Stay The Course

By Dr. JoAnne Feeney, Partner & Portfolio Manager

Investors last week enjoyed a reprieve as the S&P 500, the Dow Jones Industrial, and the Nasdaq each delivered a week of gains over 6%, putting an end to the longest losing streak (at least for the DJI) since 2001. This occurred despite some major retailers and technology companies delivering disappointing reports and sinking upwards of 20% in a single day. Enthusiasm for equities seemed to emerge from a few narratives: (1) the Fed may pause rate increases toward the end of 2022, (2) China lockdowns may be easing, (3) consumer spending showed surprising resiliency, and (4) valuations have become especially attractive. Inflows of $20 billion into equity ETFs were the most in ten weeks, according to Bloomberg. Despite the rally, investors should be aware that risks have not disappeared, so volatility is likely still with us for a while longer. But as my colleague Randall Coleman pointed out in last week’s commentary, volatility is not a good reason to give up on the long-term returns that equities have delivered throughout history. Being positioned well for the sort of risks the markets produce can, however, make the ride a bit more comfortable.

Front and center among those risks remains the US economy’s inflation challenge, and we should not expect the Fed to back off rate hikes (or quantitative tightening, QT, set to commence this week) until the data show not only that inflation is falling (it is), but that it will approach the Fed’s 2% target. The jury is still out on when and whether the Fed can achieve that goal and how painful the process may be. It is that uncertainty that creates the potential for more stock (and bond) volatility ahead, as investors parse every bit of data to judge how high rates must climb, and financial conditions tighten, to get us across the finish line.

Thus far, the Fed’s actions and, more importantly, signaling are starting to have the desired impact on consumer spending. Demand is showing some signs of easing, while supply continues to expand. Existing home sales fell last month, while single-family housing starts remain higher than pre-pandemic levels. Consumers are starting to trim gas purchases as high prices take a toll.

Several major employers have announced a slowdown in hiring and this week’s payroll report is likely to show fewer net hires after several months above 400,000 additions. This will bring some inappropriate cheers. Slower hiring could help ease inflationary pressures by reducing the upward pressure on wages, although the pace of hiring is sure to remain excessive, so the moderating effects on wages could be minimal. Also, we would not welcome a reduction in the recovery of constrained production. It is likely that we are seeing a shift in hiring, though, rather than a reduction, as workers move from goods producers into services, as consumer spending patterns recover from the pandemic. These changes, combined with ongoing easing of global supply chain snarls, have enabled inflation to edge lower; the core Personal Consumption Expenditure (PCE) price index dropped to an annualized 4.9% in April, from March’s 5.2% rate, a modest decline.

We remain cautious on the notion that the Fed can move aggressively for the next couple of meetings and then pause in September. The sequential drop in core PCE inflation is a step in the right direction, but the US remains well above the 2% target. The Fed has made it clear that higher rates and QT will operate slowly on the forces underlying the recent inflation surge and we should be prepared for it to act while that process plays out. We continue to favor including stocks of companies that can benefit from higher rates to mitigate this particular risk (certain financials, REITs, energy, and consumer stocks work). Fortunately, the broader investing environment remains encouraging for equity investors.

Recent earnings reports showed that demand, while slowing a bit around the edges, remains surprisingly robust both among US consumers and for the global customers of leading technology firms. The vast majority of Consumer Staples and Discretionary firms reported results for last quarter which were ahead of expectations. The same was true for Information Technology firms. The primary disruptions to earnings came from costs and supply chain problems, not from weak demand. Retailers unable to pass on higher labor or transportations costs, for example, saw margins contract and investors extrapolated that trend into a future of declining profit margins. These companies have struggled to pass those cost increases into prices. These companies also saw consumers shift spending to necessities and away from higher-margin discretionary items. Those stocks were punished. But retailers that positioned to serve that shift in spending came in with stronger margins and sales. Spending is proving more robust than many had feared, as consumers continue to emerge from pandemic habits and return to travel and leisure.

Among tech companies, we saw signs of robust demand in reports last week (for data center expansion, enterprise spending, telecommunication infrastructure), but the China Covid shutdowns reduced the ability of many of these suppliers to meet that demand. With signs that those lockdowns are now easing, investors realized some of those stocks were priced far too low while being positioned to offer multiple years of above-market earnings growth. Many have been able to preserve margins by passing inflationary costs through to prices, and this is unusual in a world where all things tech usually fall in price as technology advances bring costs down. Others serving these end markets tend to depend less on labor as an input, so they should be protected from the worst of wage inflation’s impact on margins. As supply chain problems continue to ease (and transportation costs eventually fall), we see some of these technology companies offering a way for (long-term) investors to bring growth into portfolios. As chip supplies improve, we do expect prices to fall along with unit costs, but, importantly, margins (and profits) should be protected.

Investors who have looked past the recent volatility will have noticed that the S&P 500 has risen 27% since January 2020, before the pandemic disrupted life as we knew it. And even with the significant pullback in growth stocks since early November, the Nasdaq has climbed 30% relative to pre-pandemic levels. Inflationary pressures remain and the Fed will take the needed steps to bring inflation lower, but the path may not be a smooth one. In the meantime, though, the US consumer is showing surprising resilience and select technology companies offer both growth and margin protection making for an attractive investing environment, while the US economy continues on its expansionary path.

The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.