The vast majority of Strategas’s published research reports can trace their origins to questions from clients we receive when they are on the road. What follows are some simple answers to the questions they are currently getting most frequently. We are happy to hop on a call to discuss them in greater detail should you have further questions about their answers.
1. What is your most non-consensus view? Where do you think the consensus is potentially most offsides?
We have a relatively high conviction in the idea that the “Fed put” is gone for the foreseeable future. The Fed took the liberty of forecasting inflation last year and it whiffed. Politically and professionally, it no longer has that luxury. In our opinion, the Fed is unlikely to stop tightening until its preferred measure of inflation, the Core PCE, is closer to 3% than its current 5.2%, almost regardless of movements in the financial markets. That may take a lot longer than the consensus believes. We are all victims to some degree of recency bias. It has been a very long time since the Fed had to deal with a CPI of 8.5%. The institution’s own credibility is dependent upon its ability to get control of a problem it is partly responsible for creating. In the most immediate term, this is likely to have a bigger impact on earnings multiples than it will on earnings. We fear another 10% to the downside on the S&P 500.
2. From whom do you get the most disagreement on your call?
Died-in-the-wool growth managers and those who run ESG funds. Generally speaking, growth managers believe that the spike in inflation will be temporary as supply chain issues get worked out. The low levels of interest rates, they argue, should also keep a bid in secular growers who have already tapped the capital markets for growth capital. There is also a sense that many deep growth stocks have declined so much already that further declines seem unlikely. ESG managers believe we are being short-sighted in our overweight of the Energy sector, viewing the sector as home to future stranded assets and the movement toward renewable sources of energy as inevitable.
3. Is it too late to buy the Energy sector here?
We don’t think so. Our work on the sector suggests companies can cover operating expenses with oil prices above $40 and that the breakeven for a new well is $70. Given the fact that the prices of WTI are currently $110, it would have been normal in the past to expect those who run energy companies to keep punching holes in the ground. The Biden Administration’s commitment to renewable energy and the ESG movement’s insistence on capital discipline make sufficient levels of new capital investment in the sector difficult. This should provide the basis for the sustainable outperformance of the sector. While the stocks have moved substantially, they still only rest at 4.4% of the S&P Index. The sector was about 30% of the Index in the late 1970s and as high as 16% as recently as 2008. Only a significant change in the attitudes among policymakers towards fossil fuels or significant demand destruction would ease the upward pressure on the commodity. Some truce between Russia and Ukraine would help but one also must consider what the price of oil might be if China were fully back online.
4. Has the Fed lost its credibility in your view?
Yes but perhaps not for the reasons popularly cited to support that view. In my estimation, the continued reliance on quantitative easing since 2008 created enormous economic distortions and a misallocation of capital that favored the wealthy over the ordinary saver. More recently, the Fed’s decision to continue asset purchases as late as March 11th seems like a mistake given recent inflation readings. As for its decisions during the pandemic, we are more sympathetic. Never before have policymakers decided to lock down the global economy. There were few good options.
5. Do you believe investors are positioned for a recession based on your conversations and the flow data?
Conversations with clients suggest they are still not positioned defensively although the April flows data is beginning to show a different tune. Healthcare and Utilities led inflows during the month with Financials seeing the biggest losses. We continue to hear clients adding to Technology stocks which had been leadership during QE but the tune is changing as policy tightens. The S&P has broken below 4200… what comes next? With the important 4200 level falling this week, the question from clients is… where next? Readers of our work know we’re not big on levels – they’re too precise for a very imprecise business. So our thinking remains more along the lines of, lots of important stocks /groups have given back the majority of their covid ramp (e.g., JPM, AMZN, FB, BLK, etc.), so should we be surprised if the Index does itself? It gets you to somewhere around 3500-3700 on the S&P – consistent with the 200-week moving average, roughly the 50% midpoint of the entire advance, and in step with Jason’s assumptions on both earnings + the likely multiple. We’re not dogmatic about any of this, but absent without change to the character of the market’s message, continue to proceed cautiously.
6. Central bankers generally don’t want to tighten into supply shocks, so what is the Fed doing?
The macro policy is generally aimed at getting supply & demand to balance. But extreme shocks have made this task very difficult in the past 2 years. Inflation has been the result. Supply shocks have contributed significantly to this inflation, and it’s true the first instinct of central bankers is to look thru such inflation. However, if there’s evidence longer-term inflation expectations are becoming unanchored, there’s a need for action. If supply cannot rebound to meet demand, demand must fall to meet supply. So numerous central banks including the Fed are already looking at more aggressive +50 bp hikes and Quantitative Tightening (QT).
