Investors are hoping for another March-like bounce in May because April looked a lot like February. Can stocks climb a wall of worry once again?
The Federal Reserve Meets Early in May and Could Set the Tone for the Month
Earnings Season Is in Full Swing for Spring. How’s It Going?
Which Market Trends Are Most Likely to Continue?
Shawn Cruz, Director of Derivative Strategy, TD Ameritrade
It almost feels like we’re back in February looking over the edge of the abyss and wondering how far we have to fall. You may remember skyrocketing commodity prices due to Russia’s invasion of Ukraine, inflation hitting historical levels, wondering if COVID-19 would ever go away, and fearing what the Fed might do next.
Here we are once again at those February lows, looking into the abyss, commodity prices are still really high but have settled a bit, the Russia-Ukraine war wages on, inflation hit a new 40-year high last month, China continues its lockdown due to COVID-19, and the Fed sounds as hawkish as ever. Unfortunately, my crystal ball is a little cloudy, so, while I can’t tell what stocks will do in May, I can tell you a few things to watch out for.
As I said, the Fed has really upped its hawkish tone since the March meeting. It seems that nearly every public statement is about the importance of curbing inflation. We’ve seen similar sentiments from Fed Chair Jerome Powell, Fed Governor Lael Brainard, and St. Louis Fed President James Bullard.
Chair Powell told Congress at the beginning of April that he could imagine a half-point hike in May and reiterated those comments in speeches later in the month. Gov. Brainard said that inflation is of “paramount importance” and that the Fed would raise rates and reduce its balance sheet at a more rapid pace than in the past. She also said that the Fed has an opportunity to raise rates in every meeting this year but felt that the U.S. economy was strong enough to handle the rate hikes.
While the Fed’s overnight rate is still at 0.25%, the probabilities have shifted for other rate hikes throughout the remainder of 2022. The market continues to anticipate a 50-basis-point hike for May 3-4 meeting, but now it’s also anticipating another 75-basis-point hike in June. That would take the overnight rate to 1.50% after the June hike. Previously, the market was anticipating the Fed’s rate to be between 2.0% to 2.25% by the end of the year, but now it’s pricing in 2.75% to 3.0% by year-end.
However, Mr. Bullard said that he thinks the markets have already priced in the Fed’s tightening. It’s likely that Mr. Bullard was referring to the 2-year Treasury yield because it’s often seen as a proxy to the Fed’s interest rate policy. The 2-year has been as high as 2.72%, which is not quite the 3.5% Mr. Bullard suggested.
The Fed’s discussion of rate hikes caused the yield curve—as measured by the 2-year and 10-year yields ratio—to invert momentarily in April. Many investors see an inverted curve as a harbinger of a recession. In fact, the inverted curve may have been the impetus for Governor Brainard’s remarks about the Fed unloading its balance sheet. Her comments caused the 10-year Treasury yield (TNX) to rally, which steepened the yield curve.
The balance sheet matters because much of it deals in longer-term Treasuries because the Fed was using its purchasing power to provide liquidity at that end of the curve when it was stimulating the economy during the pandemic. Ms. Brainard’s comments may have been a calculated move to signal to investors that the Fed is paying attention to the yield curve and would work to normalize it.
Despite all that the Fed is doing, former Treasury Secretary Larry Summers told Bloomberg Economics that the most likely end for the U.S. economy is a recession. Mr. Summers thinks the Fed will have to keep raising rates well into 2023 until inflation turns to disinflation. He said rising prices and rising rates will likely result in a “hard landing” for the economy at some point in the next two years. He also pointed to history as a guide, stating that there’s never been a time when inflation was above 4% and unemployment was below 5% and a recession didn’t occur within two years.
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Similar to the previous quarter of earnings, Q1 2022 earnings are seeing companies beat expectations at a higher rate than FactSet’s five-year average, but lower than the last four-quarter average. The margin at which earnings are being beaten is actually below the five-year average. As of April 22, only 20% of the S&P 500 companies had reported earnings.
