Inflation is still in the driver’s seat
No matter how good or bad third-quarter earnings are, pervasive macroeconomic volatility is going to remain firmly in control, says Matt Orton, CFA, Chief Market Strategist at Raymond James Investment Management.
Yet Orton says this remains an attractive environment for long-term investors. Flexibility is key, he says, and there are a growing number of opportunities for stock pickers. Floors are starting to form within “the market of stocks,” he says, but they’re unlikely to have enough demand to achieve escape velocity until credit conditions peak. As a result, ranges will form and investors will have the chance to pick their levels.
But don’t chase the market higher, Orton says.
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Inflation is still in the driver’s seat
Oct. 24, 2022
October has been a wild ride, and it’s unlikely to get any calmer this
week, said Matt Orton, CFA, Chief Market Strategist at Raymond James
Investment Management. Despite a surge in realized volatility, the S&P
500 Index is up nearly 5% with improving internals and market breadth.
But traditional volatility measures mask the true extent of the recent
market swings. In fact, only one day in October so far has had an intraday
move of less than 1% (Oct. 12 had a 0.96% intraday swing), with a median
intraday move of 2.04%.
“Last week’s volatility highlights the environment that we’re in,” he
said, but it’s important to note that “earnings, corporate margins, and
guidance have been better than what a lot of people feared. Blended
corporate profit margins for the S&P 500 still sit at 12%, which is lower
than the last couple of quarters, but put that in perspective: We have
the worst inflationary environment in four decades, coupled with out-
of-control wages and a constant barrage of uncertainty with respect to
hiring and supply chain dislocations. Yet profit margins have held up at
very high levels. In fact, prior to the current post-COVID streak, the net
profit margin only hit 12% once in the previous 10 years. The question is
how long this continues.”
This week, earnings results will pour in with heavyweights from every
sector reporting. Perhaps, Orton said, earnings can help guide this
market if results from mega-cap companies continue to give investors
a break from the unrelenting news about inflation and interest rates.
The U.S. Federal Reserve (Fed) has also entered a blackout ahead of
the Federal Open Market Committee (FOMC) meeting on Nov. 2, which
will further focus attention on earnings this week. Still, Orton said, no
matter how good (or bad) earnings results are this quarter, the pervasive
macroeconomic volatility is going to remain firmly in control. Just look
at the massive intraday surge on Friday after Federal Reserve Bank of San
Francisco President May Daly said that that future interest rate increases
could come in smaller increments to achieve the Fed’s target neutral rate.
Unfortunately, Orton said, bonds remain skeptical of any change in the
current Fed course and touched some key milestones last week: The
yield on the U.S. 10-year Treasury note rose above 4.25% for the first time
since the Global Financial Crisis; 10-year German bunds traded at 2.5%;
and 10-year U.K. gilts moved back above 4%. Market U.S.-dollar overnight
index swaps moved in excess of 5% before the Daly news but still priced
a peak fed funds upper bound at 5.06%. The upward trend in rates comes
in stark contrast to growing recession risks with manufacturing sentiment
and housing showing further downward momentum this week while
the Conference Board Leading Economic Index® printed at levels that
usually only precede recessions. This divergence highlights the challenge
facing fixed income investors looking to harvest increasingly attractive
yields. Principally, while the drivers of inflation are well known, inflation,
and especially core inflation, continues to surprise in magnitude and
persistence against a backdrop of a still tight labor market. As such, Orton
said the status quo, where little confidence can be taken in the full extent
of central bank tightening, persists.
All of this highlights why macroeconomic uncertainty is so high and why
it’s going to be the Fed that ultimately determines the direction of the
market, he said. Correlations between the U.S. dollar, bonds, stocks, and
commodities are incredibly high right now.
