Treading Water

By Crest Capital Advisors on April 1, 2022

Dow: (0.65%) to 34,818.27
S&P 500: 0.06% to 4,545.86
Nasdaq: 0.65% to 14,261.50
Russell 2000: 0.63% to 2,091.11
10 Year Yield: 2.83%
Outperformers: REITs 4.51%, Utilities 3.71%, Consumer Staples 2.33%
Underperformers: Financials (3.28%), Energy (2.40%), Industrials (1.49%)

The major averages were little changed, albeit with a modest upside bias this week. The S&P 500 and Nasdaq each edged out a third-straight weekly gain. Bond proxies, REITs, and Utilities led the market, while other “defensive” groups also posted solid relative performance. All in all, the broader market was just treading water this week as we turned the page to a new calendar quarter on Friday.

Yield curve flattening was the big media story of the week, with the 2-year/10-year treasury curve inverting for the first time since 2019. (much more on this topic below) JPMorgan’s Marko Kolanovic wrote this week that there’s too much negativity in the markets, arguing that equity and credit markets have historically fared well at the start of tightening cycles and that real rates are still extremely negative and thus stimulative. We present further data that stocks tend to do quite well from the point of curve inversion.

The week’s headlines around Russia and Ukraine were fairly volatile. Earlier this week, Russia pledged to scale back its campaign in parts of the country. However, the prospects for a breakthrough were immediately met with skepticism. Russia’s attacks near Kyiv continued, though the latest reports indicated that Ukrainian forces stepped up their offensive against Russian units around the capital. Western officials have also continued to assess Russia’s next moves amid reports Moscow is trying to regroup for a major offensive in the Donbas region. Peace talks resumed Friday. We hope they can gain traction soon.

Inflation, commodities, and energy prices remain key overhangs. President Biden announced this week that the US would release ~1 million barrels per day from the Strategic Petroleum Reserve as part of a coordinated release with Western countries and allies. However longer-dated oil futures rallied after the decision as traders see the move leading to higher prices in the future, while some expect the move to disincentivize production.

Yield Curve Inversions & Subsequent Market Performance

A lot of noise is being made as the yield curve is at or close to inverting for the first time in a long time. Of course, this development has created a lot of discussions around whether a recession is around the corner. We do think that recession fears will be growing throughout the next 15 months as it’s likely PMIs will head lower as the Fed is faced with the prospect of raising rates to combat inflation. But, this doesn’t mean the opportunity in the market is over. Far from it.

The curve flattening/inversion process continues relentlessly and predictably, as the market pushes up its expectations of Fed tightening in the near term and continues to expect cuts in 2023-24.

Last week, we discussed what inversions tell us; today, we look at how equities and fixed-income markets did following inversions in the past.

Generally, the broad stock market appreciates between inversions and the onset of the subsequent recession. With the exception of the Volcker years, fixed income assets always appreciated, with mortgages, investment-grade corporates, and muni bonds as top performers.

In general, we would say that turning pessimistic around yield curve inversions does not pay for either equity or fixed-income investors.

However, the current situation is challenging for fixed-income investors because inflation is very high.

It seems that with every day that passes, the market pushes up the number of expected rate hikes for this year and early next year. That imparts a strong flattening pressure to the yield curve since Treasury yields are nothing else than the average of the expected fed funds rate over the maturity of the bond plus a term premium. At the same time, the market paradoxically also continues to expect a couple of rate cuts in late 2023 and 2024. That is because it sees the Fed hiking above neutral, and going above neutral has been historically dangerous for the health of the economy. The projection of rate cuts at relatively short horizons and so soon after liftoff precipitates an inversion of the curve. In fact, the curve is now completely inverted between three and ten years, as the chart above shows. (Update: On Friday, the 3 and 30-year curve inverted as well)

With likely more flattening and inversions of longer portions of the curve coming, we think it’s useful to go back and look at how different stocks performed after past inversions. Specifically, we look at what stocks have done over the last four curve inversions (dating back to the late 1980s) and we define inversions as two-year yields being higher than ten-year yields. (The 2-to-10 curve)

Here’s the takeaway. The last (4) times the 2/10 yield curve inverted (as it did, albeit barely, this week):

• The S&P 500 was up an average of 28.8% before the ultimate peak occurred
• The ultimate peak occurred on average 17.1 months after the inversion date
• A recession started on average 21.0 months after the inversion date.

