Economic Headwinds or Tailwinds & Other Economic News

for the Week Ending January 21 2022

Treasury yields were mixed over the course of the week as the yield curve flattened with shorter duration yields rising moderately and longer duration yields falling. (Not a good sign when short term rates are higher than longer term) Treasury yields rose significantly on Tuesday as traders priced in some risk that the Federal Reserve may raise rates by 50 basis points in March. We think that they may only go as high as 25 bps as a larger jump will have too much of an impact on the economy.

The market implied probability of a rate hike for the March meeting increased from 91.5% last week to 99.6% on Tuesday, and settled at 98.6% on Friday.

Treasury yields then dropped (prices rose) significantly the rest of the week as there was a significant sell-off in the equity market causing investors to seek the perceived safety of Treasury’s. However, yields for shorter duration Treasury’s either rose slightly or did not fall as much during the equity sell-off as the 2-year Treasury yield hit a 52-week high on Thursday.

Investors are nervous and took a more risk-off approach with initial jobless claims exceeding expectations with a 3- month high of 286k. 

Headwinds or Tailwinds

If you have any familiarity with sailing you know that headwinds are resistance and tailwinds are support to how your boat will move. In economics we have a similar analogy

While know one can predict with certainty what will happen, we can evaluate the environment and make intelligent assumptions based on certain data we have and know. For several weeks we have discussed the health of our economy. We have been seeing headwinds and the market is now reacting to this data.

Potential Headwinds

The biggest challenge for our economy is the COVID issue regardless of the severity of any new variants, consumer response to the media will have a significant impact on our economy. While we do not diminish the severity of the initial virus, we are concerned that the pandemic has become more of a political media issue than a health issue and that has dangerous implications to our economy.   

So, with that Investors need to be open-minded to the notion that this pandemic, in all its potential forms, may continue to disrupt all aspects of our daily lives. We have been told by health care experts that, like the common cold and flu, this virus is here to stay. o Inflation –

Inflation while we still believe is transitory (supply driven) “Fed” Chairman Jerome Powell has changed his expectations on inflation from characterizing it as transitory to it being more persistent in nature. This we feel was due to media and political pressure One key measure of inflation is the Consumer Price Index (CPI). The CPI stood at 7.0% on a trailing 12-month basis in December 2021, up from 1.4% in December 2020, according to data from the Bureau of Labor Statistics. The CPI has not been this elevated since 1982. However, we do believe a large part of this is a self-inflicted wound. By this we mean that “Rent” /housing accounts for 30% of the inflation calculation and with so many people opting to spend their government pandemic money of discretionary items instead of rent this is the pay back for being irresponsible

A 7.0% CPI is high enough to begin to compete with the historical gains generated by common stocks. This is Not Good. The Fed announced it is reducing (tapering) its purchases of Treasuries and mortgage-backed securities by $30 billion per month. (Removing money from the economy) At that pace, it should be done buying bonds in the open market by the end of March 2022. This program has been successful at pushing down intermediate and longer maturity bond yields and keeping them artificially low to help stimulate economic activity, such as housing. The Fed also foresees hiking short-term interest rates three times in 2022. The federal funds target rate (upper bound) is currently at 0.25%. Its 30-year average is 2.52%, according to Bloomberg. The threat from inflation moving forward is that it remains elevated or trends even higher, forcing the Fed to act more drastically with respect to monetary policy.

Supply-Chain Disruptions/Bottlenecks – This is another large contributor to the inflation issues. We expect them to persist at least into the middle 2022. Semiconductor shortages are negatively impacting many industries, especially autos causing used car prices to sky rocket. The backlog of container ships waiting to unload their cargo in the ports of Los Angeles and Long Beach, California, is being reduced slowly. The bottlenecks are contributing to “too much money chasing too few goods,”  (Inflation) and too many goods are still sitting out at sea or in the port with fewer Truck drivers to deliver them to their destination These delays are also racking up added expenses for those companies waiting for their goods.

Build Back Better Act (BBB) − The President social spending bill has been unable to gather enough support within his own party to pass. Attempts have been made to pare it down so that it is less costly. The Democrats have even discussed splitting it up into smaller bills. The money needed to fund this plan was supposed to come from higher taxes. That is the part we believe could potentially impact sentiment/behavior in the stock market. If companies are hit with higher taxes, then less will go into capex and innovation we need to keep the engine going slowing it down is not a good idea

Valuations (P/Es) − Multiple expansion is nothing new. In this ongoing climate of low interest rates and bond yields, equity investors have in part been willing to pay more for a dollar’s worth of earnings. But as we have discussed in the past another large contributor to the rising levels are index and ETF’s which are Buy only products that are paying more for equities than perhaps, they are worth. But where else are you going to put your money and with fixed income instruments just a volatile as equities

The trailing 12-month price-to-earnings (P/E) ratio on the S&P 500 Index, stood at 26.20 on 12/31/21, according to Bloomberg. This is well above its 17.21 average P/E over the past 50 years.

