The Wall Street Journal recently discussed the last decade’s stellar returns.

“Investors’ optimism is easier to understand if one looks at the 10 years through the end of 2021, during which the compound annual return of the benchmark S&P 500 was a very good 16.6%. Not so far from what those surveyed extrapolated. Its components need closer scrutiny, though.”

While the Wall Street Journal then tries to make the case that profit margins were responsible for the bulk of the gains, the reality is most of the excess returns came from just two unique sources.

  1. A decade of monetary interventions and zero interest rate policies; and,
  2. A massive spending spree by corporations on share repurchases.

The chart below via Pavilion Global Markets shows the impact of stock buybacks on the market over the last decade. The decomposition of returns for the S&P 500 breaks down as follows:

  • 21% from multiple expansions,
  • 4% from earnings,
  • 1% from dividends, and
  • 5% from share buybacks.

 

 

In other words, in the absence of share repurchases, the stock market would not be pushing record highs of 4700 but instead levels closer to 2800.

Such would mean that stocks returned a total of about 3% annually or 42% in total over those 14 years.

Given the low growth economic environment, low rates, and weak inflation, a market return significantly lower over the last decade is logical. However, given the injections of over$43 Trillion in liquidity, corporate stock buying, and the artificial suppression of rates, the outsized returns were not surprising.

The question is whether those artificial influences can be sustained for another decade?

 

 

US Economy

 

  • The Philly Fed’s manufacturing report points to substantial downside risks for corporate earnings.

 

 

  • Recession fears have reached a feverish pitch, as financial conditions tighten.

 

 

  • Here is Morgan Stanley’s recession model.

 

Source: Morgan Stanley Research

 

  • Companies are increasingly mentioning recession on earnings calls.

 

 

  • Retailers are facing an inventory overhang, …

 

 

  • Projected inflation rates for 2022:

 

 

  • Wage growth hit the highest level in nearly 40 years, according to the Atlanta Fed’s wage tracker.

 

 

  • Shipping capacity is improving.
  • The congestion at West Coast ports has been easing.
  • Shipping rates are expected to moderate.
  • But container shipping costs ticked higher last week. Demand is not crashing.
  • Mobility continues to recover.
  • Visits to coffee shops have been surging
  • New home sales dropped to pandemic-era lows last month, dipping well below the trend.
  • New home inventories, measured in months of supply, surged. This trend contributed to the deterioration of homebuilder sentiment

 

 

  • The average new home price has sharply diverged from the median, indicating a shift toward higher-end homes.
  • Homebuilder margins have peaked.
  • Demographics will remain a tailwind for the housing market.

 

 

  • So far, home prices are not budging.
  • Service-sector PMI came in below estimates but is holding in growth territory.
  • On the other hand, the Richmond Fed’s regional manufacturing index fell sharply this month.

 

 

  • Cost pressures are worsening, while demand is deteriorating, putting pressure on margins.
  • Supply bottlenecks are disappearing, which means suppliers will have a tough time raising or even maintaining prices.

 

 

  • Hiring is expected to slow sharply, as outlook dims.
  • The Philly Fed’s service sector report also shows extreme cost pressures.

 

 

  • The combination of the NY, Philly, and Richmond Fed reports doesn’t bode well for manufacturing activity at the national level.
  • The slowdown in China also points to downside risks for US factory activity.
  • But weaker manufacturing conditions could signal moderation in inflation.
  • Economic surprise indicators point to a sharp slowdown in growth.
  • Bloomberg’s economic surprise index:

 

 

  • The market has transitioned from inflation worries to growth concerns. The correlation between stocks and bonds has turned negative.
  • BCA Research sees the Fed rate hike trajectory starting to lag current market expectations later this year as economic growth slows.
  • Durable goods orders were softer than expected last month.
  • As a result, the Atlanta Fed’s GDPNow Q2 growth model forecast dipped below 2% (annualized).
  • Capital goods shipments have been robust during the COVID-era recovery,  indicating strong investment spending.
  • But CapEx expectations point to a slowdown in business investment ahead.

 

 

  • The mix of high commodity prices, a strong dollar, and rising rates point to a sharp slowdown in economic growth.

 

 

  • Higher bond yields and credit spreads also signal a slowdown
  • Consumer confidence continues to deteriorate.
  • Job openings are expected to moderate.
  • Mortgage applications have declined substantially but are not collapsing.
  • The recent spike in mortgage rates points to a significant decline in home price appreciation, as affordability deteriorates.
  • Housing demand weakened this month.
  • More sellers are cutting prices.