Energy companies are by far the biggest gainers in earnings growth. Thus far, the energy sector is reporting a growth rate of 259.4%. Materials has the second-highest growth rate at 34.7%, followed by industrials at 32.6%. Communications, consumer discretionary, and financials are reporting negative growth rates at -0.27%, -12.6%, and -21.4% respectively. The average earnings growth rate for the S&P 500 is 6.6%.
Currently, analysts are projecting improvement for the rest of the year. Their Q2 earnings growth rate is 7%, Q3 is 11.7%, and Q4 is 11.2%.
Despite the energy sector’s big earnings growth rate, it performance has declined in April. The Energy Select Sector Index had lost 6.2% as of April 25. This is due to falling oil prices. Instead, consumer staples and real estate have been the best performers for the month per the Consumer Staples Select Sector Index and the Real Estate Select Sector Index at 3.17% and 0.16% respectively. All other sectors are in the red, with the Technology Select Sector Index performing the worst at -10.76%.
Investors looking for the big mega-cap tech companies to pull the sector out of its funk have seen some help from Microsoft (MSFT) and Twitter (TWTR)—due to Elon Musk’s buyout. But, Netflix (NFLX) and Alphabet (GOOG) have disappointed.
An interesting observation from FactSet was that international problems aren’t hurting multinational companies, at least not yet. S&P 500 companies that generate at least 50% of their revenues from outside the United States, had an earnings growth rate of 13.5%, while companies that generated more than 50% of their earnings in the United States had a growth rate of 1.8%. It appears to be important for companies to diversify their customer bases.
Despite a strong showing in earnings for multinationals, one theme that’s already coming out of the earnings season is that multinationals are seeing the strong U.S. dollar as a future headwind. The stronger dollar makes U.S. products and services more expensive for foreign customers. Companies like IBM (IBM), Procter & Gamble (PG), Johnson & Johnson (JNJ), and Meta (FB) have forecasted some diminishment in earnings because of “currency headwinds.” Analysts have warned similar issues will arise for companies like Netflix (NFLX), Twitter (TWTR), and Ingersoll Rand (IR).
The U.S. Dollar Index ($DXY), which measures the strength of the dollar against a basket of currencies, has risen nearly 13% from its 2021 low. While that may not seem like much when compared to other assets, it’s a big move in currencies, which are commonly traded in a fraction of a cent. The dollar index is testing highs from 2016 and 2019. Otherwise, you have to go back to 2001 to see higher highs.
While multinationals may not like the stronger dollar, a strong dollar is needed to curb inflation. In fact, one reason the Fed raises interest rates is to strengthen the dollar to increase its purchasing power. So, as long as inflation remains a problem, rates will likely go up and multinationals will likely see struggles in their overseas earnings growth.
While the stronger dollar may be hurting multinationals, it should be a boon for U.S. travelers heading overseas because the dollar is likely to buy more souvenirs and go further for lodging and food.
The travel and leisure, and more specifically—airlines, industry group has held up well during the last sell-off. Higher fuel costs and stronger demand has driven airfares up more than 20% since March 2021, according to Insider. The travel app, Hopper, has recorded a 40% rise in airfare since the start of 2022 and is predicting another 10% rise in May.
However, travelers have been cooped up for two years due to the pandemic, and they don’t seem to care about the increased prices. They’re willing to pay the price to see the world. In fact, online spending for domestic flights is up 28% higher than pre-pandemic levels.
Airlines have only recently seen these benefits from the demand. Until March, the AMEX Airline Index (XAL) was still downtrending from its high in 2020. Better-than-expected earnings from United Airlines (UAL) and American Airlines (AAL) gave the group a boost near the end of April, and lower fuel prices may finally allow the group to break the downtrend.
Hotels were the first group in the travel and leisure industry group to bounce back from the pandemic and maintain their gains. The Dow Jones U.S. Hotels Index is up more than 125% in the last two years. The broader Dow Jones U.S. Travel & Leisure Index is only up about 54% because of the drag from airlines and cruise lines.
