Now for the toughest trick.
Equity markets just turned in their worst first half since 1970. You do realize how long ago that was, right? I was in first grade. In the blink of an eye, I am now one of the older kids. The S&P 500, by the way, ended the calendar year 1970 virtually unchanged from 1969 (+0.1%). With the S&P 500 now down a rough 20% year to date, it would take a rally of just about 25% to repeat that feat. Likely? Not likely.
What do we think we know about the current situation as we sit half-way through 2022? We know that consumer level inflation is too hot. June CPI is due on July 13th. May CPI printed very hot (+8.6% headline, +6.0% core). The Federal Reserve appears committed to the tightening of monetary policy until inflation returns to their stated 2% target (or more likely, at least until significant progress is made). That's a positive.
The negative there would be that external factors such as Covid-related lockdown in China and what is more than a "smallish" regional war rages in Europe's breadbasket. These two external forces have choked off the flow of energy and agricultural commodities to much of the world, while containing manufacturing facilities and global supply chains.
The result of that is most likely a global economic recession in which the US will either be a participant in, or slow so much as to narrowly avoid contraction. Neither outcome is desirable for the US economy, nor for corporate America, for which equity holdings represent not just an ownership stake, but a claim on futures earnings.
Currently, according to FactSet, consensus view for Q2 2022 is for S&P 500 earnings growth of 4.3% on revenue growth of 10.2%. Projections for the third and fourth quarters are for earning growth of 10.8% and 10.0%, respectively, on revenue growth of 9.8% and 7.5%. For the full year, still sticking with FactSet as a source, earnings are expected to have increased 10.4% on revenue growth of 10.7%.
The problem may be in projections for profit margin, as we all know expenses for raw materials, finished goods, services and wages have all increased dramatically since the start of the year. Currently, estimates for Q2 S&P 500 profit margin are for 12.4%. which is still well above the five year average of 11.1%. My opinion is that 12.4% is higher for Q2 2022, even if it would be down from 13.1% for Q2 2021.
I also feel that Q3 and Q4 will likely struggle to maintain a net profit margin of 11%, and that there is a real probability that we see this metric drop to something with a 10 handle by year's end.
We already know that the US economy contracted 1.6% (q/q SAAR) for the first quarter. According to the Atlanta Fed's GDPNow model, the second quarter is showing some very minor growth. We may not enter into a technical recession for H1, but we are pounding on the door, and even if GDP ends up growing less than 1% for Q2, we still would have had a negative half.
Inflation is way too hot, but there are signs, such as collapsing prices for industrial commodities, that at least core inflation could abate with the Fed's help. The potential problem is in how households and businesses handle a more expensive existence. Behavior changes once the mind understands that the economy has entered into a recessionary period, technical or not. This is when and where the consumer, the business owner and the CEO all cut back heavily on spending plans. This is where both the labor and housing markets become susceptible to going where none of us want to go.
It is beyond crucial that the nation stay out of technical recession. Only bad things happen from there.
The FOMC increased their target for the Fed Funds Rate by 75 basis points at their last meeting in early June to sit where it is now... in a range spanning from 1.5% to 1.75%. The Fed also (finally) kicked off their quantitative tightening program that will ultimately reach a pace of $95B per month in maturing Treasury and Mortgage-Backed Securities where the proceeds will roll off of the balance sheet and not be reinvested by the central bank.
The central bank has been aggressive on the size of this planned QT, but has not taken heed of my suggestion to focus more heavily on MBS early on in the program more so than Treasuries. The idea here is to suck the excess liquidity (monetary base) out of the US economy that has been created through decades of fiscal largess enabled through monetary irresponsibility.
My expectation is that this plan has the potential to be slowed well ahead of where Fed officials probably think they need to go, especially if the US economy contracts, or worse contracts while labor and housing markets suffer badly.
Looking ahead, the most recent FOMC economic projections show a median expectation of 3.4% by year's end for the Fed Funds Rate as GDP for 2022 ends up at +1.7%. If they are correct, the US economy has to absolutely roar over the year's final six months. I expect that they are not on target GDP-wise.
