MIXED SIGNALS

The second half outlook

Issue 246?????

By Jeffrey Trusheim, Chief Financial Officer, Mortgage Solutions of Colorado, LLC DBA, Mortgage Solutions Financial.

Mortgage Solutions presents Issue 246 of Market Pulse. This commentary will provide Trusheim's perspective of the economic, political, and technical considerations that will have an impact on the global & domestic financial marketplace. The report will provide a recap of the previous week's activity as well as a look at the important market-moving factors in the week ahead.

Our January, “Outlook for 2022”, missive suggested that we were in for a volatile roller-coaster ride as the markets needed to correct the unprecedented (120%)?surge from the March 2020 pandemic panic lows. Fueled by a tsunami of fiscal and monetary stimulus, approaching $10 trillion, the S&P 500 took off like a rocket from 2200 to 4800 in the span of less than two years. The correction so far has given back about 45% of that rally, with a recent low just above 3600.?

It’s been painful, and there has been no place to hide. So, what can we expect going forward for the rest of 2022 and into 2023? The volatile roller-coaster ride we have been on is likely to continue. You can also expect to get mixed signals and inconsistencies from the Fed, the bond market, the stock market and the economy. I envision the peaks and valleys of these four indicators arriving at different times, making it difficult and confusing for investors. However, inflation is the key and should be watched closely. The bottom of the stock market won’t arrive until the inflation rate begins to drop towards the Fed’s target.

We are still dealing with a war, a 40-year high inflation rate, a Fed aggressively raising interest rates, record low consumer confidence, back-to-back quarters of negative GDP growth and a recession that has already arrived or will be here shortly. On the other side of the ledger, we have an amazing party in progress. TSA screenings are at a post-pandemic high, 2.5 million weddings are expected this year, which is the most since 1984, and over 70 million concert tickets have been sold year to date - 36% above 2019 levels. Many resorts and hotels are sold out, restaurants are full (despite much higher prices) and airports are overcrowded with more demand than supply of available flights.?

There is little argument that the surging price of crude oil is responsible for much of the inflation we are currently experiencing and that the Fed is mandated to fight. The current Administration’s policies that abandoned fossil fuels are partially to blame, as are the fiscal and monetary decisions to add trillions of stimulus to our economy when it was running above pre-pandemic levels.?

Despite what you may read or hear, our inflation problem is not due to Russia attacking Ukraine. Russia provides roughly 10 percent of the global supply of oil, and we have seen evidence that their production is at or above pre-war levels. There is the same amount of oil on the global market as there was before the war started. It was a “blame game” tactic used by Washington, and is confirmed by watching crude oil prices plummet from $130 to $95 recently.?

There has also been much said about the rising food costs being blamed on the declining wheat crop in Ukraine after the Russian invasion. Ukraine supplies about 10% of the world’s grain and has been cut by about 60% due to the war. Russia supplies about 17% of the world’s wheat and their exports have not been cut. Russia may export 39 million tons of wheat in 2022 out of a harvest of about 85 million tons, up from 76 million tons in 2021. Simple math tells us the grain supply has been minimally affected, if at all. Wheat futures have plummeted 40% from their highs including a 27% decline in June. In the current month’s Services PMI report, the number of commodities in “short supply” was the lowest since February 2020. Bottom line: The “war” premium is gone and the supply of commodities hasn’t been affected to the degree as suggested.?

EMPLOYMENT

The Non-Farm payrolls for June grew by 372k, which was 107k more than expected but mostly offset by a downward revision to the prior two months of 74K. The 3-month average job gain now stands at 375k versus the 6-month average of 457k and the 12-month average of 542k. The 2021 average was 562k. Although there is a clear and obvious deceleration in job growth, this is normal given the current tight labor market.?

The unemployment rate held steady for the fourth consecutive month at 3.6%. Average hourly earnings rose to a y-o-y increase of 5.1%, but still well below the current inflation rate, meaning that “real” earnings declined again. The labor force participation rate fell slightly to 62.2%.?

An interesting data point that is not talked about too often is the number of Americans “employed part-time for economic reasons”, which fell by 707k to it’s lowest level in 21 years. These are workers who want to work full-time but are involuntarily working part-time because their employer cut their hours or they can’t find a full-time gig. This dynamic suggests workers have increasing leverage and bargaining power in the current job seeker’s labor market.?

Bottom line: The demand for workers remains near all-time highs, and layoffs remain near all-time lows. Wages are growing at the fastest clip in decades. If the current job-growth trajectory holds, the U.S. would fully recover the 22 million lost jobs during the pandemic era by this coming August. This stronger-than-expected jobs report will reinforce the Fed’s aggressive stance towards raising interest rates. They fully expect the unemployment rate to increase as they slow the economy through their “demand destruction” policies. The FOMC has predicted that the unemployment rate would increase slightly to 3.7% by the end of 2022, and to 4.1% in 2024.?

THE FED

The minutes from the June FOMC meeting revealed that voting Committee members judged that an increase of 50 or 75 basis points “would likely be appropriate at the next meeting” given the current economic outlook. They also “recognized the possibility that an even more restrictive stance could be appropriate if elevated inflation pressures were to persist.”?

In light of their hawkish stance, and Friday’s strong jobs report, a 75-basis point increase in the fed funds rate at their upcoming July meeting should be a done deal. Fed policy has switched from doing “whatever it takes” to keep the economy and markets rolling ahead, to doing “whatever it takes” to slam on the brakes and tame inflation.?

