ICYMI: Things Have Changed Fast; Inflation and the Fed Have Damaged the Economy
publication date: Oct 7, 2022
author/source: Brian Nelson, CFA
This article was originally published October 5.
Image Source: EpicTop10.com
By Brian Nelson, CFA
The year 2022 started out with the popping of the bubble in the alternative investments arena--namely in the cryptocurrency (BITO), non-fungible token (NFT), and the collectibles markets--coupled with worries about the Fed raising interest rates to combat inflation and weakness in the most speculative equity areas, namely disruptive innovation stocks (ARKK).
It's important to note that the consumer price index (CPI) started to edge meaningfully higher in early 2021 (not this year). Though the writing was on the wall with respect to impending Fed tightening, as investors, we have to assess what the Fed will do and the impact on the markets, not necessarily what the Fed should do. We can’t confuse the two.
That said, as the market started to roll over this Spring due to a negative wealth effect from weakness in alternative investments and concerns about potential Fed activity, investors started to feel the pinch--and began to sell equities in some of the strongest areas, including big cap tech (SCHG). We may have attributed this selling to margin calls in crypto across Silicon Valley, but the sell-off was nonetheless notable.
When Walmart (WMT) and Target (TGT) warned about weakness earlier this year, however, we started to grow concerned that something might have “broken” in the economy. However, it wasn’t until Nike (NKE) released its earnings report June 27, in which the the athletic shoe and apparel giant revealed weak gross margins and a huge inventory build, that we grew very cautious.
Inflation Has Moved From a Positive Catalyst to a Negative One
We think being patient through the first half of 2022 was reasonable. After all, inflation had been increasing meaningfully since early 2021, and the past three years in the equity markets had been fantastic. We didn’t want to be too early or raise the red flag about potentially deteriorating conditions without identifying established trends first.
Said another way, we had to let things unfold and interpret them as we see them. For starters, inflation coming out of the COVID-19 meltdown wasn't bad to begin with. Inflation was a positive catalyst for business pricing in 2021, helping to drive the market to new highs. Inflation, however, has now become a negative catalyst to consumer spending power in 2022.
This change is undeniable. Those that had concerns about inflation would have sold out at the COVID-19 market bottom as the government balance sheet swelled. However, we turned bearish with the simulated Best Ideas Newsletter portfolio down just 8.6% on the year (on a price-only basis), at a time when it was beating both the SPY and the 60/40 stock/bond portfolio.
There are many still holding on to the belief that nominal earnings will still be positively impacted by inflationary tendencies in the long haul (once our primary thesis, too), and this may still be true, but such a dynamic won’t be felt in the stock market for some time yet. Rising interest rates are too powerful of an overwhelming force to valuations at the moment.
A jump in the 10-year Treasury rate from under 1.5% in December 2021 to north of 3% in a matter of months, and the move's implication on equity values is yet another tangible valuation headwind. Not only are gross margins and inventories building at some of the strongest companies but borrowing costs and discount rates have been rising. The 10-year Treasury rate now stands at 3.77%, attracting non-US investment that is driving the U.S. dollar (UUP) higher as money flows into a comparatively “safer” U.S. market. This will have a negative impact on exports, hurting U.S. GDP.
Economic Conditions Have Deteriorated Fast
FedEx (FDX) recorded a big miss for the period ending August 31, 2022, preliminary earnings released September 16, and while this, itself, isn’t too much to worry about, the package delivery giant also withdrew its guidance for fiscal 2023. Visibility has been significantly reduced. FedEx’s stock has been hammered as a result, and while there are some firm-specific execution issues at FedEx, the implications on the broader economic environment are hard to ignore. Here's what FedEx CEO Raj Subramaniam had to say in the press release:
Global volumes declined as macroeconomic trends significantly worsened later in the quarter, both internationally and in the U.S. We are swiftly addressing these headwinds, but given the speed at which conditions shifted, first quarter results are below our expectations. While this performance is disappointing, we are aggressively accelerating cost reduction efforts and evaluating additional measures to enhance productivity, reduce variable costs, and implement structural cost-reduction initiatives. These efforts are aligned with the strategy we outlined in June, and I remain confident in achieving our fiscal year 2025 financial targets.
Let me reiterate what FedEx is saying: Things have deteriorated fast!
Readers have to remember that inflation was a big tailwind to equity returns in 2021. For example, we started getting inflationary readings on the CPI of 5% as early as May 2021, 6% as early as October 2021, and 7% as early as December 2021. The markets rallied through all of this, as we interpreted this as higher prices à higher nominal earnings à higher valuations. However, when we started seeing the food cost inflation in August of this year, that was the straw that broke the camel’s back, so to speak, especially with the rising 10-year Treasury rate as the backdrop.
