'It's going to be a volatile year'
Fed tightening and evaporating fiscal stimulus should make for a bumpy road.
So says everybody. Tightening cycles always are bumpy. But this one’s bringing an end to two years of uber dovishness that doubled the size of the Fed’s balance sheet, equally matched by some $5 trillion in fiscal stimulus, which is going away—the amount of rolling off this year represents 9% of GDP, comparable only to the post-WWII drawdown in 1946-47. Shifts in the yield curve typically whipsaw rotations, and the market got a strong taste Wednesday. December’s surprisingly hawkish meeting minutes caused the 10-year Treasury yield to spike above 1.70%, near 2021’s high, and spawned a violent move out of Growth stocks that pushed the cumulative 3-day rotation from Growth into Value to near April 2009’s record 8.8%. Value’s 5% rise during Growth’s sell-off was in line with the start of the dot-com bust. The equal-weighted S&P 500 also set a new high, aided by the highest inflows since early 2000. History tells us the S&P tends to rise roughly 8% on average in the six months after the inaugural rate hike, with a cyclical bias leading up to it. But cyclical performance tends to struggle afterward, and a Strategas Research review of four past rate-hiking cycles found technology stocks tend to be the best performers over the course of a cycle. So, Value now, Growth later? As we start the year, Value’s got both valuation and momentum going for it, so its move may have legs. Seems Value has found center stage.
Midterm election years can be unsettling. Leading up to Election Day, stocks tend to experience a pronounced pullback—19% on average—before rallying afterward. This would be a dramatic change from last year, when 5% represented the maximum drawdown—ranking ninth out of the past 70 years in terms of the smallest intra-year declines. Calm markets rarely are repeated the following year. And midterm years historically have been volatile, even though equity performance for the entire year often is positive—the S&P on average has risen 32% off the midterm election-year bottom. And it has not declined in the 12 months following a midterm election since 1946. (Decent odds.) Low rates have been neutralizing equity volatility—the 10-year was rangebound between 1.20-1.70% the past nine months—but this week’s breakout, if it holds, suggests challenges ahead. Even if the 10-year climbs to 2% or higher (gradually), rates are still low enough and economic and earnings fundamentals strong enough to remain supportive of stocks. Not so most bonds. Rising rates and inflation are anything but bond friendly. The Bloomberg Global Agg Index in 2021 just had its worst nominal year since 1999. Still, with inflation running hot and several hawkish regional Fed presidents rotating onto the policy-setting committee (while doves rotate off), the days of equities relying on a “Fed put” appear numbered. Mindful of sagging polls amid blame for inflation, the Biden administration isn’t likely to get in the Fed’s way as it turns to tightening. If inflation doesn’t start moderating, might the Fed shift from quarter-point to 50-point increments. (Alan Greenspan was the last Fed chair to make this rarely used move.) That would be bad.
Maybe inflation has peaked? Cornerstone Macro notes that real goods imports and real retail inventories (that is, actual units as they are inflation-adjusted) hit all-time highs in November, signs the supply surge is hitting just as demand for many goods is declining. As relief stimulus evaporates and Americans start to view Covid as a nettlesome epidemic rather than a scary pandemic, the shift in spending from goods to services that occurred late last year is likely to continue at an accelerating rate, unwinding pandemic-driven spending patterns. And as goods demand moderates and inventory building picks up (there’s a lot of ships still stuck at sea), inventory/sales ratios should climb, too, putting downward pressure on prices. Cornerstone may be too optimistic—it sees core prices below 2% by the end of the year. But they could ease enough to keep the Fed on a steady pace, which would be just fine with stocks and possibly bonds. Consumers, too. Unlike this past Christmas, when the fox pillow I ordered last May (!) has been delayed again (!), we may face a multitude of choices and sales next holiday season as retailers try to unload stockpiled inventories. A shopper’s paradise.
- Supply chains starting to normalize The average of unfilled orders and delivery times in five regional Fed bank business surveys peaked at 27.3 in May and was down to 16.3 in December, a 10-month low. In a much smaller sample, an SIS Research executive notes a neighborhood haircut that cost 50% more early in the post-lockdown era had fallen back to its pre-pandemic level last week, and home exercise equipment that cost 20% more and would be delayed in shipping when he was considering buying it was, as of last week, immediately available at 25% below its pre-Covid price.
- All those homes are going to need furniture Renaissance Macro estimates less than 10% of new housing inventory has been completed, a record low, while a fourth of new homes for sale have not even been started, a near record high. With inventories tight and mortgage rates near a 2-year high, demand keeps rising—Evercore ISI’s proprietary homebuilder’s survey is at its highest level since June on increasing customer traffic and sales—as buyers want to get in while rates remain relatively low.
- Primed to spend across the pond European consumers have been slower than their U.S. counterparts to bounce back, but economists now anticipate a revival in Europe this year, perhaps exceeding 5% growth in real terms. One reason: excess savings in the euro area amount to roughly 12% of a year’s worth of pre-pandemic spending.
- Where are all the workers? Another big headline miss on nonfarm payrolls, which at 199K in December was less than half the consensus. That, and an expected big upward revision to November that failed to materialize, were the only real disappointments. A 4.7% year-over-year jump in hourly earnings and a sub-4% jobless rate point to a tight labor market and consumer strength that should keep the Fed on its hawkish path. Elsewhere, at 807K, December ADP private payrolls doubled consensus, jobless claims held near all-time lows relative to the size of the labor force and the quits rate set new highs.
- Services slow The ISM non-manufacturing gauge fell more than in expected in December as underlying components—business activity, new orders and employment—softened. At a headline 62, the index remains at a healthy level, and the report hinted that price pressures are starting to ease. December’s manufacturing ISM also slipped but remained elevated and came in slightly above consensus.
- Omicron’s dark winter? The variant is spreading through the U.S. at the fastest pace since the start of the pandemic, disrupting school openings, return to work and leisure activities. The good news is it’s expected to pass just as quickly. Still, its impact, along with deteriorating fiscal prospects with the ending of the monthly Child Tax Credit, suggest Q1 GDP will be lower than expected, though growth likely will be recovered in subsequent months.
Build Back (a Little) Better? Odds of the Senate passing a bill via reconciliation by April 1 fell after Manchin on Tuesday said he’s not in talks with the White House on reviving Build Back Better. If a deal eventually is cut, it’s almost certain that Manchin will demand all spending be matched with offsets, suggesting a 65% shrinkage in outlays that will force Dems to prioritize key areas of spending: 1) Climate; 2) Health; 3) Pre-K; and 4) Child Tax Credit.
Just in time for midterms (state and local edition) Flush with cash from higher tax revenues due to above-trend growth and a $1 trillion Covid windfall from the federal government, state and local government operating budgets are in the best shape of our lifetimes. The timing could not be better for governors, as more than 30 are up for re-election.
Built to sell Worth Charting says it’s a silly convention to predict where the market will be on a particular day, 12 months in the future, when one considers the fact that not once (never) have Wall Street strategists, as a group, predicted a down year for the market.