 

 

  • The Q1 GDP revision showed a larger negative impact from inventories but a stronger increase in consumption.
  • Outside of net exports, growth was robust, with real final sales to private domestic purchasers rising 3.9% (annualized).
  • As we saw yesterday, high-frequency indicators point to ongoing deterioration in consumer sentiment. Record gasoline prices and the stock market rout are some of the drivers.
  • Consumers increasingly think the economy is already in a recession.
  • The Ukraine War also changes matters. China can no longer afford to help Russia politically or economically, and Russia can’t help China militarily.
  • With both China and Russia facing serious problems, the US is re-emerging as a global hegemon by default.
  • George Friedman foresees three important developments in the next 10-20 years: Poland emerging as a leading power in Europe, Japan becoming the dominant Asian power and Turkey rising in its region. These will happen concurrent with China’s weakening.

 

The Fed

 

The FOMC minutes confirmed the Fed’s goal to frontload rate hikes, which the markets fully expected.

FOMC: – Many participants judged that expediting the removal of policy accommodation would leave the Committee well-positioned later this year to assess the effects of policy firming and the extent to which economic developments warranted policy adjustments.

There was nothing in the report to suggest a 75 bps hike in the months ahead. The market has started pricing in a very small probability that we may not even get the full two 50 bps hikes over the next two months if economic growth hits a wall.

There is also some talk about a pause and “reassessment” in September.

Stocks moved higher, and the dollar declined.

Longer-term market-based inflation expectations declined sharply this month amid concerns about economic growth.

The Federal Reserve minutes of the May meeting gave investors a pretty clear roadmap for the summer. The minutes, out Wednesday afternoon, painted a picture of an FOMC strongly focused on inflation, with rate hikes of 50 basis points in the June and July meetings. But some members also indicated that price pressures may not be getting worse.

Stocks rally: The market appeared to take the minutes as more dovish than hawkish. Half-point hikes were already priced in for the next couple of meetings and there was no mention of 75-basis-point moves that had become the base case for a few Wall Street banks at the end of April.

The S&P 500 (SPY) rose about 1% to finish out the session and S&P futures (SPX) are up again this morning. Treasury yields (SHY) (TBT) (TLT) continue to creep lower today.

“We think that after the July meeting the Fed is likely to become more ‘data dependent’ with regard to rate hikes, which essentially means that the policy path after July will depend upon the trajectory of inflation and progress toward correcting the supply/demand imbalances in the labor market,” BlackRock fixed income strategist Bob Miller said.

There are already signs that the U.S. economy is weakening. Of the last 19 major economic indicators, 13 have missed economists’ expectations, Nomura noted. The question is whether that will bring about a Fed pause, which stock bulls are hoping for, or will it stiffen the central bank’s resolve.

If there are signs of falling inflation and improved labor market imbalances “the Fed gains some breathing room and can shift policy adjustments to 25 bps increments, while still pursuing something in the estimated range of neutral,” Miller said.

Pantheon Macro economist Ian Shepherdson says the door is still open to a smaller hike in July given the minutes show policymakers “appear utterly oblivious … to the rollover in housing demand, which has been evident in the mortgage applications data since the turn of the year.” That will change in the June minutes, he added.

But Nomura strategist Charlie McElligott says those hoping for a Fed pause will likely be disappointed, noting Fed chief Powell’s willingness to endure “some pain” in getting price stability.

“I think that if anything, the Fed is seeing the results of their (financial conditions index) tightening campaign through these broad measures ‘slowing’ and could actually become incrementally ’emboldened’ to keep PUSHING on their hiking path until they see the ‘whites of the eyes’ of sustainably lower inflation as opposed to the notion of ‘pausing and hoping’ for the inflation data to move lower – a view that is increasing held by some in the market,” he said.

 

Market Data

 

  • Global sentiment shifted to “risk-on” as the Biden administration reviews the current US tariffs against China. The Aussie dollar, which has been correlated with equities is up sharply.
  • Fearing a recession, the market continues to punish consumer shares. Retailers may face some inventory overhang and will be forced to offer discounts. Margins will tighten. We are basically returning to the pre-COVID regime.
  • The S&P 500 divergence from VIX widened further last week amid limited demand for hedging.
  • The Nasdaq 100 breadth is near the post-2009 lows.

 

 

  • It’s been a challenging period for post-IPO stocks.

 

 

  • The pullback in global liquidity doesn’t bode well for equity markets.

 

 

  • All large US tech stocks were down last week.

 

 

  • Sentiment on silver has been terrible. A buying opportunity?

 

Source: Sentix; @Callum_Thomas

  • Precious metals ETF flows have turned positive

 

 

  • Markets expect a decline in dividends next year.

 

 

  • The market hasn’t punished negative earnings surprises this much in years. It hasn’t been too kind to positive earnings surprises either.

 

 

  • The cyclicals/defensives ratio is increasingly pricing in a deterioration in economic growth.
  • The gap between value and growth stocks keeps widening.
  • The dollar is entering a seasonally weak period.

 

 

Quote of the Week

 

“Truth and news are not the same thing.” —Katharine Graham (1917-2001)

 

Picture of the Week

 

 

 

All content is the opinion of Brian J. Decker