There are many signs that inflation may have already peaked, especially in the commodities market. Copper (aka Dr. Copper) is known to have a PhD in economics, fell 21% in June. Cotton prices have plummeted 35% so far this year. Money Supply is moderating, inventory levels are bloated, freight rates have been falling, prices of semiconductors, fertilizer and industrial metals are tanking and the Fed’s preferred inflation gauge (Core PCE) has moderated from the highs. Bottom line: IF inflation drops as fast as it rose then we should expect fewer and lower rate increases, with an end target in the 3.00% - 3.25% range by year-end. If inflation stays “sticky” at these elevated levels, then you can expect the Fed to push interest rates into “restrictive” territory and bring our economy into a hard-landing recession.?

THE STOCK MARKET

The key question for the second half of 2022 is simply: “When will this madness end…where is THE bottom?” The simple answer is that ultimate bottom of this painful correction will come in conjunction with a peak in oil prices, inflation, and bond yields. This bear WILL eventually turn into a BULL and will bottom well before the economy bottoms.?

Having been a student of the markets, as well as a market historian for about 40 years, I can tell you that there is no historic analogue or playbook to guide you through this mess. Never before in history have the entire global economies been shut down and put into a coma, while being flooded with trillions upon trillions of free money, and with interest rates held at zero (or negative). 100% demand with 0% supply created massive inflation and endless speculative bubbles, all of which are being popped. The punch bowl has been taken away from the party. The tide has rolled out to sea, and there are lots of bathers not wearing swimsuits. Trillions upon trillions have been lost this year, with the poster-child assets being technology stocks and the various crypto markets. This was an experiment conducted in real-time, which produced unprecedented market moves. The recent seven-session period from June 8 to June 16 was “the most overwhelming display of selling in history.” A period where 90% of the S&P 500 stocks fell in five of those trading sessions. That has NEVER happened before.?

In attempting to determine the highest technical probability of where THE bottom may be struck, I first step-back and look at the big picture. We are in a secular bull market that began after the Great Depression in 1932. The current phase began after the Financial Crisis in 2009, and within that phase we are in a correction of the rally from the 2020 pandemic low. The current correction has Fibonacci targets in the 3200-3500 region. If the current pullback has a typical (recession) 30% decline that would put it around 3375. The 50-month moving average is currently near 3500. As far as important resistance is concerned, it will take a penetration of the 4200 level to convince me that the next rally phase is underway, with upside targets in the 4800-5000 range. Meanwhile, short-term resistance is set at 3900-3950 and short-term support rests at 3750-3800.

From a fundamental perspective, earnings and valuations are what drive stock prices. We are currently moving into Q2 earnings season with the economy either in or about to be in a recession. My concern is how those results will come in relative to expectations and how stock prices will react to those results. We do, however, has historical guidance as to what to expect during a recession. The S&P 500 has found a bottom at a14-16x P/E multiple in the previous severe corrections. If I assume a drop to $215 in S&P 500 earnings (currently around $243), a 16x multiple would put it at 3440. And a 16x multiple would equate to a 43% P/E contraction from the January peak at 28x. This would be in line with the P/E contractions during the dot-com bubble in 2000 and financial crisis in 2009.?

Bottom line: Both the technicals and fundamentals are pointing to a high probability that the S&P 500 will eventually see the 3500 (or below) level before this correction is complete. Once it falls below the recent low of 3636, I plan to scale-in, selectively look for good stocks that are profitable, pay a dividend, have low debt to equity & P/E ratios, and produce a positive free cash flow.?

THE BOND MARKET

The bond market has been on it’s own extremely volatile roller-coaster ride so far this year. As mentioned in last week’s missive, the first half of 2022 was the worst start to a year ever…going back to 1788 when the Treasury was first allowed to issue bonds. I can’t imagine a repeat performance in the second half of this year.?

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From the June 14th peak at 3.49% the 10-year Treasury yield declined rather dramatically to a low of 2.74% last Wednesday, but by Friday it had shot higher to 3.10% before finishing the week at 3.08%, up 20 basis points. Interestingly, the 2-year Treasury finished the week at 3.10%, which caused another inversion in the yield curve and possibly indicating an upcoming recession.?

It would appear that the bond market has done most of the heavy lifting for the Fed, and the recent high yields near 3.50% MAY cap the current tightening cycle. The Fed will now be data driven, looking for inflation and inflation expectations to begin to roll over. They are walking a tightrope, raising rates (to slow borrowing) just enough to tame inflation, without causing a hard landing for the economy. The big question now is how high and for how long will they tighten monetary policy…until they have to reverse course and start lowering rates?

Pay close attention to the CPI & PPI inflation reports this Wednesday and Thursday. This data will set the stage for the July FOMC meeting when they are expected to raise rates by 75 basis points.?

It should be an interesting second half. I expect to see a peak in inflation and interest rates, as well as a bottom in this stock market correction. It may be a Q4 event (after the mid-term elections), but once we get the “all clear”, a nice year-end rally could be in the cards. Stay tuned, and good luck to all!

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Make it a great week!

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Jeff Trusheim is the CFO of Mortgage Solutions Financial. Jeff is a 30+ year veteran in the Wall Street arena, with a background in economics, risk assessment and finance (banking and mortgage). He has previously worked in Fortune 500 companies in growing their portfolio and economic footprint.?