Watching Our Step

The S&P 500 is on better footing after a rough start to the 2022 campaign. Having bounced nearly 9% from its March 15th low, the index now sits roughly 5.3% below its all-time high. Encouraging is the fact that the recent momentum surge has been broad-based. Roughly 90% of stocks in the index are trading at a 20-day high. A move such as this is often a prerequisite for a durable rally to take shape.

Improvement is certainly welcome but should be viewed with caution against a backdrop of persistent headwinds. Inflation remains hot, the Fed is hawkish, supply chains remain in disarray, and war rages on in Europe. As such, we continue to see a few troubling signals. Utilities have outperformed through the bounce, and the spread between the two-year treasury yield and the ten-year treasury yield is nearing inversion. Taken together, the market is showing some concern about the future course for economic growth.

The war in Ukraine has forced the Fed to alter its course. Going into the year, they had hoped inflation would moderate on its own. This would have allowed the committee to gradually raise the Fed Funds rate. Instead, the war is adding significant pressure to already rising energy, material, and food prices. At the same time, an extremely tight labor market is forcing wages higher. Together, these forces are contributing to broad based inflation. The Fed has no choice but to get more aggressive. At the March meeting, the committee increased the Fed Funds rate 25 basis points. Markets now expect 50 basis point hikes at the next two meetings and several more 25 basis point hikes thereafter.  

The Fed is tag teaming its rate-hiking with Quantitative Tightening. QT equates essentially to the Fed pulling money out of the economy. When combined, the hope is that inflation can be brought down without pushing the economy into recession. The defensive character of the recent rally and the shape of the yield curve suggest that the market might have some doubts about their ability to do so.  

A recession is not our base case, but we believe a more cautious stance is warranted. We have increased exposure in our portfolios to companies that are domestic, essential, energy immune, and that have pricing power. In our view, companies with these characteristics are best suited for an inflationary environment where growth could potentially slow. On the opposite end, we have reduced exposure to international consumer-driven companies and companies with supply chain pressures. We think it is important to be looking very closely at where we step.

Preston May, CBE®
Research Analyst