“It’s a one-variable market,” Orton said. “It’s all about how any single
data point, including earnings, impacts the outlook for the Fed.” So
far, he said, the Fed has been steadfast in playing the expectations
game, broadcasting a hard stance in the face of deteriorating forward-
looking data. Recent inflation and labor market data have been worse
than expected from an inflation standpoint, further fueling the current
trajectory of the Fed. Until this changes, Orton said we shouldn’t expect
to see the U.S. dollar roll over or 10-year real yields peak. Thus, while
the equity market has a laundry list of reasons to stage a rally – it’s at
long-term support, with bearish sentiment, favorable seasonals, and
massive underweight positioning – Orton said it will be prone to failure
until we have some macroeconomic resolution. Maybe that comes from
Fed Chairman Jerome Powell’s commentary on Nov. 2. Fed rhetoric, and
certainly Fed pricing, has continued to push the envelope of what seems
possible during this cycle, but Orton said we certainly can’t count on
that. And that’s why he said it is difficult to fight the prevailing trends too
aggressively right now.
Despite the encouraging equity price action in the face of rising
yields and maybe some optimism around the trajectory of the Fed,
macroeconomic uncertainty is too pervasive. The big intraday moves
this month are a reminder of just how quickly the market can change.
Consequently, Orton said he continues to favor maintaining a core
defensive bias. That means leaning into dividend growth,
profitability,
and growth at a reasonable price (GARP). Healthcare
remains Orton’s
preferred sector and, he said earnings results last week further reinforced
his conviction right now. He said he expects energy
strength to continue
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as companies are focused on maintaining strong free cash flow
generation and returning cash to shareholders. This is not the time
to throw in towel and this remains a very attractive environment for
long-term investors, he said. Flexibility is key, he said, and there are
an increasing number of opportunities for stock pickers. Floors are
starting to form within “the market of stocks,” but they’re unlikely
to have enough demand to achieve escape velocity until credit
conditions peak. As a result, ranges will form and investors will have
the chance to pick their levels, so don’t chase the market higher, Orton
said. Additionally, the price action in small caps remains constructive
and he said he likes the asset class to position for any sort of market
bounce. Negative investor flows as well as compelling valuations, a
shift to services, and better U.S. capital expenditures and reshoring
should all provide tailwinds, he said.
The dollar has been a wrecking ball for risk assets, and the sharp
rise in real yields also is problematic, particularly for longer-duration
assets, Orton said. It looked like the upward momentum of real yields
might have paused, but no such luck. While equities have taken the
persistent rise in yields in stride over the past week, he said it’s hard to
see how that is sustainable should the trend continue.
What consumers say vs. what they do
We still get some important economic data this week that will provide
updates on wage inflation and the state of the consumer, Orton said.
The Employment Cost Index (ECI) is the Fed’s preferred wage measure
and hopefully starts to show a small deceleration. An upside surprise
would prevent the Fed from downshifting the pace of policy tightening
at the coming meetings. Recall: It was the re-acceleration of the wages
and salaries component in the second-quarter ECI that played a key
role in Powell taking a hawkish turn at the Fed’s meeting at Jackson
Hole and the resulting September FOMC upward dot-plot revisions.
What to watch
While earnings will be the focus, some important economic data
will help illuminate two key trends: wage inflation persistence and
consumer resilience.
Fifty percent of the S&P 500 by market capitalization reporting
earnings this week. Orton said energy was on a tear last week, and
57% of the sector within the S&P 500 are scheduled to report. Other
reorts are coming from companies in auto manufacturing; package
delivery; soft drinks; online advertising; information technology,
telecommunications; restaurants; aircraft manufacturing; aerospace
and defense; foods; railroads; hotels; online retail; consumer
electronics and software; semiconductors; heavy equipment
manufacturing; brewing; pharmaceuticals and biopharmaceuticals;
airlines; and tobacco.
