Good Evening:
Markets had a strong week and rallied robustly on Friday. Stocks rallied into the close and ended near sessions highs. All sectors were in the green. The top three sectors on Friday were Materials, Financials and Consumer Discretionary. Earlier in the week Defensive sectors like Healthcare, Utilities and Real Estate showed relative strength, but everyone joined the Party on Friday, even Energy which was down big for the week. The University of Michigan Consumer Survey showed new record lows in consumer sentiment this morning. Consumers across many different categories expect economic weakness. While inflation expectations for the year ahead remain at the elevated level of 5.3% the crucial long-term inflation expectations moderated significantly to 3.1%. This is an encouraging sign for those who fear inflation expectations are becoming unanchored. Earlier in the week, Powell referred specifically to this figure in the last report as “quite eye-catching.”
The Purchasing Managers’ Index for June was just expansionary at 51.2. A reading below 50 indicates that activity is contracting. Nearly 80% of surveyed consumers expected bad economic times in the year ahead. This reading today was only slightly lower than heights experienced in the 2008-2009 Financial Crisis. Similarly, business confidence came in it a low level usually suggestive of an approaching recession.
Jay Powell was bashed with rhetorical cudgels from partisans on both sides of the aisle as he delivered his semi-annual report on monetary policy. His testimony was mixed. While he seemed to acknowledge that geopolitical risks would increase the difficulty of engineering a soft-landing, he also mentioned that it was possible inflation might come down faster than many economic models suggest. Some may approach that with a “boy who cried wolf” sentiment, and that is understandable. However, it’s very possible that many of the factors leading to the Fed underestimating inflation in the post-pandemic period could become double-edged sword and lead to the inverse occurring in coming months. Our Head of Research, Tom Lee, will elaborate on these prospects below.
Markets have certainly been worried about inflation but now the possibility that we are already in or are quickly approaching a recession is rising according to many economists. Economists in both America and Europe, which is reeling from an Energy supply crisis, Goldman Sachs economists, for instance, doubled their probability recently that the US will enter a recession this year from 15% to 30%. Over a two-year horizon it is nearly 50%. Moody’s Chief Economist Mark Zandi also suggested the risk for a recession is rising. He put it at about 40% within the next 12 months. A Federal Reserve economist named Michael Kiley also wrote a paper released this week suggesting that the probability of recession eclipsed 50% in the next 4 quarters. He postulated that imbalances in the markets for goods and services suggest such an outcome. Historically, the paper showed when there is high inflation and low unemployment economic contraction has followed.
There are no shortages of things that can go wrong in today’s market. Exogenous risks like supply chain woes and a raging conflict in the heart of Eurasia are formidable negative catalysts. Until the third week of July, we will be experiencing a lack of corporate news and macro headlines may push markets in spurts of either direction. If there is suddenly a Russian peace deal and some of the trade barriers associate with the war decline, you could get a renewed pep in the consumer’s step. Their wallets have been squeezed by high prices at the pump.
However, even if the conflict stops the trade barriers and sanctions may not be reduced meaningfully enough to have the effect on supply that some would hope. A frozen conflict with an effective economic siege of Ukraine preventing it from exporting its considerable resources to the rest of the world doesn’t change much from the market’s perspective even if the shells stop flying. The high intensity conflict going in Donbas and the rest of the country is of a ferocious nature that typically only ends one side is completely exhausted.
High-intensity conflicts throughout history have tended to escalate, not the other way around. This week Ukrainian leadership ordered their soldiers to retreat from Severodonetsk, the center of Russian offensive efforts over the last two months, to avoid being enveloped by the enemy. While this may be a slight symbolic victory for the Kremlin, it is also a Pyrrhic one. Despite suffering high casualties, the Ukrainians were able to slow Russian progress, avoid encirclement and by all accounts inflicted severe casualties on the invaders.
On the supply chain side, there has been a lot of progress since COVID entered a more endemic phase. But there are still potential tripping points like the expiration of the International Longshore and Warehouse Union’s contract expiration on July 1st. Negotiations are ongoing, but clearly a strike at the West Coast ports where most of the imported goods flow into the United States could renew risk in this area which has hitherto been improving. The bottlenecks at ports are already reverberating through the rail supply chain, which is now somewhat clogged as well. With the rising prices of gasoline and diesel, using trucks is sometimes necessary but certainly not cheap. Containers have gone from piling up at the docks to piling up at major railroad junctions.
Darden Restaurants reported earnings and beat on the top and bottom line during a particularly challenging environment. Their report validated some of the soft reports we’ve been receiving from people in the know about food prices coming down. Importantly, the executives indicated they thought higher costs for key inputs like chicken and dairy would be alleviating significantly in the not-too-distant future. In a surprise, weakness at their more economic offerings like the Olive Garden were weaker than their higher end options. Given the pressure on consumers, one might have expected the opposite.
So, is it glass half empty or glass half full? The true answer to this will only be told with time. The future is more uncertain than ever and, in many respects, we’ve gone down the rabbit hole. Markets and data can appear very topsy turvy and the ways many investors typically orient themselves as to where we are in the business cycle are less effective than normal. Many cycles have been broken. There’s much uncertainty in demand and exogenous risks continue to stalk this market. Nonetheless, it is more important than ever to stay data driven and grounded in evidence-based principles of equity research.