As for the Fed Funds Rate, futures markets trading in Chicago are now pricing in a 77% probability for another 75 bps rate hike on July 27th. From there, these futures markets are pricing in a Fed Funds Rate of 3.25% to 3.5% by December 14th, which would place this market in line with FOMC projections.
Interestingly, futures markets are also now pricing in a rate cut (easier policy) by May of 2023. Guess we'll know when we get there.
We understand that dollar strength will likely persist. We see that longer-dated Treasury prices may have bottomed for now. Further upward pressure will exacerbate what is already an uncomfortable looking yield curve. As I write this, the US 3-Year, 5-Year, and 7-Year Notes are inverted against the 10-Year.
The spread between the 5-Year and the 30-Year is down to nine basis points, the spread between the 2-Year and the 10-Year, which is important, is down to three basis points, and the spread between the 3-Month and the 10-Year, which is the most important spread of them all is down to 130 basis points from 225 basis points less than two months ago.
This tells investors to batten down the hatches.
Remember, US equity markets have never turned higher, and formed a lasting market bottom with the Fed engaged in a tightening phase of monetary policy without the Fed first turning dovish. That's a fact that can not be ignored. Psst... The Fed is not close to turning dovish.
Therefore, I am increasing exposure to the long end of the Treasury curve, while focusing my equity investment, not my trading, which is a different game entirely, but my investment book in four directions.
Unless people stop shooting each other in eastern Europe and unless American producers feel confident enough to invest here at home, demand for crude and natural gas will outstrip supply. Not saying it can't break, but support for WTI Crude is in the high $90's. I am long Chevron (CVX) for integrated oil and gas, Apache (APA) for global production with a US centric focus, and Schlumberger (SLB) for oil services.
I need exposure to a number of Staples for their consistency and historically low beta. Yes, inflation can squeeze margin here too, these firms are not immune, but the good people of Gotham will still buy their stuff. My names in this space right now are Colgate-Palmolive (CL) , PepsiCo (PEP) , and Procter & Gamble (PG) .
This group is controversial. The group is down horrifically this year with the Philadelphia Semiconductor Index off 34.5% year to date. These stocks are tradable. They move around a lot. If you do not have the time to focus on doing that, then maybe this group is a skip, or maybe just don't allocate all that much here. The fact is that with these names already off this much, that I want to focus on cloud computing (the data center) and artificial intelligence.
I do not suggest any and all semis, just the ones that do those two things well. For me, that's Advanced Micro Devices (AMD) , Nvidia (NVDA) and Marvell Technology (MRVL) . These three names are also "China reopening plays" without having to invest in Chinese companies.
Note on trading... AMD is down 45.8% ytd. I have been long all year, but have traded the name heavily, very heavily of late. I was down a little more than 1% for the year as I wrote this. You can defend yourself in these markets.
Aerospace & Defense
I covered this to some degree in Market Recon this morning. With the S&P 500 down 20% year to date and the Nasdaq Composite down 29% in 2022...
Northrop Grumman (NOC) is up 20.33%
Lockheed Martin (LMT) is up 19.41%
L3Harris Technologies (LHX) is up 13.06%
Raytheon Technologies (RTX) is up 9.67%
General Dynamics (GD) is up 6.34%.
This is an industry where it really pays to pick your stocks, while sticking to the major contractors. The ETFs have outperformed the broader market, but have not performed with the names mentioned above so far this year...
iShares US Aerospace & Defense ETF (ITA) is down 5.23%
Invesco Aerospace & Defense ETF (PPA) is down 4.44%
Is Defense recession proof? Not in "normal" peacetime, but maybe this time. NATO is expanding, Turkey will be buying fighter aircraft. Nearly all NATO members feel threatened by Russia's aggression, and will be spending more for defense even with tighter fiscal budgets going forward. In addition, Japan, South Korea, Australia and New Zealand all had representation at the NATO meetings this week, despite not being members of the alliance. Can you say "worried much about China"
I am currently long Lockheed Martin, Northrop Grumman, Raytheon Technologies and General Dynamics. These stocks have been the saviors of my portfolio through the first half.