This week’s data releases
Monday
Flash Purchasing Managers Indexes for the U.K. and
Eurozone; Mexico Consumer Price Index (CPI)
Tuesday
U.S. Conference Board Consumer Confidence Index; ifo
Institute Business Climate Index for Germany
Wednesday
Brazil interest rate decision; Australia CPI
Thursday
U.S. third-quarter gross domestic product; European
Central Bank interest rate decision; China industrial
profits
Friday
U.S. third-quarter Employment Cost Index, plus
personal income and spending; Japan unemployment,
interest rate decision, and Tokyo CPI; Gross domestic
product and inflation from France, Spain, and Germany;
Italy inflation
Source: Bloomberg, as of 10/21/22
The strong dollar is punishing equities (with rising yields waiting in the wings)
The U.S. Dollar Index versus S&P 500 chart, the Dollar Index line is inverted to reflect the negative correlation between the two indices – that is, higher values
for the Dollar Index are correlated with a weaker equities market. The values for the inverted Dollar Index are computed by dividing 1 by the value of the index.
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S&P 500
U.S. Dollar Index
(inverted)
U.S.
Dollar Index (USD) vs. S&P 500 Index
S&P 500
U.S. Dollar Index (inverted)
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U.S. 10-year real yield (left axis)
U.S. 10-year nominal yields (right axis)
U.S.
10
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year Treasury note real and nominal yields
U.S. 10
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U.S. 10
-year
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yield (right axis)
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Realized volatility, also known as historical volatility, measures levels of volatility that took place in the past. Realized volatility is thus different from implied volatility, which
describes the market’s assessment of future volatility.
Internals refer to quantitative market indicators that investment professionals monitor to spot trends and forecast movements within securities markets. A subset of technical
indicators, internals include a number of formulas and ratios, such as the number of stocks moving in the same direction as a larger trend, the ratio of securities with rising and
falling prices, the ratio of new highs to new lows, and price and volume indicators that are seen as indicators of overall market sentiment.
Blended profit margins combine actual results for companies that have reported earnings and estimated results for companies that have yet to report.
Bunds are bonds issued by Germany’s federal government. They are generally viewed as the German equivalent of U.S. Treasury securities.
Gilts are bonds issued by the U.K. government. They are generally viewed as the British equivalent of U.S. Treasury securities.
An overnight index swap applies an overnight rate index such as the U.S. dollar, federal funds or London Interbank Offered Rate (LIBOR) rates. Indexed swaps are hedging contracts
in which one party exchanges a predetermined cash flow with a counter-party on a specified date. A debt, equity, or other price index is used as the agreed exchange for one side
of this swap.
The federal funds rate, known as the fed funds rate, is the target interest rate set by the Federal Open Market Committee of the Federal Reserve. The target is the Fed’s suggested
rate for commercial banks to borrow and lend their excess reserves to each other overnight.
The Conference Board Leading Economic Index® for the United States is designed to signal peaks and troughs in the business cycle, to be highly correlated with real (adjusted
for inflation) GDP, and to be a predictive variable that anticipates (or “leads”) turning points in the business cycle by around seven months. It is comprised from 10 components:
Average weekly hours in manufacturing; Average weekly initial claims for unemployment insurance; Manufacturers’ new orders for consumer goods and materials; Institute for
Supply Management® Index of New Orders; Manufacturers’ new orders for nondefense capital goods excluding aircraft orders; Building permits for new private housing units; S&P
500 Index; Leading Credit Index™; Interest rate spread (10-year Treasury bonds less federal funds rate); Average consumer expectations for business conditions.
Core inflation, as measured by the “Consumer Price Index for All Urban Consumers: All Items Less Food & Energy” is an aggregate of prices paid by urban consumers for a typical
basket of goods, that does not include food and energy. Core CPI is widely used by economists because food and energy typically have very volatile prices.
The neutral rate is the theoretical federal funds rate at which the stance of U.S. Federal Reserve monetary policy is neither accommodative nor restrictive. It is the short-term real
interest rate consistent with the economy maintaining full employment with associated price stability.
The U.S. Dollar Index is a measure of the value of the U.S. dollar relative to the value of a basket of currencies from most of the U.S.’s most significant trading partners.
Defensive stocks provide consistent dividends and stable earnings regardless whether the overall stock market is rising or falling. Companies with shares considered to be defensive
tend to have a constant demand for their products or services and thus their operations are more stable during different phases of the business cycle.
Growth at a reasonable price (GARP) is a stock investment strategy that seeks to combine tenets of both growth and value investing in the evaluation and selection of individual stocks.
