’s preliminary University of Michigan sentiment index fell to 50.2 from 58.4 and is below the record low set during the 1980 recession. Consumer expectations led the decline, dropping from 55.2 to 46.8, a new cyclical low. Current conditions fell from 63.3 to 55.4 reaching a new record low. The May NFIB Optimism Index fell 0.1 to 93.1, the fifth consecutive month below the 48-year average of 98. Small business owners expecting better business conditions over the next six months decreased four points to a net negative 54%, the lowest level recorded in the 48-year-old survey. Expectations for better business conditions have deteriorated every month since January. In short, there are signs of recession if one dares to look. We apologize for being so glum, but we believe it is wise to remain cautious a bit longer, or until the market can produce a convincing 90% up day. The good news is that discussions about the possibility of recession are now on the rise. The bad news is that this has not yet been factored into earnings forecasts. After the market close of SPX 3735.48, the market has dipped within our valuation model’s year-end fair value range of SPX 2735-3866. It is only 13% above the mid-range of our model (SPX 3300) which would be a great buying opportunity. See page 7. In short, equity prices are reaching good long-term valuation levels, but prices could still fall a bit more.

Gail Dudack

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