The Three Fs: Fear, Fed, and Fundamentals

The Three Fs:  Fear, Fed, and Fundamentals

The financial markets have been under pressure for several months, with NASDAQ declining the most from its November peak.  The purging of the speculative segment occurred, as the focus shifted to fundamentals and away from concept and “no clear road to profitability” stocks.  The purge has taken many of these stocks down as much as 80% – 90%.  For example, Teladoc Health fell 90% from its February 16, 2021, high of $308 to a low of $28.75 on April 28, 2022.  Robinhood and Peloton experienced a similar decline.  Many SPACS (special purpose acquisition companies) disintegrated during this period.  The fall in value of this subset of the market has placed pressure on many leveraged hedge funds and other leveraged investors, forcing liquidations which spilled over into the Large Cap segment of the market (very liquid tech stocks as sources of funds).  At one point, according to Morgan Stanley’s prime brokerage data, the positions of hedge funds in the Top 50 most popular stocks were over 40%.  That position has now been reduced to 27%.  The selling and shorting of these stocks at the end of 2021 and into 2022 have moved many of these names to attractive valuation levels.

A number of these companies have P/E multiples below the S&P 500 and very attractive cash flow yields.  The rise in interest rates induced by the Fed’s change in policy direction would tend to lower P/E multiples in general, as earnings are discounted at a higher rate.  Even though the Fed’s actual rate increase in March (25 basis points on the fed funds rate) was a minor increase, the prospect of more increases in the future, as the monetary authorities attempt to move interest rates toward neutral rate to help anchor “inflation expectations,” has caused yields to rise.

In fact, the 10-year Treasury has increased 140 basis points since early March.  During this period, forecasts of many rate increases were abound.  At the May 4 meeting, the Federal Reserve increased the federal funds rate by 50 basis points as expected, and outlined a path with additional rate hikes and provided guidance on the impending balance sheet reductions.

Two future rate increases of 50 basis points each were articulated, one at the June meeting and one at the July meeting.  At the same time, balance sheet reductions will begin in June, starting with a $47.5 billion reduction for three months, then rising to $95 billion.

Subsequent rate increases are likely to follow as the Fed attempts to move toward a neutral rate, which Powell indicated falls in the 2–3 % range, but lacks precision.  It is clear from the chairman’s comment that the labor market is a key component to future rate moves, and the Fed will be “adaptive” to the changing environment.

In recent weeks Wall Street firms have forecast 8 rate increases and some indicated as many as 12.  How many is too many?  Following the March FOMC meeting, the parade of Federal Reserve Presidents and Board Members espousing aggressive steps to unwinding monetary stimulus, particularly Bullard and Brainard, stand in stark contrast to the policy stance of the Federal Reserve over a year ago.  At that time, no rate increase was forecast for 2022 and inflation was “transitory.”  The change reflects the difficulty of forecasting the unfolding events within a sufficient range so as to fashion policy without undergoing dramatic change.

For over a decade, the Fed was unable to hit its 2% inflation target and were more concerned about deflation.  At the same time, it overestimated the neutral rate.  Given the historical experience and the difficulties in forecasting, what makes one think that his or her forecasts of the future (and that of many others) will materialize and come anywhere close to their expectations?

From a policy implementation perspective, it seems incongruous that the Central Bank was still buying bonds until March and then two months later begins raising rates and engages in a bond reduction program.

The rhetoric and “Fed speak” did bring about a significant increase in the yield on the 10-year bond which is already manifesting itself in rising mortgage rates and a decline in the affordability index.

The yield curve, which only a few weeks ago showed a slight inversion between the 2- and 10-year Treasuries, has moved back to upward sloping and now stands at 40 basis points.  The inversion generated a lot of discussion about an impending recession.  However, following a yield curve inversion, lead times have been on the order of 12 to 18 months.

Moreover, the inversion must be sustainable.  From our perspective, the relevant yield curve analysis rests with the relationship between short term rates, T-Bills, federal funds, and long-term rates (10 – 30 year treasuries).  This relationship is not in jeopardy but stands at a positive 250 basis points.

Despite the growing economic concerns – inflation eroding income growth, the ongoing crisis in Ukraine, the COVID shutdown in parts of China – the economy should generate positive economic growth this year.  Q1 did record a negative GDP reading.  However, the presence of negative real rates, an upward sloping yield curve, and positive liquidity growth does point to continual economic expansion.

The actual moves the Fed makes in coming months should determine the “risk of recession” with the faster and more aggressive the moves, the higher the risk.  A more gradual approach may avoid serious demand destruction.  One of the biggest risks is that the Fed feels compelled to act quickly to make up for past misjudgments, thus not allowing the economic system to adjust to diminished liquidity.

Despite the emphasis on inflation in coming weeks and months, the focus is likely to shift to the labor market.  Its strength has been highlighted consistently.  But there are signs that the employment picture may be changing.  ADP reported a gain in employment in April of only 247,000.  The ISM manufacturing report indicated the employment index fell to 50.9, barely reporting expansion.  Additionally, the Challenger job cuts report showed an increase of 6% in April, with initial jobless claims rising to 200,000.  Anecdotal evidence from Amazon and Facebook on their hiring practices points to a cooling trend.  These changes are small but may well be indicative of what is coming.

Although non-farm payroll employment showed a solid 428,000 gain in April, the unemployment rate was unchanged, and the participation rate fell.  Moreover, wage gains did not accelerate.  Average hourly earnings increased 0.3% in April and recorded a year/year increase of 5.5%, down from 5.6% the prior month.

As we move into the second half of the year, the Federal Reserve may have to adapt its stance with respect to the magnitude and frequency of rate changes.  Its current strategy may prove to be too much too fast.  In 2018, following 9 rate increases over 3 years, the Fed indicated there would be multiple increases in 2019, as it strived to reach the elusive neutral rate.  Those increases never materialized, and in fact rates were lowered as the Fed responded to changing economic and financial conditions.

The economic, financial, and geopolitical uncertainties have rattled markets and caused extremes in investor sentiment.  The AAII bullish/bearish weekly survey shows bullish sentiment at levels last seen in 2008, 2009, and even 2002.  These periods were at market bottoms.  Moreover, the VIX, a measure of volatility, suggests a high level of fear is present in the market.

With greater clarity as to the evolution of monetary policy, an important uncertainty has been reduced.  Barring any extraordinary externalities, with valuation becoming more compelling each day, the market appears to be poised for change, and most likely it will occur when least expected.