7. Are we at a peak 10 year yield for this cycle?
Likely no, but we’re nearing the peak. Most portions of the curve are closing in on the 3% level, which would be consistent with a Fed funds rate terminating between 2.75% and 3.25%, and a recession no sooner than the middle of 2023. This suggests to us that 10s will peak in the next 1 to 3 months, somewhere above 3%, but below 3.25%, while 2s should peak there, or slightly higher, and perhaps a month or 2 after 10s peak. Now, if the Fed is forced to reassess its rate path outlook up, then the peak in the 10s may not come until later, and at a slightly higher level, though again assuming that this increase in rate hike expectations doesn’t pull forward recession forecasts. So, for example, if the Fed brings its terminal Fed funds rate forecast to 4%, then 10s are likely to peak above 3.5%, and perhaps as late as the end of Q3, with 2s peaking near 4%. This tells us that even though we would expect a higher 10 year yield from a higher Fed funds rate, it doesn’t prevent the curve from inverting. In fact, it actually makes the inversion deeper, as one might expect, as it raises the odds that a recession occurs sooner and runs longer than we might otherwise experience.
8. What’s your outlook for equities given recent market volatility?
Last month, we trimmed our Equities exposure from 62% to 60% as the pre-recession progression intensifies. We view the potential to be greater than the odds of a U.S. Recession will rise in the coming months and prolong equity market volatility. We have reduced our allocation to U.S. Large-Cap Growth shares significantly and made smaller downward adjustments to U.S. Large-Cap Core, Developed International, and Emerging Markets within our tactical asset allocation portfolios.
9. Given the current environment, what sector is most at risk?
While we remain overweighed to Industrials in our U.S. equity sector portfolios, we acknowledge that continued weakness on the economic front would intuitively lend itself to more defensive exposures. The diversified constituency of the sector reduces security concentration risk that exists more prominently in other sectors (i.e. Technology and Communications). Despite economic weakness, we remain constructive on Aerospace & Defense. The U.S. Industrial Production has climbed to new highs but has not translated into durable sector outperformance. The global bid for the U.S. Dollar, firmly in an uptrend and above pre-covid levels, is one of the biggest risks to the call, especially given the global revenue exposure that the Industrials possess.
10. What quantitative factors are the most reliable during market corrections?
First quintile constituents within quality factors (e.g. FCF growth, margin, etc.) have consistently proven to be the most reliable during market volatility. That does not mean that these factor quintiles and the best names will not get hit but high margin, high ROE, high ROIC, high free cash flow growth, and high shareholder yield have historically outperformed both the market and low quality shares in both corrections and bear markets. We’d start doing work on names in these buckets first.
11. How does 2022’s equity market decline compare to that of other midterm election years?
At the start of every midterm election year, we grit our teeth knowing a big equity market correction is coming, though we don’t know when. The past three midterm corrections have been quite painful. Midterm election years are the most volatile for stocks during the four-year presidential cycle, with an average intra-year correction of 19 percent. We have generally found midterm election years to be marked by declining presidential approval ratings, tighter monetary policy, tighter fiscal policy, and an increased likelihood of a change in the political party. This year is no different, although the timing has been faster and the scope of the decline has been deeper than usual, largely due to higher inflation and geopolitical risk on top of the other factors. The 13 percent decline from January through April is the largest equity market drawdown in a midterm election year we could find on record. Interestingly, the S&P 500 has been trending very similarly to its 1982 pattern, the last time we were dealing with inflation, Russia, and a midterm election at once. The good news is that the S&P 500 is up one year after its midterm low and by an average of 32 percent, and the faster and steeper the decline, the stronger the recovery. And not to jinx it, but the S&P 500 has not declined in the 12 months following a midterm election since 1946.
12. Could we see tariff relief with the USTR’s four-year anniversary review?
Tariffs imposed by President Trump are coming up on their four-year expiration date. This creates an opportunity for the Biden Administration to change, repeal, or keep the existing tariffs. Prominent officials in the Biden Administration are trying to get ahead of this review process, namely Treasury Secretary Yellen, by pushing for lower tariffs. Yellen sees lower tariffs as one of the few tools the administration has to lower inflation. Still, the US Trade Representative remains opposed to repealing these tariffs. USTR has made it clear that it wants to maintain pressure on China, especially as China failed to meet obligations under the Phase One Trade Deal. Given that a “tough on China” approach has bipartisan support, we believe the Section 301 tariffs will remain in place. Relief could, however, come in the form of an expanded and more generous tariff exclusion process. In March, USTR retroactively reinstated 352 of the 549 previously granted exclusions through year-end and Congress is considering more changes as part of the China competitiveness bill.
13. How does the Supreme Court ruling overturning Roe v. Wade impact the midterm elections?
We expected the Supreme Court to issue a ruling in June with a major change to Roe v. Wade based on the composition of the court and the oral arguments in the case challenging it, but we did not expect a leak of the text in May or the aggressiveness of the draft decision. The text could still change, but a complete reversal of the draft opinion is unlikely. While the decision will motivate Democratic voters, it is unlikely to be enough to overcome the midterm election environment which has moved 13 points away from Biden. Inflation is a far larger issue, and abortion is not a big enough issue to close that gap. However, the ruling could limit Republican gains in the House and Senate (particularly in the NH, NV, and CO Senate races), and play a role in state races this fall. We will be watching Biden’s approval rating, the generic ballot, and Democratic enthusiasm to see how much of an impact the issue is having on the midterms.