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Edition 39: Where Do We Go From Here?

Where Do We Go From Here?

Signal Definer: Weak. The S&P 500 squeaked by with a barely-positive return, and the bond markets were largely positive, marking the first positive month of the year for most sectors.

May Market Recap

The S&P 500 Index returned 0.01%

The Bloomberg U.S. Aggregate Bond Index returned 0.64%

Fed Funds Target Range: 0.75 – 1.00%

 

Economic Review

The May economic releases captured the ongoing story: A strong labor market, slowing but positive growth, an expanding manufacturing sector and declining but still strong consumer confidence. All of this would seem to indicate an economy that can weather rate increases without tumbling into a recession.

Except that everybody seemed to think the opposite.

Let’s get into the data:

  • The National Association for Business Economics reported a lower projection for GDP. The median forecast for inflation-adjusted gross domestic product (real GDP) for the fourth quarter (Q4) of 2022 is an increase of 1.8% from Q4 2021, compared to a median forecast of 2.9% in the February 2022 survey.
  • The survey also addressed respondents’ outlook on recession. More than half (53%) of respondents assign a more than 25% probability of a recession occurring within 12 months.
  • The Bureau of Labor Statistics released the May non-farm payrolls on June 3rd. The economy beat expectations and created 390,000 jobs.
  • A key manufacturing sector index is still positive. The Institute for Supply Management Purchasing Managers’ Index for May was 56.1. Any number above 50 indicates expansion, while numbers below 50 show shrinkage.
  • And consumers are still spending. The Conference Board said on May 31st that its consumer confidence index dipped to 106.4 in May, from 108.6 in April. This is still a strong reading.

Inflation is Moving in the Wrong Direction, with Velocity

The Fed’s coordinated reassurance of a 50 basis point hike at the June and July meetings, combined with the mid-month inflation release that showed CPI declining slightly, ultimately served to alleviate concerns that the Fed would move even more aggressively. In some quarters, it raised hopes that the Fed would move back to a 25 basis point increase in September, or even pause rate increases, if labor markets continued softening and CPI trended down.

So much for that. The spike in headline CPI from a 0.3% increase in April to a 1% increase in May was the largest since 1981. At the June FOMC meeting, The Federal Reserve raised the key short-term interest rate by 75 basis points, for the first time since 1994. The June increase will likely be followed by either a 50 or 75 basis point increase in July and another increase in September.

Besides the upward spike in CPI, among the data that the Fed looks at is the expectations for inflation going forward. Inflation tends to be a self-fulfilling prophecy, where consumer expectations for inflation in the future result in higher inflation.

The most recent University of Michigan consumer sentiment survey said that the public’s expectation of inflation five years from now jumped to a reading of 3.3% from 3% in May. That was the first increase since January. Expected inflation a year from now also ticked up, hitting 5.4% versus 5.3%.

Will the moves work on inflation? Or will we end up in recession or stagflation? The Fed does have a strategy:

  • The labor market currently appears to be very strong, and is supporting the economy
  • The key short-term rate is currently at 1 ½ to 1 ¾ % — for inflation to get to 2% (from 8.6%) the key rate needs to be closer to 3%.
  • Moving rates dramatically now will give the Fed room to cut back if the economy begins to sputter in 2023

In the Summary of Economic Projections, the Fed indicated an unemployment rate of 4.1% by 2024. Powell acknowledged the increase in his remarks, but stated that the number is historically low, and that achieving the joint goals of low unemployment and inflation on a downward path to 2% would be a “successful outcome.”

 

Market Review

As of early June, Q1 2022 earnings season is mostly complete, with over 97% of companies reporting. Of 489 issues, 377 beat operating estimates (77.1%), while 350 of the 486 (72.0%) have beaten estimates on sales. Earnings for the quarter were expected to decline 12.7% from the Q4 2021 record and be up 4.4% over Q1 2021. For 2022, earnings are expected to set another record, increasing 7.5% over 2021.

The 10-year U.S. Treasury ended the month at 2.85%. Intra month, the key rate reached 3.21%. This marks the first time this rate has been above 3% since December 2018. The Bloomberg U.S. Aggregate Index was up, returning 0.64%. As represented by the Bloomberg Municipal Bond Index, Municipal bonds returned 1.48%. High yield corporate bonds were positive, with the Bloomberg U.S. High Yield Index returning 0.24%.

The US High Yield market returned 0.24% in May, bringing the YTD return to -7.74% as measured by the ICE BofA US High Yield Constrained Index (HUC0). Signs that the Federal Reserve would be flexible in rate hikes led to a rally later in the month. BBs rallied first and outperformed for the month, while Bs and CCCs lagged.

In the alternative credit markets, a recent report from S&P Global Market Intelligence looked at the evolution of private credit and compared the asset class to more liquid options in the face of the ongoing market volatility. “The volume of high-yield bond issuance has plunged this year in the face of market volatility. That’s not unusual when equity markets swing wildly. But private credit providers, still flush with cash, have swooped in, underwriting transactions that may have been done in the traditional high-yield bond market in the past.” The report also addressed a shift to larger deal sizes in the private credit space: “In recent months, private credit providers have increasingly taken down larger deals that in the past would have been done in the syndicated loan market.”

Chart of the Month

National Association of Realtors Home Affordability Index

The combination of higher mortgage rates and higher home prices has led to a drastic decrease in the affordability of home ownership.

Year over year change in National Association of Realtors Home Affordability Index

Source: FactSet; Chart: Erin Davis/Axios Visuals

By The Numbers: A Directional Snapshot

  • Even “sticky inflation,” which is supposed to change more slowly, was up in May. The Atlanta Fed's sticky-price consumer price index (CPI)— increased 7.5 % versus a 7.1 % increase in April.
  • Used car prices shot back up, too – the first increase in three months.
  • Heat waves are getting more personal. Seville, Spain will begin naming heat waves, and several U.S. cities are piloting programs to categorize them, similar to hurricanes.

Source: Atlanta Fed; Bureau of Labor Statistics; Axios

Read Enough? Check Out What We’re Listening To

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