Some Serious Extreme Conditions

Is the US Economy strong or not? It totally depends on who you ask. There are strong opinions on both sides, which sure frames why the Market has been so volatile.

The Fed still thinks the Economy is strong. Fed Chair Powell said so again this week: “The underlying strength of the US economy is really good right now. The US economy is strong, the labor market is extremely strong. It is still at very healthy levels. Retail sales numbers, the economy is strong. Consumer balance sheets are healthy. Businesses are healthy. The banks are well-capitalized. This is a strong economy.” That is the perspective from the central bank that is finally fixated on fighting inflation. A full percentage point rate hike is a given this Summer, ½ a point each across the next 2 meetings. The most important question is at what cost. Are they willing to drive the Economy into recession? The Market is clearly rattled with this unknown.

The American Consumer accounts for 70% of economic activity. Inflation has spiked the prices people pay. We saw a flood of data this week with the April retail sales report and earnings from the biggest retailers. Retail sales increased 0.9% month over month.  That was in line with expectations and a slowdown from the upwardly revised 1.4% rise in March. Sales increased over 8% from last year. Areas of strength included department stores, restaurants & bars, as well as constant activity in e-commerce. There was a shrinkage in sales at the grocery store and building supplies. Sporting goods were notably weak too. Spending continues, but it has made a dramatic shift from stuff to services. People are out and about with increasing frequency. Airlines continue to see huge traffic in the friendly skies. It’s the reopening of America theme.

The price at the pump reached all-time highs this week. Americans will spend roughly $5,000 on average this year on gas. That’s nearly twice the amount spent last year; $2,800. Gas prices are eating away at discretionary spending. Consumers are trading down from big brand products to private label/generics with increasing frequency. Companies are no longer able to pass on inflated prices to customers. There’s a shortage of staff. Stores have to pay more to get people to work. Profits are getting squeezed by inflation.

America shops at Walmart. It’s a tough time for retailers. The company is facing some serious challenges. Earnings missed Street expectations. The miss was due to higher-than-expected supply chain costs, a shift towards lower margin grocery sales, markdowns and higher costs. A chunk of the higher costs was increased wages to employ stores. Management said it was caught completely by surprise, mostly due to the spiking prices of food and fuel. Walmart’s earnings dropped 25% from January to April. Half of what Walmart sells is food. Management lowered guidance to an actual earnings contraction for the rest of the year. That was a shock to the system. Walmart’s stock had its worst day since 1987. The takeaway is essentially, Americans are paying more and buying less.

Target had it worse. The national retailer missed on both revenues and profits. Management explained it faced unexpectedly high costs in freight, fuel and transportation. That’s clearly a theme. The company increased its inventory of goods that were under such strong demand in 2021. The big earnings miss at Target was driven by a switch from higher-margin goods such as kitchen appliances and TVs to basics like food and toiletries. Sunscreen was apparently a big item purchased. Target did not anticipate the demand shift from stuff to services. The company stocked up on too many discretionary categories. Inventory grew 43% from a year ago. That led to significant markdowns.

Target’s earnings release mirrored Walmart’s report: Inflation, labor costs, and supply chain issues. Target underestimated these costs by $1 Billion. That’s a big miss and it happened within weeks. Target CEO Brian Cornell said the American Consumer is still strong, which means the Economy should be on firm footing. Customers were in the stores and spending. The company simply didn’t anticipate the shift in purchases. Target’s stock fell 25% in one day. It was also its worst day since 1987.

This shift from goods toward services is having an impact on the Market. It’s a negative for corporate profits. Sales of goods account for 20% of US Gross Domestic Product. But it counts for 50% of S&P 500 earnings. That’s playing out presently. Lower profits mean weaker employment & slower wage gains, as companies defend their margins. Both of those factors will dent consumer purchases. Wage gains are already slowing, and layoffs are on the rise. Excess inventories will lead to lower prices as retailers try to unload them. That is all deflationary. But it’s also recessionary. That’s the price the Fed has apparently decided to pay to get pricing under control.

Food scarcity is a major risk around the Globe. Wheat futures in Chicago jumped by their 6% limit on Monday after India banned exports of the grain, citing concerns over “food security.” This move drove food prices even higher, adding to the already painful inflationary environment. Russia blocked off Ukraine’s Black Sea ports in attempt to conquer its coastline. That slows exports. The region is referred to as the “breadbasket of Europe.” Ukraine and Russia account for a third of global wheat exports. No surprise, the largest cut to production is in Ukraine, which is now expecting a crop one-third smaller than last year due to the ongoing war. Food scarcity is a real risk.

