June 2022 Stonemark Market Commentary

Equity markets wrapped up the 1st half of 2022 with yet another negative month as the S&P 500 fell 8.39%, the Dow Jones Industrial Average lost 6.71%, the NASDAQ shed 8.71%, the Russell 1000 Growth dropped 8.00% & the Russell 1000 Value declined by 8.93%. June’s sell-off was led by continued rising inflation & worries that the Federal Reserve (“the Fed”) may have to ramp up their efforts to contain the record-setting inflation that we continue to see grow on a monthly basis. As a result of higher inflation & subsequent higher interest rates, investors are bracing for how this will impact 2nd quarter corporate earnings results.

While every major S&P 500 sector was negative for the month of June, the selloff in the broader markets were led by Energy (-16.99% for the month of June) & Materials (-14.08% for the month of June) as we have seen oil & other commodity prices retreat from their recent highs. Despite the broad market selloff, sectors such as Healthcare (-2.84% for the month of June), Consumer Staples (-2.87% for the month of June), Utilities (-5.13% for the month of June) & Real Estate (-7.48% for the month of June) managed to weather the selloff relatively well compared to other sectors & the broader markets.

With the month of June coming to an end, we will begin to see 2nd quarter earnings results starting in the middle of July as the large banks kick off 2nd quarter earnings season. According to FactSet, 103 of the S&P 500 companies have previously issued 2nd quarter earnings guidance with 71 of those companies issuing negative guidance & just 32 companies issuing positive 2nd quarter earnings guidance, which indicates that we could be in for a rocky next month or so as companies report their earnings results. With interest rates on the rise & ongoing supplychain issues still hindering certain industries, it shouldn’t come as much of a surprise that the majority of companies issuing negative 2nd quarter earnings guidance are coming from the Information Technology sector. The graphic below gives a breakdown of what sectors are seeing the majority of the positive & negative 2nd quarter earnings guidance.

Looking at the graphic below, analysts at CFRA seem to be pricing in the guidance that companies have given into their earnings forecasts as 7 out of the 11 S&P 500 sectors have seen downside revisions for the 2nd quarter as well as the S&P 500 as a whole. While 2nd quarter earnings estimates have been revised to the downside for 7 out of the 11 S&P 500 sectors, the analysts at CFRA have actually revised their full-year 2022 earnings estimates to the upside to $227.23.

Should full-year 2022 earnings for the S&P 500 come in in-line with these estimates, that would represent an earnings growth rate of 8.4% on a year-over-year basis relative to the $209.54 that was reported for full-year 2021 earnings. Additionally, with full-year earnings forecasted to come in at $227.23 for the S&P 500 & given the June 30th closing price of 3,785, the S&P 500 was trading at a 12-month forward price-to-earnings multiple (“P/E multiple”) of 16.6x. At a 12-month forward P/E multiple of 16.6x, the S&P 500 is trading below both the 5- & 10-year average multiples of 18.6x & 17.0x, respectively. If we hypothetically assign the 10-year average P/E multiple to S&P 500 earnings of $227.23, we get a year-end price target of 3,862, a mere 2% higher than June’s closing price. With that in mind and given the fact that higher interest rates often correlate to lower P/E multiples, which essentially rules out multiple expansion, we will be keeping a close eye on earnings for the rest of the year as we will need to see better than expected earnings results in order to drive the broader markets higher.

During the middle of June, the Fed concluded their June monetary policy meeting, which culminated in a 75-basis point (“bps”, 100bps = 1%) interest rate hike – the largest increase since 1994. While the market was expecting a 50bps interest rate hike at the June meeting, another record-setting consumer price index (“CPI”) print for the month of May pushed the probability of a 75bps interest rate hike at the June meeting to the odds-on favorite move by the Fed. This is what the Federal Open Markets Committee (“FOMC”) had to say about the change in sentiment that justified a 75bps interest rate hike:

Looking at the graphic below, which is data pulled from the CME Group’s FedWatch tool, market participants are still pricing in a 75bps rate hike for the July meeting to bring the target range for the Fed Funds rate to 225-250bps. Following an expected 75bps interest rate hike at the July meeting, market participants are now pricing in a 50bps hike at the September meeting followed by 25bps interest rate hikes at the November & December FOMC meetings to bring the Fed Funds rate to a targeted range of 325-350bps by the end of the year.

With another 175bps worth of interest rate hikes priced in by the end of the year (to a 325-350bps targeted range), the graphic above is indicating that it might be the end of the Fed raising interest rates. If we look out past 2022, the February ’23, March ’23, May ’23 & June ’23 probabilities are all indicating that the Fed is going to maintain its 325-350bps targeted range for the next year before they CUT interest rates next July (light brown bar). This trajectory would seem to support a concern of ours that we have had for some time, which is that the Fed was too accommodative on the downside & is going to overshoot on its tightening path.

That being said, this data should be taken with a grain of salt. As we have noted before when using data from the FedWatch tool, these probabilities are set by traders who are actively trading futures contracts for where they expect the Fed Funds rate to be at a given point in time & can be quite volatile as certain economic data is released. Ultimately it is the Fed who sets the targeted range for the Fed Funds rate, which they do in accordance with maintaining their two stated mandates of price stability & full employment. With prices anything but stable & the unemployment rate sitting at 3.6%, unless we start to see inflation start to come down significantly, we believe that the Fed could be forced to raise the short-term rates above the 3.25-3.50% that the markets are currently pricing in. With that in mind, we do believe that once the Fed raises interest rates by the expected 75bps in July, future monetary policy actions will be much more dependent on the economic data that is reported. In other words, once inflation begins to ease & CPI numbers begin to come down, the Fed will not need to be as aggressive with interest rate hikes as they have been in the recent months.

