Third Quarter Forecast and Opinion

The Fed is acting aggressively to control inflation, which came in far above expectations yesterday at an annualized 9.1% for the month of June. By raising interest rates in amounts larger than expected, they are hoping to cool off the economy by aggressively slowing it. This bodes for a lower stock market in the third quarter.

Unfortunately, the inflation we are experiencing is a supply issue, which the Federal Reserve cannot control. Even former Fed Chairman Bernanke said recently that “factors beyond the Fed’s control can contribute to inflation… Supply side forces are, indeed, important today – not only the increases in global energy and food prices...but also pandemic related constraints, like the disruption of global supply chains. Unfortunately, the Fed can do little about the supply side problems”.

At this point, dislocations in the oil and gas market, food and fertilizer markets, constraints in shipping and trucking routes, and distortions in Chinese supply/demand due to Covid, are the major drivers of inflation. There is little the Fed can do but constrain the economy through much higher interest rates. It’s quite possible that the Fed Funds interest rate will exceed the 10 year yield in the near future which disincentivizes banks from lending any money at all.

The popular theory that a recession will serve to bring prices down may be premature until the aforementioned global problems are resolved. 40 years of inflation credibility at the Fed is now on the line, and it portends much higher interest rates from the Fed.

The futures market predicts peak short term interest rates of 4% next June, and then an eventual lowering of interest rates, when inflation begins to taper. This expectation is likely to be revised upward after yesterday‘s very hot inflation numbers.

The first half of 2022 was the worst first half for stocks in 52 years. Stock declines of 20% + occurred over concerns about inflation and recession, while the US government bond market lost 10% of its value simultaneously.

The “everything bubble “, so named because most asset classes were at record levels due to rampant speculation, is unwinding just as the Fed is raising interest rates to intentionally cool off the economy.

While it is tempting to begin bargain hunting for value in the stock market at this point, it is likely that we will see lower levels first.

The narrative of the first half of 2022 focused upon inflation, and it seems to now be turning more toward concerns over corporate earnings and recession. S&P 500 companies have strong balance sheets and generally fixed rate debt. Nonetheless, higher interest rates are still increasing their borrowing costs. A 1% rise in interest rates is expected to reduce overall earnings by 3%. Add to this 5% wage inflation and significantly higher raw material and transport costs, and it’s easy to understand where this pessimism comes from.

Anticipation of higher US interest rates is driving up the US dollar to 20 year highest. US multinational corporations that do large amounts of business abroad will face earnings headwinds as their foreign profits translate back into less dollars.

Earnings season begins next week for the second quarter.

“Leading “economic indicators are concerned with future changes in economic activity. Among the most important leading indicators are GDP, employment, industrial production, consumer spending, inflation, and housing.

On July 1, the Federal Reserve Bank of Atlanta lowered its Q2 GDP projection to -2.1%. Coupled with the first quarter decline of -1.6%, they are now officially forecasting a recession. This would argue in favor of a “hard” economic landing.

US consumer confidence is now at a 16-month low, which translates into a decline of real consumer spending in May for the first time this year by 0.4%. This collapse of consumer sentiment suggests that corporate margins are likely to soften going forward, especially when we consider that manufacturers face much higher costs of capital, raw materials, and wages.

Both manufacturing and services indices are oriented lower (see ISM charts below):

temp-post-image temp-post-image

These are important monthly indicators of US economic activity. It should be noted that the level below 50 indicates a contraction of the economy, which looks likely by September for both indices.

One of the most important economic indicators to follow at the moment is the Fed “Financial Conditions” index, which measures financial variables that influence economic behavior, and thereby the future state of our economy. When financial conditions tighten, stocks and bonds go down. The following chart Inverts that index and then compares it to the stock market. As can be observed, this index drives stock multiples. Easy financial conditions encourage risk-taking and buying of risky assets. Tightening financial conditions, such as what we have experienced since last December, tend to do the opposite, and contract stock multiples.

temp-post-imageSource: Blooomberg

Financial markets are undergoing a paradox at the moment. How can employment be so strong in the US while consumer sentiment is so weak? The answer may be that employment is lagging indicator, and is about to start reflecting weakening consumer and business confidence.

Looking at all recessions since 1961, the predictive nature of the 2 year-10 year bond yield spread is relevant. When short-term interest rates become higher the long-term interest rates, as they are now, it usually predicts either recession or a major slow down in economic growth, with a lead time of anywhere between six and 16 months.

As a percentage of their total assets, US households hold some 27.5% of their wealth in stocks. This exceeds the peak reading of 26.3% at the end of the dot com bubble in Q1 2000, when that number crashed 11.6% after the NASDAQ lost 78% of its value.

Some market participants are still hoping for a “soft landing “for the economy as the Fed tries to contain inflation. History demonstrates that whenever inflation goes above 4 1/2% there has never been a “soft landing”. Furthermore, when inflation goes above 5% it has never come down without the Fed Funds rate going above the CPI inflation rate, now at 9.1%. Once inflation goes above 5%, it has never been tamed without an economic recession.

Due to the Fed’s easy money policies over the past 14 years, there have been very low levels of bankruptcies. With much higher interest rates, we should expect more corporate economic distress. To that end, the Fed’s latest annual stress test of banks concluded that the nation’s largest banks needed 1% more capital to absorb any potential losses from a coming recession. Yesterday, JP Morgan announced results for the second quarter that fell 28% from a year earlier after building reserves for bad loans, and it suspended its stock buyback program.

China is a concern for several reasons The Chinese economy advanced 0.4% year-on-year in Q2 of 2022, missing market consensus of 1.0% and slowing sharply from a 4.8% growth in Q1. Growing numbers of Chinese homebuyers are threatening to stop mortgage loan repayments to protest against unfinished apartments that they have bought but can’t move into. The mortgage bad-loan ratios for banks could rise three- to five-fold as a result, in the $220 billion Chinese mortgage market. Bank runs in Henan Province, and subsequent public protests, are being met with police action. And most importantly, Wall Street is watching China carefully over any clues that China might emulate Vladimir Putin and invade Taiwan, an unlikely but non-negligible risk.

Lastly, there is talk that Europe may be the next “black swan”, as the realization sets in that Russia may cut off supply of natural gas altogether to the continent. The largest chemical conglomerate worldwide, German-headquartered BASF, has indicated it would have to stop all production If its natural gas supply fell to less than half its needs.

In the first half of 2022, The S&P 500 was down 20.6%, the Dow was down 15%, and the Nasdaq was down 29.36%.

Grant Rogers


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