If travelers are able willing to take to the air and the roads despite inflation, then these groups could continue to grow. However, there are a number of headwinds here too. The biggest is fuel costs. Rising oil prices have led to rising gas and jet fuel prices too. These are major costs for airlines and can greatly affect the cost of ticket prices. In fact, according to CNBC, East Coast jet fuel inventories are at their lowest levels since 1990. Additionally, like nearly all other businesses, airlines are struggling with labor shortages. Both of these problems have already resulted in canceled flights.
FIGURE 1: GREASY BUSINESS. Crude oil futures (/CL—candlesticks) have pulled well off their highs but support around $95 appears to be holding up. Data Source: FTSE Russell, S&P Dow Jones Indices, Nasdaq. Chart source: The thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.
Oil prices have been batted around by numerous influences, but more recently by international issues. Back in February, oil prices spiked when Russia invaded Ukraine. Then they went higher as many in the international community placed sanctions on Russia’s oil and gas. Oil prices began to settle down as investors got a better idea of the effect the war and sanctions were going to have on the supply of oil.
However, oil prices started falling as China instituted a lockdown on Shanghai amid rising COVID-19 cases. China’s zero-COVID policy has extended lockdowns and now new cases are showing up in the capitol city of Beijing as well as Shenzhen where much of Apple’s (AAPL) production takes place.
On April 25, oil prices fell 5% on the threat of more lockdowns because lockdowns in China means less demand for oil worldwide. Shanghai is about eight times the size of New York, with Beijing approximately two and a half times, and Shenzhen about one and a third times larger than the Big Apple. In short, extended lockdowns in these cities would greatly reduce the demand for oil and other commodities around the world. The Shanghai Composite Index has been in a bear market much of 2022 and continues to fall.
Meanwhile, many European countries are still reeling from the pandemic restrictions, but the Russia-Ukraine war is a bigger problem. It has also driven prices higher for oil, gas, gasoline, wheat, corn, rice, and many other commodities. While Russia’s gross domestic product (GDP) isn’t that big compared to other countries like the United States and China, Russia is a big provider of commodities.
Additionally, Russia is second only to Saudi Arabia for oil imports to China and the European Union (EU) imports roughly 40% of its gas and 25% of its oil from Russia. Wartime sanctions on Russia is one reason why the EU has recorded two quarters of negative GDP, which means it has been in a recession for more than six months.
On the bright side—if this counts as a bright side—oil and gas supply issues in Europe may be offset by declining demand issues in China, depending on how the war and pandemic lockdowns play out.
The last few months have been crazy for the commodities markets. Oil, gas, wheat, and corn have seen multiyear highs. The S&P GSCI Softs Index, which tracks soft commodities including coffee, sugar, cocoa, and cotton, is nearly 50% higher over the last year. Other commodities like lithium, uranium, tin, nickel, and more have also seen major price increases. For now, markets appear to have discounted the harm done to commodity prices, but if new sanctions are added or tension escalates to include other countries, more spikes could still take place.
It’s notable that the money markets seem to have done much of the Fed’s work in trying to tighten the money supply. Lending rates have shot up, causing mortgage rates to move well above 5%. Many economists believe that the tighter money supply and the known supply issues have brought us to the point of “peak inflation”.
In other words, inflation may be topping out.
The March Consumer Price Index (CPI) hit 8.5% annually for the United States. Of course, peak inflation could mean inflation stays at or near 8.5%, so maybe the term doesn’t mean much. What we need is declining inflation or disinflation. For that to come about, we need commodity prices to start falling. Unfortunately, that will likely happen only with the tightening of the money supply as the Fed raises rates and unloads its balance sheet.
It’s been said that “the stock market climbs a wall of worry.” This means that bad news isn’t necessarily bad for stocks as long as investors remain bullish. Unfortunately, investors don’t appear to be very bullish right now, and if support fails to hold, it could get downright ugly as major indexes would then be testing bear market territory. So, keep an eye on support and know it’s OK to worry—but just a little. If you get too worried, turn off your computer, change the channel, and take your dog, or your neighbor’s dog, for a walk.
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