Is the equity head fake over?

Bottom Line

It was a tough first quarter for investors across the board. The bond market suffered its worst decline in more than 40 years, as benchmark 10-year Treasury yields soared from 1.5% at the end of last year to a 3-year high at 2.65% today. The S&P 500 posted its worst quarterly performance in two years, dropping 4.6% on a total-return basis. But that return masked an extremely volatile first quarter. Stocks plunged 14% from the beginning of the quarter to the start of the Russian/Ukraine war on Feb. 24 before rallying 10% into the quarter’s end. Commodities, however, enjoyed their best quarter since 1990, with supercharged rallies in energy, agricultural products and metals. 

Nominal Consumer Price Index (CPI) inflation soared 7.9% year-over-year (y/y) in February, its highest level in 40 years, but that’s before we include the spike in crude oil prices (West Texas Intermediate, or WTI) from $90 to $130 per barrel after Russia’s invasion. We expect next week’s CPI update for March to be an enormous 1.2% month-over-month gain (which annualizes to a 14.4% surge) and an 8.4% y/y increase. We anticipate it could rise to 9-10% in coming months, as the Russian atrocities in Ukraine continue with no end in sight.

Fed getting out from behind the curve At last month’s policy-setting meeting, the Federal Reserve raised the fed funds rate by a quarter point, the first hike since 2018. Based upon yesterday’s release of the minutes from that March 16 meeting, we believe policymakers plan to hike rates at each of their six remaining meetings this year. We anticipate that the first three will be half-percentage-point increases (which would be the first such jump in 22 years), with four more quarter-point hikes over the course of 2023. That would take the fed funds rate up to 2.5% by the end of this year and to 3.5% by the end of 2023. 

In addition, the Fed may begin to shrink its $9 trillion balance sheet at its upcoming May 4 meeting by one-third over the next three years, with a monthly cap of about $95 billion ($60 billion in Treasuries and $35 billion in mortgage-backed securities). According to our research friends at Evercore ISI, an annual reduction of $1 trillion in the Fed’s balance sheet would equate to an additional tightening of about 25 basis points. 

Earnings growth slowing First-quarter corporate profit season starts next week, and FactSet is expecting a muted 4.7% y/y increase, down from a 5.7% expected gain at the end of last year. That compares with an outsized 48% y/y gain in the first quarter of 2021. Management guidance for the first quarter has been running at more than a two-to-one negative pace over the past three months. 

The profit cycle peaked in the second quarter of 2021, with an enormous 88% y/y earnings per share (EPS) gain. Last year’s third quarter growth fell to a y/y gain of 39%, and the fourth quarter slipped to a gain of about 27%. Corporate earnings are on a glide path to normalization, with difficult y/y comparisons on tap for each of the next three quarters. 

Profit margins should remain under pressure, as companies have been absorbing higher commodity, transportation and labor costs, the latter of which rose to a 2-year high of 5.6% y/y in March. But with nominal retail inflation surging 7.9%—and heading higher—the average worker has sustained a 2.3% decline in relative purchasing power over the past year, leading many to demand higher wages or switch to jobs that offer them. 

Tide is turning Companies have been passing their higher costs onto customers in the form of higher prices, creating a self-reinforcing inflationary cycle. But that trend may be turning, as the personal savings rate has plummeted to a 2-year low of 6.3% in February from 26.6% in March 2021. As a result, we may see corporate revenue growth start to slow, as customers push back against ever-higher prices, with their store of dry powder diminishing. Consequently, corporate guidance for the balance of calendar 2022 may be even more important than their first-quarter revenue and earnings report. But managements may be reluctant to offer bullish guidance, against the current backdrop of significant uncertainty.

Pulling in our horns Given our concerns, we recently cut our full year S&P 500 EPS estimates by $10 in each of 2022 and 2023, to $220 (a 5% y/y gain) and to $250, respectively. Reflecting the Fed’s more hawkish policy turn, we also trimmed our price/earnings (P/E) multiple expectations and lowered our full-year S&P target price to 4,800 this year and to 5,100 in 2023. 

Correction brewing Consequently, we believe the S&P 500’s 11% rally from March 14 to March 29 to 4,637 inappropriately ignores this cavalcade of concerns. We think stocks could grind 8-12% lower over the next several months or quarters, potentially establishing at least a double-bottom retest of February’s intraday low of 4,115, or perhaps lower. 

But by late summer or early fall, we may receive much better clarity on several of these fronts. Will punishing economic and energy sanctions force an end to Russian hostilities? Will the U.S. produce more oil and gas to fill the Russian void here and abroad? What is the trajectory of Fed rate hikes and balance sheet shrinkage? Will rampant inflation peak in the third quarter and begin to slowly recede? Did the Fed stick its soft landing, or are we facing an elevated recession risk in 2023 and beyond? How will economic and corporate profit growth respond?

Midterms a positive catalyst By Labor Day, stocks may be trading at about 16 times forward earnings, having discounted many of these concerns. Investors also might begin to look ahead to the midterm elections on Nov. 8. Given President Biden’s rapidly deteriorating poll numbers, we expect the political pendulum to swing sharply to the right, which it historically does in a new president’s first midterm election, returning divided government in Washington. 

Play defense now, offense later Equity investors prefer gridlock in Washington, so this positive confluence of events may fuel a powerful fourth-quarter rally that spills into 2023. We advise investors to hunker down and deploy a defensive investment strategy now, with a modest equity overweight concentrated in relatively cheaper, less-risky value stocks with higher dividend yield potential. We’ll have an opportunity to get the offense back on the field later in the year.