The Manley Macro Memo
- In February, stocks fell to a nine-month low as Russia invaded Ukraine, and investors worried about inflation, which surged to the highest level since January 1982. Since its January 4th all-time high, the S&P 500 declined by 14.6%, while the NASDAQ 100 and Russell 2000 fell by more than 20% peak to trough. We still believe that stocks offer a poor risk-reward and are in a bear market.
- The economy remained strong in February. The unemployment rate dropped to 3.8%, and retail sales jumped by 17.6% from a year ago. Unfortunately, inflation continued to surge to a 40-year high due to the strong economy, supply chain issues, and the massive increase in the money supply. The Russian invasion of Ukraine led to a spike in energy and agricultural commodities, which will accelerate our existing inflation problem. Historically, energy surges and inflation greater than 5% led to recession.
- On March 16th, the Federal Reserve increased short-term interest rates for the first time since December 2018. Inflation, which is currently 7.9%, has been greater than 5% for the past ten months, yet the Fed increased interest rates by only a quarter percentage point to 0.50%. Additionally, the Fed indicated they would raise interest rates to 1.9% by December and 2.8% by December 2023. Despite the Fed's action, record negative real rates (interest rates minus inflation) push inflation higher. To truly fight inflation, the Fed would have to set short-term interest rates above inflation and aggressively reduce their balance sheet to slow the growth in the money supply. Unfortunately, these actions would lead to a recession and a deep bear market.
- Last year, we believed the massive monetary and fiscal stimulus would lead to a reflationary environment (strong growth and rising inflation) where value stocks, commodities, floating loans, and TIPS would prosper. Currently, we expect the economy to slow due to strong inflation, higher interest rates, and a substantial drop in fiscal spending. In this stagflationary economic environment, we see a significant opportunity to invest in the value and defensive sectors of the market while avoiding the mega-cap tech stocks that dominate the S&P 500. Finally, since volatility is elevated, the market's intermediate-term rate of change is negative, and breadth is poor, we will continue to focus on preserving capital and reducing risk until the market offers a better risk-reward.
- During the past six days, the S&P 500 has rallied by 8.6% and retraced 58% of its previous decline not because of fundamental improvement but because of market flows (options expiration, quarterly rebalancing, and short covering). As the Fed tightens monetary conditions, fundamentals, not excess liquidity, will again drive markets.
The stock market began the new year on a sour note. In January, stocks dropped sharply as inflation surged to a 40-year high, and investors worried about the Fed's hawkish pivot. The S&P 500 declined by 5.3%, while the small-cap Russell 2000 decreased by 9.5% in January. The foreign markets were mixed, the MSCI EAFE index of international stocks declined by 3.6%, and the MSCI Emerging market index was flat.
Despite the "risk-off" environment, the "safe havens" performed poorly -- the U.S. long-bond and gold fell by 3.9% and 1.7%, respectively. The U.S. 10-year bond yield increased by 0.26% to 1.77%, while the yield curve (2-year to 10-year) flattened by 0.18% to 0.61%. Oil jumped by 17.2% as the Omicron variant threat receded and geopolitical risk increased in Ukraine.
In this "risk-off" market environment, all of the sectors of the S&P 500 declined, except for energy and financials. Also, higher interest rates and inflation caused the value sector to significantly outperform the growth sector by 6.3% (the Russell 1000 Value index declined by 2.4%, while the Russell 1000 Growth sank by 8.7%).
February Market Performance:
As discussed last month, the S&P 500 appreciated by more than 100% over the past three years, despite the Covid pandemic, economic shutdowns, and inflation surging to a 40-year high. We believe stocks surged not due to the fundamentals but because of the unintended consequences of the Fed's profligate monetary policy.
The Fed cut interest rates to 0% and printed $4.8 trillion over two years to stabilize the economy during the pandemic. Interest rates plunged, stocks soared, and inflation surged. By May of last year, inflation reached 5% -- a level that historically led to recessions -- yet the Fed did not raise interest rates until last week.
The Fed's failure to remove their emergency monetary measures and their flawed analysis that inflation was "transitory" was the monetary mistake that led to the highest inflation rate since 1982. History shows that the Fed will likely make another mistake that will lead to a recession. The Fed's economic framework focuses on the demand side of the economy while ignoring the supply side and the money supply. Historically, the Fed raised interest rates to reduce demand and slow the economy to fight inflation. Unfortunately, the Fed's history of interest rate tightening cycles is nearly perfect – since WWII, the Fed's 12 tightening cycles led to 11 recessions (see chart below).
The only successful "soft landing" occurred during the 1994 tightening cycle. In February 1994, the CPI was 2.5%, and the Fed raised short-term interest rates by 0.25% to 3.25%. By February 1995, the Fed had increased short-term interest rates to 6.0%, and inflation peaked at 3.1% before heading lower. The Fed tamed inflation and avoided a recession because they acted preemptively (before inflation was out of control), and they increased real rates from 0.50% to nearly 3.0% (see chart below).