As inflation continues to come in very hot, equity markets continued to sell-off in June & as we see cracks in the housing market (something we discussed in May’s Monthly Commentary), many Wall Street professionals & everyday Americans alike are starting to ask if we are already in a technical recession or is one coming in the very near future. According to Investopedia, a “technical recession” is defined as “two consecutive quarters of economic decline, as reflected by GDP in conjunction with monthly indicators such as a rise in unemployment.” On June 29th, the U.S. Bureau of Economic Analysis (BEA) released their final read on 1st quarter GDP, which came in at -1.6% on an annualized basis. This marked the first quarter since the 2nd quarter of 2020 (-31.2%) that we saw negative annualized GDP. With that in mind & looking at the graphic below, as of the end of June, the Atlanta Fed’s GDPNow tool was forecasting -2.1% GDP growth for the 2nd quarter, which indicates that we may already be in a technical recession. We will get the preliminary read on 2nd quarter GDP towards the end of July, but we won’t receive the final 2nd quarter GDP release until the end of September.

If we look at what some economists & Wall Street professionals have to say, many individuals believe that we are already in a technical recession or are on the precipice of one in the coming 6-12 months. Recently, TD Securities’ Head of Global Strategy, Richard Kelly, said that the odds of a recession by next year are greater than 50%. Kelly went on to say, “We haven’t even hit the peak lags from gas prices & Fed hikes really won’t hit until the end of this year. That’s where the peak drag is in the economy. I think that’s where the near-term risk for a U.S. recession sits now.” Additionally, former president of the Federal Reserve Bank of New York, Bill Dudley, warned back in April that a recession is “virtually inevitable” because “the central bank is too far behind the curve in controlling inflation & Fed Chairman Jerome Powell remains too optimistic about a soft-landing”. However, some economists are not so convinced that a recession is imminent. For example, Moody’s Analytics Chief Economist, Mark Zandi, said in a recent interview that he is still not forecasting a recession into his models. However, he did go on to say that, with inflation & the Fed raising rates, the risk of a recession are high but he believes that “with a little bit of luck & some reasonably good policy-making by the Fed, we’re going to be able to avoid a recession.” Zandi went on to say that he has never seen anything like this before when asked about how the majority of individuals that he talks to & works with forecast an imminent recession.

So how did we go from experiencing double-digit performance in the equity markets to a fear-induced sell-off on the heals of the prospects of a recession in just two years? Well the answer is quite simple actually. During the height of the COVID-19 pandemic & the year that followed, Americans enjoyed historically low rates as the Fed cut interest rates to near 0% as well as stimulus checks that were sent out to qualifying individuals/couples. While these rate cuts & stimulus checks were meant to help individuals & the economy weather the COVID-19 pandemic, many economists argue that these policies were too accommodating & are now the root cause of putting the economy on the brink of a recession (if we aren’t already in a recession). The combination of low rates, “free money” via stimulus checks & supplychain issues have created the perfect storm for prices to soar, aka inflation. As we have discussed in the past, when demand for goods & services increases & the supply of those goods & services either stays the same or decreases, the prices of those goods & services is forced to increase. Now, as we mentioned earlier, the Fed has two primary mandates that they look at when determining monetary policy, so in an attempt to stabilize prices, the Fed has been raising interest rates in an attempt to reign in inflation. However, raising interest rates is also a restrictive action that has the potential to slow the economy to the point of economic contraction, which leads to negative GDP readings. With all of that in mind, the Federal Reserve is currently walking a tightrope as it balances raising rates at the appropriate pace in order to combat record-setting inflation while also trying to avoid sending the economy into a recession.

With the 1st half of the year now in the rearview mirror, we, along with the rest of Wall Street, are eagerly awaiting to see what the 2nd half of the year has in store for the financial markets. In the short-term, we will be monitoring 2nd quarter earnings results for companies that we own & companies that we are looking to initiate a new position in or add to an existing position. Aside from earnings, we will continue to keep an eye on economic data, particularly inflation data, in order to get a better sense of what the Fed’s upcoming monetary policy moves might be. We fully anticipate a 75bps interest rate hike in July & expect to end the year at the 3.25-3.50% target range for the Fed Funds rate. Finally, in just a few months we will have the mid-term elections, which have the potential to dramatically change the political landscape on Capitol Hill. While we will have to wait & see what the outcome of those elections are, Democrats currently hold the slimmest of majorities in the Senate & a shift to Republican control of the Senate and/or House could make it nearly impossible for President Biden to accomplish the agenda items he has remaining in the 2nd half of his presidential term. As we get closer to the fall when these mid-terms take place, our Monthly Commentaries will take a more in depth look into the elections & what the potential implications of the various outcomes could be. We will continue to review our current holdings as well as names that meet our investment criteria, which we would look to initiate a new position in or add to a position that we already own. Finally, with plenty of potential market moving catalysts on the horizon, we will maintain our diligence when it comes to positioning our portfolios.

As always, please feel free to reach out with any questions or concerns.