08.03.2022 The Fed is tightening, the economy is in technical recession, the mood is sour . . . yet S&P 500 companies continue to pump out profits. With nearly three-quarters of companies now having reported, Q2 revenue and profit reports have been better than what investors have feared, setting the stage for a 9.2 per cent July rally. S&P profits grew 9 per cent over the last 12 months on 16 per cent revenue growth, with every sector reporting top-line growth. Corporate guidance suggests revenue growth will continue into next quarter. But confidence, like semiconductors and natural gas these days, is in short supply.
Consumer confidence plunged to levels not only below those at the height of the pandemic – they are more pessimistic than they were at the depths of the 2008 housing bust and global financial crisis. Investors are wringing their hands as well. The share of investors declaring themselves “bullish” is in the 13th percentile of its historical range, up from the first percentile a month ago. Small business owners are similarly concerned. The National Federation of Independent Businesses (NFIB) Optimism Index, while not as pessimistic as its customers, has fallen below levels last seen when the world was locked down in 2020. Like small business owners, corporate CEOs are increasingly anxious, as evidenced by cascading confidence – although it should be noted that businesspeople are relatively more sanguine than seemingly inconsolable consumers. COVID-19 hit household sentiment hard; though it picked up as vaccines were rolled out, it never fully recovered to pre-pandemic levels.
Consumer expectations could become self-fulfilling, as dour expectations lead to slower spending. The US economy is technically in recession already, thanks to two consecutive quarters of negative growth. Other indicators are forecasting a recession to come. An inverted yield curve (which occurs when the 2-year Treasury yield exceeds that of the 10-year yield) has flawlessly predicted the last seven US recessions with no false signals. Currently, the 2-year yield exceeds that of the 10-year yield by nearly 25bps, a significant inversion. Manufacturing statistics confirm that view: new manufacturing orders have plunged in recent months, leading to massive inventories. We suspect manufacturers and retailers double- and triple-ordered late last year to combat supply shortages. Months later, final demand proved fleeting.
The future path of inflation is critical to the direction of the Fed, interest rates and equity markets. Persistent inflation will force the Fed to raise rates aggressively, risking a more severe recession and equity market pullback. Current indicators suggest inflation may be rolling over. Food and energy prices, which had an outsized influence in recent price data, are coming off the boil, according to current commodity markets. It’s comforting to see that, with the exception of natural gas, many food and energy prices abated in July. The national average price of a gallon of unleaded gasoline is $4.30, down from $4.84 on June 30, according to the American Automobile Association. Wheat, corn and soybeans, key ingredients in much of the food we eat, are off double-digit increases. While beef prices rose more than six per cent for the month, pork is off more than five per cent. The Institute for Supply Management’s index confirms prices are falling among US manufacturers. The diffusion metric dropped to 60 in July from a recent peak of 87 in March – a good thing, but bear in mind that readings above 50 are expansionary, meaning more input prices are rising than are falling. We also note that 70 per cent of small businesses surveyed are raising their prices, according to the NFIB. That’s consistent with 9.1 per cent year-over-year inflation. While we believe 9.1 per cent will represent an inflation peak, the direction in pricing growth is uncertain.
Bond investors are optimistic inflation will peak this year, overnight rates will peak in the beginning of next year, and the Federal Reserve will lower rates in 2023. Inflation is expected to drop to 3.5 per cent next year and ease toward 2.5 per cent in 2024, according to the Treasury Inflation Protection (TIPs) market. At the same time, corporate bond spreads (the yield premiums lenders require to extend credit to lower-quality borrowers) remain relatively low by historical standards, suggesting corporate bond investors are optimistic that their borrowers would be able to weather a Fed-induced economic downturn without much credit deterioration. Unfortunately, bank lenders are not as optimistic: nearly one-quarter of large banks surveyed by the Fed are tightening their lending standards. That suggests corporate bond spreads, particularly among lower-quality companies, could be vulnerable in an economic downturn.
The equity market downturn and recent rally were directly related to changes in the bond market. Higher yields earlier this year drove equity prices lower, while the bond market’s recent optimism fueled the July rally. While the equity markets’ future path will be interest-rate dependent, equity valuations are currently positioned at a slight discount to bond yields. With the exception of 2009 through 2020, when global central banks embarked on quantitative easing, the S&P’s forward price/earnings (P/E) ratio traded in line with 10-year, BBB bond yields. That’s the case this year. Most recently, the market’s forward P/E is incrementally below what the corporate bond benchmark would imply, giving equity investors a slight valuation cushion in the event yield, or more likely spreads, rise.
Bottom line: Like the Fed, equity investors need to be data dependent, and the path of inflation is one of the most important indicators to track. If bond investors’ views are correct, equity markets are properly positioned. Investors in lower-quality corporate bonds, however, could be vulnerable to spread widening, particularly if lenders are accurately assessing credit risks.