· After a week in which the NASDAQ Composite (growth stocks) outperformed, perhaps in anticipation of slowing economic growth, all eyes will now turn toward second quarter earnings, which begin in earnest this week with many large money center banks reporting, including the likes of Morgan Stanley, Bank of New York, Citigroup and JP Morgan (see below). We will pay particularly close attention not only to the results, but more importantly to what the companies are saying regarding their expectations for themselves, their industries and for the economy over the coming quarter.
We anticipate cautious tones from those companies reporting as there remains a lot of economic uncertainty as a result of a hawkish Fed, the lingering global economic impact of COVID, the war in Ukraine and high energy prices. However, perhaps many would consider the following a bold statement – we believe that the bottom for this market cycle will be made during the third quarter or at the latest mid-October and want to exit this period positioned for future growth. That said, expect companies to remain cautious and the Fed hawkish which is a recipe for volatility throughout this period.
Why the above? We believe the hawkish tone from the Fed will ease a bit at their September 20-21 meeting which will be evidenced within their policy statement released at the conclusion of the meeting. This softening will come as the economic data posted between now and then, especially that pertaining to inflation, will begin to have shown the impact of the Fed tightening that began with their harsh jawboning during November 2021 and carried through this year in the form of the Fed raising interest rates and buying U.S. Treasuries as well as mortgage-backed securities (quantitative tightening).
In conclusion, our base case at this time is for investors to expect volatility and perhaps more downside to the tune of five to ten percent, especially over the first half of the third quarter. However, as the quarter rolls on, investors will begin to focus on the opportunities within the financial markets rather than the risk thereby setting a floor and allowing them to proceed higher, albeit in an uneven fashion.
· On balance, we are still of the mind that this inflationary cycle is slightly more secular than transitory as we believe elevated energy prices (perhaps not at this level, but higher as compared to the past two decades) are here to stay as are higher wages. The impact of permanently higher wages will be felt more severely in the United States than in developing countries as we are a service economy. That said, we do expect wages to plateau shortly as the workforce reappears, having spent their COVID windfall. However, when and if the supply chain gets somewhat realigned manufacturing costs should stabilize as should the cost of shipping. We also believe that technology will begin to reassert itself as a disinflationary influence on production.
In addition to empirical data, we are of the belief that the trend line for inflation will not be one way up as gold, traditionally a hedge against rising prices, has gotten no lift. In fact the price of gold has declined by 4.70% thus far this year and by 3.76% over the trailing twelve months. Anything can change, but for now this is worth watching. When one compares this to the 1970s, a period when retail inflation as measured by the Consumer Price Index (CPI) averaged 5.8% and gold quadrupled in price, the difference in the performance of gold then as compared to now is stark.
· The yield curve (the difference between the yields on different maturities of the identical securities, in this case U.S. Treasuries) has recently inverted, historically a predictor of a recession. In fact, an inverted yield curve has predicted every recession since 1955. That said, it has also predicted recessions when one did not occur. This past week, the yields on the two- and five-year Treasury Notes were inverted or higher when compared to the ten-year U.S. Treasury Note. Many market pundits will point to this as evidence of a looming recession. At this time, due to prior Fed monetary policy as well as the strength of the labor market, we are not willing to take that step.
· Let’s keep an eye on the rising dollar, which is at its strongest level in nearly twenty years as compared with many of our major trading partners, as it caps inflation by reducing the cost of imports and raising that of exports. For those that believe the U.S. Economy is not relatively strong, the rise in the dollar due to domestic and foreign demand, debunks that.
· Historical data provide a guide, a potential window to future events. Investors must keep in mind that after every bear market in the history of the United States, stocks have gone on to set new record highs. Furthermore, we have allocated your assets for these trying times as well as those that are more fruitful. Regardless of this it is important to keep in mind that ultimately markets such as this test the patience, faith and resolve of even the most seasoned investors.
· A component to traditional, longer-lasting bear markets is the emotional strain it places upon the investor. Just as bull markets place pressure on investors sitting on the sidelines, bear markets exert the same force on those that have money in the market. Should the market remain choppy as we believe it will at least throughout the summer, you can count on a steady drumbeat from talking heads questioning the validity of long-term investing. We have regularly noted that unlike recent pullbacks, the recovery from this one will most likely be more of a process rather than an event and would recommend our clients to ignore the short-term and focus on your long-term objectives.
· The Fed has become too important in regulating the economy. Hopefully, when this is over, we can get to a more normalized economy with less overt Fed intervention. Recessions are necessary as they bring back into balance supply and demand. In addition, vis a vis creative destruction, recessions revitalize the economy, positioning it for a new era of growth.
· An Important Note Regarding the Table Titled, “Select Sector SPDR Exchange Traded Funds (ETFs).” In an effort to provide a more concise, definitive picture regarding the performance of the equity market, this data, a broad basket of eleven market capitalization weighted, industry-specific ETFs will replace the “Dow Jones U.S. Total Market Industry Groups.”
· The Vanguard Balanced Index Fund (VBAIX), somewhat of a proxy for balanced investors has fallen 15.56% through the close of the first half as in addition to the pullback in stocks, bonds, which comprise nearly 40% of the portfolio, have been under pressure. For example, the Vanguard Total Bond Market Index Fund (VBMFX) has fallen 10.77%.
· The upcoming week is chock full with potentially market moving economic data, especially as it pertains to inflation. These include on Wednesday, retail inflation as measured by the Consumer Price Index (CPI); on Thursday, wholesale inflation as measured by the Producer Price Index (PPI) and the Weekly Report of Initial Claims for Unemployment Insurance. Then finally, on Friday June Retail Sales, Capacity Utilization, Industrial Production and Consumer Sentiment as well as May Business Inventories.
· The corporate earnings season is about to kick off. There are several key reports expected this coming week to include Pepsico (PEP), Pricesmart (PSMT), Delta Air Lines (DAL), Fastenal (FAST), Cintas (CTAS), JP Morgan (JPM), Morgan Stanley (MS), Blackrock (BK), Citigroup (‘C), State Street (STT), Bank of NY Mellon (BK), PNC Financial (PNC), US Bancorp (USB), United Health (UNH) and Wells Fargo (WFC).