“You'll never find a rainbow if you are looking down.”
– Charlie Chaplin
Financial conditions are tightening, spearheaded by the Fed’s desire to slow growth and keep inflation in check. Bond yields have surged higher, and commodities have spiked as the volatile geopolitical backdrop adds to an already anxious investor base. Encouragingly, the developments are happening at a time of strong employment and record corporate profitability that should blunt the sting of a more restrictive policy. We see the economy braking, but not breaking.
Inflation (CPI) is at its highest level in over forty years. With employment in good standing, the Fed has its eyes set reigning in the price component of its dual mandate (full employment and price stability). Last month they raised rates for the first time in several years which, combined with the effects of the war in Ukraine on commodity prices, pushed bond yields sharply higher. Until late last year, the Fed took a gradual approach to monetary policy. They pointed to downside risks in the economy amid Covid, saying high inflation numbers were “transitory” and telling investors they are going to move slowly. Now, the language has moved in the opposite direction (e.g., they are using the word “expeditiously” to describe their rate hiking approach).
There has been a pickup in both recession calls and concerns about a Fed policy mistake as those higher yields start to curb growth. The debate centers on a slowing vs. recessionary view, braking vs. breaking. We side with the former. Tightening financial conditions (e.g., more restrictive monetary policy, higher interest rates, wider credit spreads, wider earnings variability, etc.) tend to be associated with volatile markets. The start of 2022 is no different. The outlook for global growth has clearly waned and investors are taking notice (e.g., recent surveys have shown global growth optimism has sunk to an all-time low, lower than the GFC!). The Fed has a tough job ahead of itself to dampen inflation while maintaining steady economic growth. Threading that needle will be important to reducing market volatility.
We have been writing that while we remained optimistic, investors will need to get comfortable being uncomfortable this year. That outlook was based on tighter monetary policy headwinds (i.e., higher interest rates), and the war has only reinforced that message. The US economy is poised for above-trend growth in 2022 (e.g., according to Bloomberg’s survey of economists, GDP is forecasted to grow 3.5% in 2022, almost double its 20-year average). Our base case remains slowing, but non-recessionary growth.
In times like these, it is important to have an investment process in place that removes emotion from the equation. At BakerAvenue, we maintain analytical independence from pre-written market narratives. We remove preconceived biases and defer to our analytical output. Ultimately, our views are only as optimistic or pessimistic as our technical, fundamental, and macro analyses indicate. Currently, our short-term metrics are in a balanced position, while long-term trends paint a slightly more optimistic picture.
For those who have been following our market updates (view previous market update videos and commentaries), you will be familiar with several of our key concerns and opportunities. We have continually stated that the pandemic-related retrenchment in economic activity, while necessary, was self-inflicted, not structural, and prone to snapping back as re-opening resumed or vaccines entered the narrative. That snapback is now maturing, and growth is slowing.
While we acknowledge the growth brakes are being pumped, we don’t forecast a break to our longstanding gradual recovery view. We suspect another year of above-trend economic growth, robust consumer spending, inventory restocking, and double-digit earnings growth will be enough to offset monetary tightening and support a further grind higher in equities. Consolidations and pullbacks are to be expected and, provided recessionary or bear market odds stay low, should be bought. Slowing growth is not recessionary.
The Fundamental Perspective:
Fundamentally, we continue to focus on the trend in corporate profits and credit metrics. In aggregate, they remain healthy. Our weekly series for forward revenues, earnings, and margins have risen to record highs. Concerns about rising input costs have meant little to the robust trend in profit growth. In fact, corporate margins are higher now than they were pre-pandemic. We see more of the same in 2022 and expect earnings growth to again outpace economic growth. Stubborn pricing pressure and supply constraints are headwinds we are monitoring, but so far, strong demand has more than compensated. While the frequency and magnitude of earnings and sales beats are normalizing, consensus estimates look beatable, and another double-digit expansion in profits is within reach.
Valuations have corrected and are now below long-term averages. The pace of the expansion in corporate profits has far exceeded stock prices over the past couple of years, so multiples are now lower than they were at this point last year. Valuation dispersion remains high with a sizable gap between the secular growers and the more economically sensitive recovery stocks. Predictably, the backup in rates has caused this dispersion to shrink as the more speculative assets have corrected to a greater degree. We continue to see less dispersion going forward as investors embrace a more balanced view.
The credit backdrop remains supportive. Despite some widening over the past few weeks, both investment-grade and high-yield spreads vs. Treasuries remain near levels that are associated with strong equity markets. Dividend reinstatements (or increases) are running well ahead of dividend cuts. The record pace of deal activity in 2021 (e.g., IPO’s, M&A, etc.) looks to continue well into 2022 as cash flows remain strong and corporate confidence stays elevated.
