In comparison to the tumultuous markets in April, when the S&P 500 fell almost 9%, the month of May was quite boring as this index was flat as a pancake. However, that result definitely hid a lot of intra month volatility. The last two days of May saw a rally of 4.5% to salvage the month from a performance perspective. Even with the late rally, the NASDAQ lost 2% in May and that brought its year to date returns to down 22%. The S&P 500 finished May down 14% for the year. Context is important though, as the S&P 500 was up 27% in 2021 and the NASDAQ was higher by 21%.
After five months in a row of rising bond yields, the 10 yr US Treasury yield slipped by 9 basis points to 2.85%. However, as of this writing, we are right back to 2.92% in sympathy with the continued selloff in European bonds. The Bloomberg Global Aggregate Total Return index is having its worst start to any year since the index’s inception in 1990.
Looking overseas, the Euro STOXX 600 index was down 1.6% in May and marked the 4th out of 5 months this year that it has closed lower. Asia traded better with the Nikkei and Shanghai indices higher for the month. The South Korean Kospi, to name another, was flat.
The European Central Bank has not even begun to tighten monetary policy and has only overseen less easing. At the same time, the Eurozone CPI for May saw an 8.1% year over year increase. European bond market continues to tighten conditions for the ECB as yields jumped again in May. The German 10 yr bund yield this year has gone from -.18% to 1.12%. May alone saw a rise of 18 basis points. The Italian 10 yr yield has jumped almost 200 basis points this year. It was higher by 35 basis points in May. One cannot only analyze US inflation and growth in trying to predict the direction of US rates. They must acknowledge the influence of overseas bonds too.
The driving force behind all of this is the persistent pace of inflation and which is clearly a global phenomenon. There is the possibility that we have seen a peak in the pace of goods price inflation, but services inflation is still inflecting higher and food and energy prices keep rising too. Gasoline prices in particular averaged $4.62 a gallon on Memorial Day 2022 according to AAA and set a record high. That compares with $3.05 on Memorial Day 2021, $1.96 in 2020, $2.83 in 2019, $2.97 in 2018 and $2.37 in 2017.
The other important story of the month was the 2nd month of the Shanghai shutdown that also spread into Beijing. I am not even going to begin to try to rationalize the very strict approach to Covid by the Chinese authorities, but the end result is hugely disruptive, not just to the lives of the residents and businesses there, but to businesses globally. As of this writing though, the Chinese government has announced a full opening of Shanghai. It will take a few months to revert back to normal and that assumes they do not experience another Covid outbreak. If there is one thing we have all learned over the past two years, it is that lockdowns do not stop Covid. Only broad immunity does.
The Federal Reserve
In early May the Federal Reserve increased the fed funds rate by 50 basis points to a range of .75-1.00% as expected. The markets are expecting two more 50 basis point increases at the upcoming June and July meetings. The fed funds market is pricing in an 84% chance of an additional 50 basis point rate increase at the September meeting which, if realized, would take the overnight rate to a range of 2.25-2.50%. Ultimately, the fed funds market as of this writing is pricing in a terminal rate of 3-3.25%.
On June 1st, quantitative tightening began where the Fed began the process of shrinking its huge balance sheet, which at its peak was just under $9 Trillion in size. This is about double its pre-Covid level and 10x its 2007 size. The pace at which this will occur is much quicker than the last time they tried this (beginning in October 2017) and thus the impact needs to be watched closely.
As I said in my April letter, years of easy money policy has created an economy very dependent of debt and a low discount rate. This permitted financial markets to build up higher levels of valuation and credit spread tightness and where borrowers had their way. We need to understand that this era of very cheap money in this cycle is over and thus will continue to have ripple effects on business activity and market pricing.
The Markets and the Economy
While the markets have priced in the actual Fed rate hikes, it is tough to discern how markets will react to the roll off of the Fed’s balance sheet. As QE was meant to lift markets, I expect QT to be a continued headwind as it was last time. The other key question is how the economy responds to a higher interest rate environment along with inflation. What we saw in Q1 earnings was another contraction in profit margins and we expect that to continue. Also, we now worry about a slower pace of revenue growth in the quarters ahead.
The most interest rate sensitive part of the economy is housing. Combining the sharp rise in mortgage rates with home prices that are 20% above year ago levels according to S&P Core Logic, we have buyers that are calling a timeout. Both the new home sale and pending home sale reports for April that we saw reported in May confirmed a continued slowdown in the pace of home transactions. At the same time, the demand for rentals continues to be robust and Apartment List.com said rents were up 15% in May versus May 2021. Apartment List said, “Despite a recent cool-down, many American renters are likely to remain burdened throughout 2022 by historically high housing costs.”
The auto sector is the other very sensitive part of the economy to changes in interest rates. While there has been an ongoing supply challenge in producing enough vehicles because of semiconductor shortages, the high price of a car and now rising financing costs is leading to a moderation in demand. In May, TrueCar said, “Higher interest rates combined with higher fuel prices present a headwind to demand cooling off, which may explain why average used list prices are decreasing, down 1.6% in May versus April 2022.” With an epic rise in used car prices over the past few years, it would be a good thing to see prices fall back a little.
Overall US consumption, which is the majority of US GDP, is changing its mix. Consumers are spending less on goods, which they stocked up on over the past few years, and shifting to services like travel, dining, and other recreation, like going to the movies again. But prices here are jumping too. Delta’s CEO said airline fares will be up 25-30% this summer versus last summer. On the other hand, lower income consumers, which are the most hurt by higher inflation, are shifting spending priorities to needs rather than wants.
With respect to the US labor market, the pace of hiring is slowing with some notable companies announcing that they will be more circumspect in adding headcount. But the pace of firings, while recently rising, still remains historically low. Wage growth remains good but not good enough when compared to inflation.
Europe’s economy is very challenged right now because of the high level of energy prices squeezing consumer budgets. In May, consumer prices in the Eurozone rose 8.1% y/o/y. Higher energy prices, particularly natural gas, are also putting cost pressure on many industrial companies in the region which use energy as a feedstock or just to power manufacturing facilities. On a metric equivalent basis, Europe is paying 3x for natural gas that we are paying in the US and natural gas prices in the US are at the highest level since 2008.
China, the world’s 2nd largest economy, has self-imposed a massive jolt to their economy via the aggressive “Zero Covid” stance. This also comes on top of distress in the residential real estate market for many developers. Housing makes up about 1/3 of the Chinese economy. As stated earlier, Shanghai has announced that they are now reopened, but it will take a month or two to really normalize and that assumes no more Covid outbreaks, which is a tall order.
I don’t want to end this without stating a positive. Goods prices, which have been a key driver of the very high inflation we have experienced, are showing signs of moderating. If we can get a cooling in housing costs and other services, than an overall slowdown in inflation would follow. This will take time though and the Fed is still well behind where they should be with respect to policy. Also positively, we hope that China is past the worst of its approach to Covid because the world needs fully opened Chinese supply chains, and the full spending force of its consumers. Lastly, outside of China, the world has kissed Covid goodbye in terms of it be a driving force in our lives. Good riddance.
Either way, whatever the outcome will be, it remains vital that investors have a plan that suits their short term liquidity needs over the next 2-3 years. Knowing that period of time is covered can help separate the balance of one’s portfolio from what I believe will continue to be a choppy time for the economy and markets. Time horizon is really key right now and the best friend of any investor. Please do not hesitate to reach out at any time with questions or for any discussion on the economy and these markets.
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