This week, CIO Tom Weary, CFA®️, discusses the economic headwinds faced last month, analyzes the current state of the bond market, and shares data indicating that, when it comes to inflation, the worst may be behind us (for now). He also shares earnings reports from RFA companies Constellation Brands and ConAgra Brands.

Transcript

Welcome to the Weekly Market Update. As you can see, I am back in the saddle again, as the song goes.  I want to thank all of my colleagues who stepped in to cover for me during my absence. We usually focus on the stock market, but it is the bond market that has been grabbing most of the headlines this week. We will take a look at interest rates in a moment, but first let’s look at some of the economic forces at work.

The U.S. economy seems to have hit some headwinds in March, slowing from an annualized growth rate of 6.9% in the fourth quarter of 2021 to an estimated 1.3% in the first quarter. The Institute for Supply Management released their latest figures for March for both the Manufacturing and Services Purchasing Managers Index. You can see in this first chart, the Manufacturing PMI dropped to 57.1 versus expectations for 59.0. Some of this may be due to supply chain issues rather than a drop in demand. As we can see in the second chart, Factory Orders are surging to an all time-record, which bodes well for future manufacturing activity. And turning to the far larger Services side of the economy, the PMI just missed expectations coming in at 58.3 versus 58.5, as we can see in this next chart. Services appear to have rebounded after a steep plunge earlier this year, most likely due to the impact of the Omicron variant surge. Taken together, these data points suggest that while the economy struggled recently there is hope that things will pick up in the future.

The Federal Reserve has recently turned their focus abruptly from the labor market, with unemployment nearing its lowest level in 50 years, to inflation, which is running at its highest level in 40 years.  Their preferred measure of inflation is the Personal Consumption Expenditures deflator, which we can see in this chart came in at 5.4% versus economists’ expectations for 5.5%. You can see that this level is up sharply from the low inflationary environment that we have enjoyed for decades, but still only about half the level that tormented us in the late 1970s and early 80s. There is some hope that the worst may be behind us. Rising energy prices have been a big driver of inflation recently, but we can see in this next chart that the price of oil appears to be consolidating around this level. While none of us enjoys high oil prices, at least they appear to have stopped going up, which is what is important for inflation. And some notable areas, like used car prices, appear to be rolling over as we can see in this last chart.  So, there is a glimmer of hope that the economy may be rebounding while inflation may be topping out.

 

As I mentioned at the beginning, it is the bond market that has been grabbing all of the headlines this week. Fed Vice Chair Lael Brainard, usually thought of as the Fed’s most dovish member, stated that the Fed may have to move even faster in shrinking its balance sheet. Remember that Quantitative Easing involved the Fed buying bonds and mortgages to inject liquidity into the economy during the early part of the pandemic. QE helped keep long term interest rates down, while causing the Fed’s balance sheet to swell to $9 trillion. The Federal Reserve now owns 25% of the U.S. Treasury bond market. Therefore, shrinking the balance sheet, either by selling bonds back to the market or just letting them mature, will result in Quantitative Tightening, perhaps driving interest rates higher. Bond investors are doing the Fed’s work for them, selling bonds and driving rates higher. As we see in this first chart, the two year treasury note yield, the bond most sensitive to Fed policy, has skyrocketed in recent times. And now with the talk of shrinking the Fed’s balance sheet, the benchmark 10 year U.S. Treasury bond yield has also moved up sharply. There is much debate about whether a flat or inverted yield curve implies a looming recession, but there is already a real world effect. Mortgage interest rates have moved up rapidly, with the average rate for a 30 year mortgage now over 5% for the first time in years, as we see in this next chart. The housing market has been very hot recently, so it is clearly the Fed’s intent to cool it off. Refinancing activity has all but disappeared.  The Fed wants to slow down the economy without throwing it into recession. It’s a tightrope walk with many moving parts.

Before the market opened on Thursday, we heard from two of our companies in the Consumer Staples sector. Constellation Brands, the distributor of Corona beer in North America and a holding in the Core Portfolio reported results which beat on both the top and bottom lines.  Earnings per share of $2.37 beat estimates by 25 cents, on revenue of $2.1 billion which beat by $80 million. Sales grew 7.7% from a year ago.  The company also raised their dividend by 5%, which is always good news to shareholders.  Recently, the Sands family, which founded the company in 1949 with 8 employees, proposed to convert their supermajority voting shares to ordinary shares, eliminating the dual class. We applaud efforts to improve corporate governance. ConAgra Brands, a holding in the Defensive portfolio, tumbled in the premarket after issuing a weaker than expected forecast for the fiscal year ending in May.  The company saw its profit fall 22% in the most recent quarter as it grappled with higher than expected costs, but it said demand remains strong despite the company’s raising prices. Earnings were 58 cents a share, which met expectations and were level with results in the year ago period. Sales grew about 5% to $2.9 billion, exceeding analysts’ expectations.  Inflation is a challenge, hence the Fed’s sabre-rattling.

So what does it all mean? It has been a rough start to the year in 2022 for both the economy and financial markets.  While the war in Europe and the ongoing pandemic continue to be wild cards, there is some evidence that the U.S. economy may be picking up while inflation cools off.  The Federal Reserve is desperate to maintain their credibility for fighting inflation.  Not only are they planning on hiking short-term rates rapidly and shrinking their balance sheet, they are using their soapbox to cajole bond investors to do much of the heavy lifting for them.  We expect that it will continue to be a volatile year in financial markets, but that resolute investors in great companies will be rewarded over the long term. So please, sit back, relax, have a great weekend, and join us next time for the weekly market update.

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