GARP investors look for companies with consistent earnings growth above broad market levels but try to avoid companies with very high valuations. By trying to avoid the extremes
of either growth or value investing, GARP investors often end up focusing on growth-oriented stocks with relatively low price-to-earnings multiples in normal market conditions.
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Real yield curve rates, commonly referred to as “Real Constant Maturity Treasury” rates, on Treasury Inflation-Protected Securities (TIPS) at “constant maturity” are estimated by the
U.S. Treasury from the Treasury’s daily par real yield curve. These par real yields are calculated from indicative secondary market quotations obtained by the Federal Reserve Bank
of New York. The par real yield values are read from the par real yield curve at fixed maturities, currently 5, 7, 10, 20, and 30 years. This method provides a par real yield for a 10-year
maturity, for example, even if no outstanding security has exactly 10 years remaining to maturity.
Duration incorporates a bond’s yield, coupon, final maturity and call features into one number, expressed in years, that indicates how price-sensitive a bond or portfolio is to
changes in interest rates. Bonds with higher durations carry more risk and have higher price volatility than bonds with lower durations.
Equity duration is the cash-flow weighted average time at which investors can expect to receive the cash flows from their investment in a company’s stock. Long-duration stocks
include fast-growing technology companies, including those that may not pay any dividends in their early years, while short-duration stocks tend to be more mature companies
with higher ratios to dividend to price.
Real yields refer to the returns that fixed income investors earn from interest payments after adjustments for the effects of inflation. Nominal yields refer to the coupon rate on bonds
and represent the rate that the bond issues promises to pay to bond purchasers. It is fixed and applies to the life of the bond.
Basis points (bps) are measurements used in discussions of interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01%.
The Employment Cost Index measures the change in the cost of labor, free from the influence of employment shifts among occupations and industries, for three- and 12-month
periods. The U.S. Bureau of Labor Statistics collects data for the index from thousands of private and government employers nationwide.
Hawkish, dovish, and centrist are terms used to describe the monetary policy preferences of central bankers and others. Hawks prioritize controlling inflation and may favor raising
interest rates to reduce it or keep it in check. Doves tend to support maintaining lower interest rates, often in support of stimulating job growth and the economy more generally.
Centrists tend to occupy the middle of the continuum between tight (hawkish) and loose (dovish) monetary policy.
Real purchasing power is the value of a currency, after it is adjusted for inflation, in terms of the number goods or services that one unit of the currency can buy.
The University of Michigan Index of Consumer Sentiment is based on monthly telephone surveys in which at least 500 consumers in the continental United States are asked 50
questions about what they think now and what their expectations are for their personal finances, business conditions, and buying conditions. Their responses are used to calculate
monthly measures of consumer sentiment that can be compared to a base value of 100 set in 1966.
The Consumer Confidence Index (CCI) is a survey, administered by The Conference Board, that measures how optimistic or pessimistic consumers are regarding their expected
financial situations.
IHS Markit Flash Composite PMIs (Purchasing Managers’ Index) are based on about 85% of the final number of replies received each month from a survey of a representative panel
of private sector firms in select countries across the European Union.
The ifo Institute Business Climate Index for Germany is based on a monthly survey of about 9,000 firms in manufacturing, the services sector, and construction, plus wholesale and retail
sales about their characterization of their current business and their expectations for the next six months. It is published by the ifo Institute for Economic Research, based in Munich.
The Australian Consumer Price Index is a quarterly report from the Australian Bureau of Statistics measuring household inflation. It includes statistics about changes in price for a
wide range of categories of household spending.
The Tokyo Consumer Price Index, excluding fresh food, is released by the Statistics Bureau of Japan and tracks a range of consumer prices in the Tokyo metropolis.
The S&P 500 Index measures change in stock market conditions based on the average performance of 500 widely held common stocks. It is a market-weighted index calculated on
a total return basis with dividend reinvested. The S&P 500 represents approximately 75% of the investable U.S. equity market.
RJIM22-0067 | Exp. 2/24/23 | FL-RJIM-MIF102422
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