The Macro Perspective:
The macro discussion must start with a view on the global economic recovery. Incoming data at the start of 2022 has supported our sustainable recovery narrative (e.g., unemployment reached a post-Covid low, retail sales remain strong, manufacturing reports are firmly in expansionary zones, etc.). Recent worries have centered on the mix of higher inflation, combined with slowing growth and the beginning of the Fed exit. While these certainly have our attention, we expect the inflation scare will subside as conditions generating the price spikes ebb (e.g., bottlenecks ease, labor supply increases) and economic growth continues. Geopolitical conflicts have historically had little economic impact, provided they don’t result in a prolonged cutback in consumer spending. The oil price spike has our attention, and we will be monitoring sales trends over the next few weeks.
Interest rates will be the fulcrum by which investors express their economic growth views, and we continue to expect them to move gradually higher throughout the year. The Fed has acknowledged that aggressive bond purchases (QE) are not a policy that fits well with a supply-constrained economy. They recently announced plans to taper those purchases (to help address inflation), removing the largest suppressor of rates. Further, they recently adjusted their views by indicating higher inflation could stay longer than expected, and they could speed up their tapering process. As mentioned, one of the most pressing questions for investors is: can the Fed get control over inflation without causing a recession? It is going to be tricky, but at this point we believe they can.
Regarding Covid, we are mindful of the latest developments. Lockdowns, globally, need monitoring. The high-frequency data we monitor (e.g., hotel occupancy rates, restaurant bookings, retail spending, etc.) continue to support the notion that, while volatile, the recovery is intact. We do expect a shift in spending in 2022 as pent-up services spending starts to outpace goods spending.
The Technical Perspective:
The technical backdrop is volatile, to say the least. Longer term, it remains in decent shape with most major indices remaining in an uptrend, albeit just barely. Admittingly, the corrections over the past few weeks have taken their toll on many of the short-term indicators we monitor. For example, the number of new lows has been outpacing the number of new highs, and several price change indicators are flagging a noticeable slowdown in momentum. While we bounced off tactically oversold signals last month, we are on the lookout for sustained stability in these metrics with a more balanced short-term outlook.
We expect the market to broaden as we move further into 2022. Healthier markets tend to have strong participation rates, so we will be looking for improvement here. We are encouraged by the declining correlations we are seeing within sectors and industries. Lower correlations support a more active approach, an environment we welcome.
Rotation within market internals continues to be a weekly theme and has been quite pronounced to start the year. Prior to the Russia-Ukraine conflict, leadership was bouncing back and forth between defensives and more economically sensitive groups as macroeconomic influence remains elevated. Recent trends have carried a decisive “risk-off” tone. We expect this churning behavior to continue if macro uncertainty remains, but at this point see relative value in the groups less represented last year (e.g., small caps, value, economically sensitive groups, etc.).
Investor sentiment is bearish, which, from a contrarian point of view, is bullish. Surveys (e.g., AAII bull-bear survey, Investors Intelligence surveys, etc.) point to a skeptical investor base with the number of “bears” reaching the same levels as the pandemic peak (i.e., 45%, same as in March of 2020). Tactical positioning data (e.g., put-call ratios, cash balances, etc.) is leaning defensive and will act as a catalyst should the macro backdrop improve. As higher interest rates have hurt bond performance, money flows have started to reverse their years-long preference for fixed income over stocks. Encouragingly, there is still almost $3 trillion in money market funds available to invest.
We have championed a ‘barbell’ approach by investing with secular winners while simultaneously allocating capital toward assets that will benefit most in a recovery. We see no reason to change that view given the recent volatility. We do believe the frequency by which investors can actively tilt portfolios towards those pockets of opportunity or away from risk will become more pronounced as the recovery matures and growth slows.
Volatility should stay elevated given the macro uncertainties, but systemic risks that could result in recessionary or bear market conditions are increasingly present, but not overwhelming, given the accompanying growth backdrop. Our forecast for a maturing but sustained economic expansion (e.g., braking, not breaking) strengthens our belief that investor focus should be on “how” one is positioned, not “if” they should have exposure at all. That “how” should continue to include both secular growth and cyclical allocations.
Our investment philosophy is based on a dual mandate of growing and protecting client assets. With our cash positions now residual in nature, we are focusing on strategy positioning vs. our respective benchmarks to control risk. Should our base case hold, we plan to maintain our steady positioning. Of course, should the backdrop continue to destabilize, we will take a more defensive stance.
Given the volatile and ever-changing backdrop, we believe a strategy that combines disciplined fundamental, technical, and macro analyses has the best chance of generating superior risk-adjusted returns. While our forecasts are subject to revision, our commitment to client service is rock solid.
Should you have any questions, please contact BakerAvenue. We are happy to share our thoughts in greater detail and welcome your questions or comments.
Disclosure: Past performance is not indicative of future performance.