We are expecting a very volatile year.

Tailwinds

Yes, there are some tail winds and no one knows which will impact the market more. Here are a few areas that show support  

Corporate Earnings – Corporate earning have been strong during the pandemic and much of it was due in large part to the money the Federal government injected into the economy either in the form of pandemic relief, or increase in M2

We acknowledge that year-over-year comparisons to 2021’s outsized results could be challenging depending on the severity of the pandemic.  

Global Speculative-Grade Bond Default Rate − Is already well below its historical average and is expected to remain below. If there was danger on the horizon for Corporate America it would likely be reflected in this default rate. Moody's reported that its global speculative-grade default rate stood at 1.7% in December. Moody's puts the historical average default rate at 4.1% (‘83-’21). Its baseline scenario sees the default rate rising to 2.4% by December 2022.

Mergers & Acquisitions (M&A) Activity − CEOs and executives have been risk on with respect to acquiring other companies and the pundits expect that it will continue.  Refinitiv reported that global M&A activity jumped 64% year-over-year to a record $5.8 trillion in 2021. The U.S. accounted for $2.5

trillion of that total. However, rates increase may impact this and not as much new activity may be seen

Stock Buybacks − S&P 500 Index stock buybacks totaled a record high of $234.64 billion (preliminary) in Q3'21 (previous high was $222.98 in Q4'18), according to S&P Dow Jones Indices. Data Trek Research reported that companies have the means to increase buybacks in 2022 despite already sitting at record levels. In reviewing the growth over the last few years stock buyback attributed to 40% of the movement in stock prices. We expect that with much volatility companies may just continue reducing the amount of stock in the market driving up prices especially if those companies are part of index or ETF’s

By Sector

As mentioned earlier the S & P 500 index fell -5.7% this past week with the consumer discretionary, communication services and technology sectors leading a broad slide as Q4 earnings reports came in mixed and added to investors' concerns about the impacts of the pandemic, inflation and supply-chain issues.

The market benchmark ended the week at 4,397.94, down -264.91 points. The week, which only had four trading days due to Martin Luther King holiday, is the S&P 500's third consecutive week in the red. The index is now down 7.7% for the month/ year to date following a 27% jump in 2021.

The decline for 2022 has come amid increasing concerns about inflation, supply chain issues and the pandemic. This week marked the first full week of US companies' Q4 earnings results being released, and the reports only added to investors' worries as many companies confirmed their concerns. And their outlook for 2022

Every sector fell this week, with the largest percentage drops logged by consumer discretionary, down 8.5%; communication services, down 7%; technology, down 6.9%; and financials, down 6.4%. Among the other sectors with declines of 3% or more, materials lost 5.4%, industrials fell 4.4%, health care shed 3.4% and energy slipped 3.1%. But is the only sector in the black for the year so far with +12.79%

The decliners in the consumer discretionary sector included Ford Motor (F), whose shares tumbled 18% on the week as a National Highway Traffic Safety Administration report said the automaker is recalling nearly 200,000 older-model cars for an issue with their brake pedal bumper. The issue affects certain 2014 and 2015 Fusion and MKZ vehicles as well as some 2015 Mustang vehicles. Jefferies downgraded its investment rating on Ford's stock to hold from buy.

In communication services, shares of Netflix (NFLX) shares fell 22% in Friday's session alone, which put the stock down 24% for the week, as the entertainment services company released weaker-than-expected guidance for Q1 earnings per share, revenue and subscription growth. Disappointment over the guidance led to a flurry of investment rating downgrades and price target cuts by analysts.

In the technology sector, shares of NXP Semiconductors (NXPI) shed 11% this week as Piper Sandler downgraded its investment rating on the semiconductor maker ahead of the company's Q4 report due at the end of the month. The firm also lowered its price target on NXP's stock to $210 from $235.

In the financial sector, Goldman Sachs (GS) shares slid 9.7% this week as the investment bank reported Q4 earnings per share below analysts' mean estimate amid higher operating expenses and lower revenue in its global markets business. Chief Executive David Solomon said on a conference call with analysts that there is still a "fair amount of uncertainty" as COVID-19 cases, driven by the omicron variant, rise.