The current relationship between short-term interest rates and inflation is nearly the mirror opposite of 1994. When the Fed hiked interest rates last week, inflation was 7.9%, and real rates were negative 7.7% (see chart below). Since short-term rates are only 0.50%, the Fed's monetary policy continues to stimulate an overheated economy. To fight inflation, the Fed must raise interest rates significantly and reduce the size of their bloated balance sheet, but that would likely lead to a deep recession.
While most Fed tightening cycles lead to recession, history also shows that recessions typically follow oil shocks. As reported by Bloomberg, Luca Paolini, chief strategist at Picet Asset Management, shows that since 1970, every time oil prices rose 50% above their inflation-adjusted trend, recessions occurred (see chart below).
Source: Bloomberg, Picet Asset Management
As discussed last month, we believe we are in a bear market, and the S&P 500 is vulnerable to a significant decline this year. In fact, large corrections are typical in midterm election years. According to Bank of America Securities, the average decline in a midterm election year is 20.8%, and 43% of midterm election years had declines greater than 20%. The magnitude of a bear market decline usually depends on whether the economy enters recession. If a recession doesn't occur, the typical decline is less than 20%, while the average bear market decline during a recession is around 35%.
The Fed's first monetary mistake was failing to remove their emergency monetary measures and believing inflation was "transitory." That mistake led to the highest inflation rate in 40 years and an equity bear market. While history suggests that the Fed will likely make another monetary mistake that will lead to a recession, market-based indicators (the yield curve and credit spreads) indicate that a recession is not on the immediate horizon. While the yield curve has significantly flattened, it has not inverted. Yield curves typically invert 12 to 18 months before a recession (see chart below).
Economic risks are elevated because the Fed is significantly behind the inflation-fighting curve. We believe that stocks are in a bear market, and the magnitude of the decline will be determined by whether the Fed can tighten monetary policy enough to defeat inflation without causing a recession. In this high-risk environment, we are focused on preserving capital until there is less uncertainty and the market offers a favorable risk-reward.
Our Model Portfolio:
The benchmark for our model portfolio is the Traditional Blend — 60% equity, 40% bonds. Our goal is to outperform the benchmark with less risk. To outperform, our investment portfolio is diversified and economically balanced. We eliminate laggards and tilt the portfolio toward our location in the business cycle. Finally, we risk-weight our positions to manage volatility.
Last year, we believed that the massive monetary and fiscal stimulus would lead to a reflationary environment (strong growth and rising inflation) where value stocks, commodities, floating loans, and TIPS would prosper. Currently, we expect the economy to slow due to high inflation, rising interest rates, and a substantial drop in fiscal spending. To perform well in this stagflationary environment, we made new investments in gold mining stocks, utilities, and consumer staples. As the economy slows, we will gradually reduce our economic exposure and increase the duration of our bond exposure. Finally, since stocks are extremely overvalued, inflation is surging, and volatility is elevated, we are focused on preserving capital in this risky and uncertain environment. We remain underweight equities, fixed income duration, and overweight commodities and gold relative to our benchmark.
Our portfolio's risk level (annualized volatility) is 16.6%, which is less than our 60/40 benchmark.
Current Risk-Weighted Model Portfolio:
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Our short-term (three-month) outlook is negative:
The S&P 500 dropped by 14.6% from its all-time high in January to its February 24th (Russian invasion) low. Stocks were oversold, investors were fearful, and structural market issues (options expiration, short-covering, and quarterly rebalancing) led to an explosive 8.6% rally over the past six days. After retracing 58% of its previous decline, the S&P 500 is overbought, and we believe vulnerable to another move lower. We will become more constructive in the short term when investors are fearful, stocks are oversold, and market breadth begins to improve
Our long-term (more than four years) outlook is negative:
We believe that the S&P 500 offers a poor risk-reward because it is extremely overvalued. Also, we are concerned about the long-term unintended consequence of the unprecedented monetary and fiscal policy that was used to combat the pandemic. Artificially low-interest rates and historic peacetime deficits have led to a record debt burden, which will become problematic as the economy slows, and interest rates normalize. We see an opportunity to invest in the value and defensive sectors of the market while avoiding the mega-cap tech stocks and the S&P 500. Longer-term, we remain concerned about the impact rising interest rates will have on corporate profitability and stock valuations. Our Strategic Asset Allocation is underweight equities relative to our benchmark.
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Disclaimer: The material in this newsletter is for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. This newsletter is not a substitute for professional investment services. Past performance is no guarantee of future results, and there is no assurance that investment objectives will be achieved. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. All investments contain risk.
J. Lawrence Manley, Jr., CFA
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