The best offense ...
Defensive stocks can offer refuge and potential rewards.
… is a good defense. It's hard to read the direction of the market. The backdrop remains consistent with major market drawdowns of 20%, with weak momentum and breadth. But the S&P 500 is down only 10% from early January’s all-time high. Despite Russia’s brutal invasion, surging commodity prices and inflation all over (more below), the index is holding above support at 4,250. Evercore ISI wonders if this a “bullish divergence” consistent with a bottoming process or a “bearish delay” consistent with a deeper decline to 3,800 or lower. Maybe Putin knows. Oppenheimer and others suspect a possible “W” bottom, with a March/April rally followed by a final leg lower that flushes out weak hands, setting up the secular bull’s next leg. Technical indicators aren’t a lot of help. The drop in net new 52-week highs on the NYSE is short of capitulation levels and bullish sentiment has yet to hit extreme lows. While past geopolitical crises suggest their impact tends to fade with the market ultimately rebounding, it's hard to get past the knock-on effects of a prolonged Russia-Ukraine conflict. The two countries combined represent a small part of the global economy (3% of GDP), but what they export is critical. Russia is the world’s second-largest oil exporter, Europe’s largest energy supplier and a key source of platinum, palladium, cobalt and nickel used in autos and chips. In addition to rare metals, Ukraine is Europe’s breadbasket, serving up wheat and corn. Without an off ramp as he faces unprecedented EU sanctions and stiff Ukrainian resistance, what will Putin do? His legacy in shambles, the worst case is he goes nuclear. BCA Research puts odds of such at an extremely uncomfortable 10%, and yet is constructive on stocks over the next 12 months. If you say so.
Back in the U.S.A., employment growth is surging, wages are climbing at their fastest pace since the early 1980s, and housing, manufacturing, business and consumer spending are all rising. Economists surveyed by Bloomberg expect real GDP growth of 3.7% this year—nearly double its 20-year average pace, albeit down from 2021’s stimulus-fueled 5.7% surge. The New York Fed puts recession odds at just 6%, down from 9% seven months ago. ln ISI’s latest proprietary weekly surveys, homebuilder confidence neared a record high (despite 30-year mortgage rates that are challenging 36 years of resistance at 4%). February vehicle sales, while down month-over-month, remained in an improving uptrend (the economy historically has done very well when both housing and autos are doing well). And unlike some slowing in February’s ISM survey (more below), ISI’s weekly services surveys accelerated. Restaurants and hotels reported increasing activity, with leisure bookings back to pre-omicron levels. Airline forward revenues were up significantly. In fixed-income markets, credit spreads have widened but without signs of unusual stress in funding markets or EM sovereign spreads outside of Russia. The focus remains on the Fed. Chair Powell this week all but assured a quarter-point hike this month, with balance-sheet reduction to follow shortly afterward. If inflation fails to start moderating, a possibility he acknowledged as crude shot past $110/barrel, he indicated 50-point rate increases were on the table (just not this month).
This week I traveled in North Carolina, with meetings in Pinehurst and Raleigh. Met lots of interesting characters concerned about the Ukraine crisis but not yet extremely worried. Rather, in Wake County, where mask mandates were just lifted, advisors at lunch removed theirs two years ago “after the curve flattened.’’ I didn’t bring it up, but cryptos were discussed in two meetings, a believer comparing it to doubters at the time of Christ and a skeptic to the Cabbage Patch dolls craze. Given the myriad of uncertainties, defensive strength has been reasserting itself after five dormant years, with Utilities breaking out, joining Health Care, Consumer Staples and, of course, Energy. These four sectors have had positive returns over the past three months, with Energy up 31% year-to-date. And yet, valuations in Energy, Financials and Health Care are at least one standard deviation cheap relative to the market. Goldman Sachs says dividend-payers look particularly promising, especially since rising rates continue to erode tech-stock valuations—the S&P’s P/E has fallen 13% so far this year largely on the hit to Big Tech. It is expecting S&P dividends to grow 10% on average this year, with the payout ratio reaching 30%. It cites earnings growth as the primary driver and notes dividend stocks typically outperform during periods of high inflation. Moreover, dividend stocks currently are trading at an attractive 26% P/E valuation discount to the S&P, well below the long-term average discount of 12%. Ask any Super Bowl-winning coach. The best offense is a good defense.
- This doesn’t look like a weakening economy February nonfarm jobs jumped a well above consensus 678K, and the participation rate rose, too. Wage growth was just a penny, largely because the biggest job gains were in lower-paying service industries. But hourly wages are still climbing at their fastest pace in 40 years. Elsewhere, ADP employment rose a better-than-expected 475K in February to pre-pandemic highs, with January’s initial loss revised up a whopping 810K (a seasonal adjustment fluke?) to a net gain of 509K, and 4-week continuing claims fell to 1970 lows.
- Manufacturing holds up February’s ISM showed manufacturing emerging from omicron-related softness, rising more than expected on solid increases in new orders, new export orders and backlogs. Prices paid slipped but remained elevated, though off 2021 highs.
- Car prices start to break One factor driving CPI higher may be starting to fade. JD Power notes new vehicle transaction prices declined 1% in the first 20 days of February compared to the same period in January. Manheim's used-car price index fell 1.5% the first half of February, which extrapolated to the full month would make the February change the third-largest decline in used vehicle prices since the global financial crisis.
- Inflation is persistent and everywhere Gasoline prices are nearing $4, putting significant pressure on inflation expectations (and politicians), and month-over-month headline CPI could hit 8% year-over-year (y/y) this month. Eurozone headline PPI already was surging at a 70% annual rate (!) before the Ukraine crisis, and the core rate was up 12% y/y in January. Turkey’s CPI hit a 20-year high of 54% y/y.
- Russia really has an inflation problem Its annualized CPI accelerated to 8.7% in January, before the Ukraine invasion and all its knock-on effects. The subsequent plunge in the ruble is likely to push Russian inflation above 20%. The Central Bank of Russia on Monday doubled the policy rate to 20%, the latest and by far the biggest of nine hikes over 2021-22.
- Services slow The ISM nonmanufacturing gauge disappointed in February, sliding further below November’s record high versus expectations that it would improve on omicron’s sharp decline. Although the reading still points to moderate growth, it was a 12-month low, with weakness in business activity, new orders and employment and little sign spending was shifting to services from goods.
Unintended consequences The West’s unprecedented sanctions won’t come without a price. Europe now faces paying heavy premiums for energy denominated in U.S. dollars, making it more expensive and harder to borrow and potentially undermining European economic and asset price performance. In China, one consequence is that instead of heading west, Russian commodities will now head east. And if China is the only big buyer of Russian commodities, Beijing will not need its sharpest negotiators to secure long-term deals at sizable discounts. If it instead can sign long-term energy deals in renminbi, its energy position should improve dramatically.
Can anything take the edge off oil’s spike? International Energy Agency member countries, which hold emergency stockpiles of 1.5 billion barrels and another 2.7 billion in commercial inventories, could release 50 million barrels monthly for the rest of the year, which would make up for about half of the 5 million barrels Russia exports. In the U.S., the Biden administration could declare the energy crisis to be a national security problem, incentivizing major producers to ramp up beyond their current 2-3% growth guidance. A deal with Iran over its nuclear ambitions could add another million barrels daily to the flow.
Build Back Better is dead That’s Cowen take, as it expects the next three months to see endless interpretations of what Sen. Manchin will support on Biden's domestic policy agenda in the run up to Memorial Day. This is just a messaging exercise—not a policy one—as Build Back Better gets rebranded into an inflation fighting, deficit reducing, supply-chain fixing panacea.