Interpreting some of the  Data

Over the past few months, we have observed growing concerns in the economy.  Back in November we thought that December Retail Sales would disappoint because the “shortage” narrative would pull demand forward. Guess what, it did (Retail -1.9% M/M December). The same phenomenon occurred in the U.K. For those retailers that are receiving back ordered good we expect that a drop in price may occur as concerns of holding on to too much inventory will force retailers to put many items on “Sale”

We now observe that the employment and workweek sub-indexes in the Regional Fed business surveys have significantly weakened. 

We are noticing up-spikes in the weekly unemployment claims data both for the Initial Unemployment Claims (ICs) and Continuing Claims (CCs) series. If we look at this data on a state-by-state basis and we find significant deterioration in the employment series since Thanksgiving. At that time, states had reduced CCs by 65% from May 15, 2021 levels. That retreated to 54% in the latest weekly data survey (January 8).

The most recent data show a fall in Existing Home Sales (-4.6% M/M December). These are contracts signed two or three months ago that have now closed, so the slowdown in housing didn’t just begin. It stated back in September. Note that these sales were negative in every region of the country with the south and west bearing the brunt. 

True, housing starts did rise +1.4% M/M in December, but all the increase was in multi-family starts. The single-family starts were off -2.3% M/M and down -10.9% Y/Y. Much of this may have been cause by cost of material.

There is a record number of multi-family starts (highest in more than four decades) and forecast that these would impact the rent component of CPI (a 30% weight) by mid-year. It looks like it may be earlier than that. The two charts show that rent increases turned negative in December (perhaps some seasonality) while vacancies began climbing last fall.

It is possible that housing will begin to see some relief in the spike landlords had to make in order to offset losses from too many renters avoided rent.

We think that the omicron infection spike will depress January and likely some of February’s economic activity, especially on the supply side, as absenteeism has soared.

We believe that the spike was the result of “getting together” over the holidays, and that the infection spike would run its course. In addition, too many employees are staying home with the ever so slightest symptom even if not Omicron. The omicron spike does mean that, since supply continues to be disrupted, (can’t find truck drivers) inflation will be elevated for a while longer. This added to the continued depressed level of the Labor Force Participation Rate, a temporary but persistent phenomenon caused by health concerns or domestic (e.g., child care) needs.

This could keep labor scarce and wage growth and inflation elevated. Eventually, however, we will achieve herd immunity, or we will learn to live with the virus. And that is when demographics, technology, and high debt loads will reassert themselves. At that time, the U.S. and the world will return to a deflationary environment.

The Week Ahead

Investor sentiment has been pushed to levels not seen in quite some time. The latest AAII survey showed bullish sentiment at 21%, an 18-month low, while bearish sentiment jumped to 47%, a 16-month high. Readings at those extremes may suggest an oversold market in the short term. However, this week is packed with potential big-impact announcements, none looming larger than the FOMC’s statement to be released mid-day Wednesday. Will Powell change his hawkish tone given recent risk-asset performance, or stay the course laid out in December? Reaction may be volatile either way. Flash manufacturing and services PMIs, along with consumer confidence numbers, will precede the Fed’s account. Thursday brings the first look at Q4 GDP, where consensus forecasts have slowly come down and currently sit around 5.3%. Durable goods and pending home sales will also drop Thursday, and then Friday an inflation update lands with the Core PCE Price Index. And don’t forget earnings season is in full swing, with tech giants Apple, Intel, and Tesla scheduled to report. The international calendar highlights include Eurozone flash PMIs, Australian CPI, and the Bank of Canada’s monetary policy statement.

This article is provided by Gene Witt of  FourStar Wealth Advisors, LLC (“FourStar” or the “Firm”) for general informational purposes only. This information is not considered to be an offer to buy or sell any securities or investments. Investing involves the risk of loss and investors should be prepared to bear potential losses. Investments should only be made after thorough review with your investment advisor, considering all factors including personal goals, needs and risk tolerance. FourStar is a SEC registered investment adviser that maintains a principal place of business in the State of Illinois. The Firm may only transact business in those states in which it is notice filed or qualifies for a corresponding exemption from such requirements. For information about FourStar’s registration status and business operations, please consult the Firm’s Form ADV disclosure documents, the most recent versions of which are available on the SEC’s Investment Adviser Public Disclosure website at www.adviserinfo.sec.gov/