Yes, it’s a warning when the curve inverts, but it isn’t so simple.

Who Will Be The Incremental Buyer?

In times of equity market turmoil, investors often reduce their participation and activity. As a result, the buying pool is often reduced at exactly the wrong time. Who will pick up this slack?

According to Goldman Sachs, it’s corporations that will be the largest source of equity demand in 2022. Goldman recently raised their 2022 forecast for gross stock buybacks to $1 trillion, up from $872 billion. Buyback authorizations year-to-date are already on pace to exceed the record $1.2 trillion level set in 2021. Take a look at the chart below

All You Need to Know About The Upcoming Mid-Term Elections

Americans feel like their standard of living is declining…

….and they are blaming the President.

Choose Your Own Adventure

The table below shows 2 different portfolios, one comprised of digital transformation leaders, and the other comprised of large consumer staple/discretionary holdings. Each is compared by revenue growth, free cash flow margin, and valuation.

The takeaway is fairly straightforward…secular compounders and digital transformation leaders are trading today at similar valuations as the mature consumer staples businesses! (28x v. 29x) This doesn’t make any logical sense (tell us again how markets are efficient) as one would assume that if portfolio A has a revenue growth rate nearly 3x higher than portfolio B, with cash flow margins nearly 2x higher, that the value of portfolio A should be at least 2-3x higher than the lesser growing, portfolio B. Well, that’s not the case today. How long this pricing anomaly will be available is anyone’s guess.

Crazy Stat(s) of the Week

Here are this week’s crazy stats:

• State & Local Governments posted their largest budget surplus In 2021 since 1941! This week’s GDP report closed the books on state and local government finances for the fiscal year 2021. The result was state and local governments posted a budget surplus of 1.2% of GDP, the highest level in 80 years. Federal aid represented 34% of all state and local spending, a new record.
• The net worth of US households increased by $18.2 trillion in 2021, the biggest increase in history for the 3rd straight year.

• Several years ago, there were some economists calling for the United States to issue extended duration bonds…50 years in duration, even 100 years. The rationale was to lock in ultra-low borrowing rates for the government for extremely extended periods. Well, Austria did follow through with issuing a “century bond”. Unfortunately for those that bought it, the recent spike higher in interest rates has caused the value of those bonds to be cut in half! Here’s a chart of the recent price action in this bond. Ouch.

Quote of the Week

“Let us be thankful for the fools. But for them, the rest of us could not succeed.”
-Mark Twain

Calendar of Events to Watch for the Week of April 4th

The week ahead remains relatively quiet on the earnings front before we start to ramp into the Q1 earnings season in a few weeks. The brokerage conference calendar tapers off this week as well from the peak of the past few weeks. On the US economic calendar, the main event will be the Services PMI, ISM Non-Manufacturing Index on Tuesday followed the next day by the FOMC meeting minutes. As we turn the calendar to April it’s notable that 16 of the past 17 Aprils have posted positive results for the stock market.

Monday 4/4 – US Durable Goods for February is expected to be in line with previous estimates showing a -0.6% month-over-month decline. Factory Orders for February are anticipated to come in at 0.15%, down from the prior month at 1.4%.

Tuesday 4/5 – The ISM Non-Manufacturing report for March is expected to post a robust 58.1 reading, up from last month at 56.5. Fresh on the heels of a somewhat disappointing ISM Manufacturing report on Friday, investors will want to confirm the service sector remains robust prior to embracing future Fed rate hikes.

Wednesday 4/6 – The minutes from the latest Fed meeting will be released and you can be sure that traders and algorithms will be pouring over every word for more clues as to just how “hawkish” the current Fed bias is today.

Thursday 4/7 – US Consumer Credit for February is expected to post a healthy $20b increase, up from $6.8b in the prior month.

Friday 4/8 – US Wholesale Inventories for February are expected to decline modestly to 1.3%, down from 2.1% in January. Looking overseas, China will release data on money supply and loan growth year-over-year.

Source: FactSet