The thing is, India had been helping to fill the wheat supply gap following a plentiful harvest last year.  A blazing heatwave in March and April put an end to that. The high temperatures stoked concerns about lower wheat supplies which spiked domestic prices by as much as 40%. India said it would honor exports for existing contracts and grant support to countries seeking to meet food security needs. India is not a major wheat exporter. But the fact that a large nation scrambled to secure food supplies made the Market anxious. There are natural fears of a domino effect if other nations follow suit with their own export bans. Indonesia, which accounts for over half of global palm oil production, suspended trade of the widely used ingredient and feedstock.

There’s still a virus. China has a zero Covid policy. It has locked down the city of Shanghai for weeks now. It looked like things were on the right path for recovery. This week the city declared 5 consecutive days of no new cases. Commodities initially jumped, led by metals and oil. The thinking is that an economic recovery in China will be a big catalyst for the Global Economy. Not so fast. It didn’t make it to 6.  New cases occurred. It has become increasingly clear that China is unlikely to hit its 5.5% economic growth target this year. Even though Shanghai Covid trends continue to improve, a slow reopening and worries about lockdowns in other cities remain a constant. Cases are reportedly on the rise in Beijing.

The Chinese Economy has been strained. It’s the second largest in the World. New home prices fell there for the first time in 6 years. China cut the 5-year loan prime rate, which is a benchmark for mortgages, by the widest margin since its interest rate overhaul in 2019. The government is trying to kickstart their housing market again. It got the Chinese Stock Market to move, with a rally off some washed-out levels. China’s central bank is loosening monetary policy to provide support while America’s Fed tightens.

There’s only so much the Federal Reserve can do. The Fed can’t control supplies. It can’t ramp up more oil. It can’t increase more milk or bread at the store. It can’t build more houses. It can’t manufacture more semiconductors or televisions either. What the Fed can do is destroy consumer demand. That’s the campaign they have chosen in pursuit of lower prices.

Back to the Market: Bear territory was officially reached on the S&P this week. That comes with a 20% decline from the peak. A fifth of that came on Wednesday alone, which was a complete washout. The S&P fell 4%. The Tech-heavy NAS was worse. The mere 6% up‐volume session made it the most vicious trading day in this correction. In other words, 94% of the shares traded were sales. There’s been some serious selling on Wall Street, in relentless fashion. Wednesday was the worst trading day since June of 2020, in the wake of the Covid crash. Declines of 4% or more on the major index are rare, really rare.  It has happened just 170 times since 1928. That’s 0.7% of all trading days in nearly a century. According to Piper Sandler, of those 170 instances, the average S&P closing price of the down day was about 9% away from its 52-week low vs. 61% away from its 52-week high. So, it’s happened close to bottoms.

We investors are facing some serious extreme conditions. Bank of America/Merrill Lynch puts out a monthly Global Fund Manager Survey. It currently shows the highest cash level in 2 decades and lowest equity weight since May of 2000. Nearly 60% of responders said they fear a global recession ahead. Cash levels are at the highest since 9/11. Tech is the most underweight since August of 2006. That was when Technology stocks finally came back to life after the Dot-com days. There has been a complete exodus from Tech. This is actually quite bullish from a contrarian perspective. BofA/Merrill described this survey as an “unambiguous contrarian buy territory.” Nobody wants to own Tech right now. What a complete and total sea change from the previous decade when Tech could do no wrong…

As if there wasn’t enough volatility, Friday was an Options expiration day. Things started off well with a nice oversold bounce in the morning. Like so many rallies this year, it got faded quickly, leading to more selling. The Dow was down over 600 points at the lows. The S&P was down 90. Both were over 1% declines. Then a final hour jump higher began. Both the Dow and S&P saw their losses erased and ended slightly in the green. Option expiration and short-covering were at play. But this late-session rally was not insignificant in our minds. Bottom formation is process. This one has been excruciating, with relentless selling. Despite Friday’s green end, the S&P and NASDAQ have declined 7 straight weeks. That hasn’t happened since the Dot-com bubble burst in 2001. The Dow is down 8 consecutive weeks. That has only happened one other time and it was in 1932. That was during the Great Depression. I say it again, we investors are facing some serious extreme conditions.

Our defensive strategies have been working. They’ve gone a long way to cushion the blow. But Bear Markets are like a drought for stocks. It’s part of the natural cycle and we just need to fight through it, be disciplined and get to the other side. We’re doing it. We’re getting there. Importantly, the Bond Market is back to safe-haven status. As I wrote last week, it’s sending a message. An economic slowdown is upon us. It also looks like a break from these excessive inflationary pressures just might be on the horizon too. That would be great for the Economy. The Market would like that. The Market would like that a lot.

Have a nice weekend. We’ll be back, dark and early on Monday.


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