A Massively Negative Wealth Effect Is Still Ahead
We went bearish on August 19, and we remain so today. We believe consumer discretionary spending is being punished by food cost inflation, and while it does look like food cost inflation is slowing a bit based on our channel checks, the damage to the economy may be lasting (and not easily and immediately fixed by rate cuts), particularly as investors reel from not only the negative wealth effect from collapsing alternative investment markets, but also broader stock and bond markets.
The stark reality is that the 60/40 stock/bond portfolio is down 21% so far in 2022, its worst year in history since 1931. The negative wealth effect from stock and bond markets so far in 2022 has yet to be felt in the economy, and the impact from increased mortgage rates on the U.S. housing market is still in the first inning, too, if we can even say that. Perhaps, more appropriately stated, the game has yet to start, and already, homebuilders such as Lennar Corp. (LEN), D.R. Horton (DHI), and PulteGroup (PHM) are off about ~30% so far this year.
We expect as much as a 20%, 30% correction in U.S. housing prices, and maybe more based on reduced affordability from higher interest rates. When consumers assess their balance sheets to see the rapid declines in alternative assets, the weakness of stocks and bonds, and then how fast the U.S. housing market has eroded, it’s going to have a multiplicative negative impact on consumer confidence and spending, all the while food cost inflation remains elevated. Much of this impact is still ahead of the markets, and it probably won’t be felt in the economy until another 6-12 months.
Global Financial Contagion Risk Has Become Elevated
We talked in this note, Things Are Bad Out There, about how the Bank of England had to step in to “save” its gilt (bond) markets and bail out pension funds that were leveraging up too much on long bonds, suggesting that another financial crisis and systemic risk is a non-zero probability, too, particularly given industry “buzz” about the health of Credit Suisse (CS) and Deutsche Bank (DB). Though its entirely too early to tell if these banks may be in trouble, we reiterate that banks operate on confidence between counterparties, and it’s definitely not encouraging to hear Credit Suisse CEO Ulrich Koerner say the bank is at a “critical moment.”
Our move to bearish from bullish on the equity markets may seem abrupt, Now Bearish…, but we can’t stress enough how fast things have changed – inflation turned from a positive catalyst in 2021 to a hugely negative one in 2022, and FedEx won’t be the last company caught off guard with how fast things have deteriorated in just the past couple months. Apple (AAPL), too, is backing off plans for its suppliers to increase production of its iPhone 14, and we expect there will be monumental adjustments at S&P 500 companies to adapt to a new, substantially weakened global economy, one that remains mired in geopolitical uncertainty with Russia/Ukraine (RSX) and with China/Taiwan (EWT).
We continue to like how the simulated newsletter portfolios are positioned, however. We have to move past the likes of weakness at PayPal (PYPL), and while we have reduced enthusiasm at Meta Platforms (META) in light of the company’s spending patterns and the momentum at TikTok, Post-Mortem on Facebook (Meta Platforms), the firm remains a smaller "weighting." Dividend growth equities (SDY) continue to be one of the better-performing areas in this market environment, and we are fortunate to have added Exxon Mobil (XOM) and Chevron (CVX) to the simulated newsletter portfolios last year, as they have served to mitigate the weakness in other areas.
This bears repeating: It has been hugely beneficial to be significantly “overweight” the energy sector across the simulated newsletter portfolios in 2022. The Energy Select Sector SPDR (XLE) is up more than 40% year-to-date.
Things have changed fast. Inflation has turned from a positive catalyst in 2021 into a negative catalyst in 2022, all the while the 10-year Treasury rate has soared. We’ve yet to see the impact from a massive negative wealth effect from alternatives, to stocks/bonds, to the U.S. housing market, and the European financial system could eventually need life support as the U.K. bails out pension funds and the sharks start swarming around large European financial institutions. The writing is on the wall for tough times to come in 2023, and things will get worse before they get better.
Buckle up because we’re going to be in for a wild ride in the coming 6-12 months, and maybe longer.
Related: MSTR, XHB, ITB, GBTC, UPS
Brian Nelson owns shares in SPY, SCHG, QQQ, DIA, VOT, BITO, and IWM. Valuentum owns SPY, SCHG, QQQ, VOO, and DIA. Brian Nelson's household owns shares in HON, DIS, HAS, NKE. Some of the other securities written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.
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