Looking at major indices as we approach the mid-point of the year, the challenges faced by financial markets are evident. On a year-to-date basis, the S&P 500 and NASDAQ are down >20% and >30% respectively, with the bulk of the negative movement being experienced in the second quarter to date.
Our commentaries to date have expressed our view that inflation and rates would be the primary determinant of market moves. The second quarter saw the market begin to incorporate inflation/rates concerns more seriously, with a significant ramp up in expectations for rate hikes reinforced by more forceful action by the Fed.
At the beginning of the year, the market was looking for a Fed Funds rate (key policy rate), post interest rate hikes, of under 1%. This moved up to ~2.5% at the end of the first quarter and increased further to current levels of just under 4% (~3.8%). This step up in expectations in the second quarter, was matched by more decisive action by the Fed.
After hikes of 25bp (0.25%) in March, and 50bp (0.5%) in May, the Fed enacted the largest hike in almost three decades, increasing the policy rate by 75bp (0.75%) last week, with market expectations for an encore (another 75bp) at the next meeting at the end of July.
This more decisive action by the Fed should be welcomed.
While we don’t ‘like’ higher rates, and its knock-on effects, more than anyone else; its important to realize that they are a necessary ‘evil’. The real villain here is structurally high levels of inflation, that central banks, after years of loose monetary policy, want to avoid at all costs.
Since early in the year, we have been arguing that the Fed has been behind the curve; this attempt to re-assert their role and regain the narrative on inflation is a positive.
Let us be clear though, while we may live in a world of instant gratification, there will be none here. We are in the midst of an adjustment phase in markets and the economy; a process that will take time to play out.
Looking at recent US inflation data, we have seen some moderation in the goods component (shipping costs continue to decline), but the food (soft commodity prices remain elevated), energy (oil prices remain elevated) and services component continue to increase.
As we did previously (“Market Forces 001”) we continue to flag the services component of inflation as being a key data point to focus on in terms of assessing the degree to which inflation is becoming entrenched.
Looking forward
To date, the impact we have seen from this rates cycle has been fairly direct, via the discount rate mechanism (i.e. the reduced present value of future cash flows due to an increase in the discount rate). Now that it has been firmly established that we are the midst of a fairly significant hiking cycle, we need to turn our attention to second order affects, namely the impact on aggregate demand (i.e. economic growth) and the resultant feed through into corporate earnings.
Interest rate hikes are by their nature contractionary. At a corporate level, the impact of an increased cost of capital means less projects are approved (due to an increased hurdle rate), and all else equal, this results in lower corporate spend/investment. Individuals (read consumers) see increased demands on disposable income as servicing costs (interest payments) on their personal borrowings increase, at the same time at which their wallet is under assault on multiple fronts from the effects of inflation (increased food and gas bills).
Directionally, we can expect to see a reduction in expectations for consumer expenditure and economic growth as well as an increase in the unemployment rate.
We will explore the potential quantum of these moves in a future “Market Forces”, as well as expanding on our view of the appropriate playbook to follow, namely high-quality defensive companies with the ability to pass on input cost increases that trade at reasonable valuations.
For now, it is worth noting that earnings estimates appear optimistic all considered.
The McIver Capital Management playbook to create value for clients remains the same, namely disciplined asset allocation.
Sincerely,
Warren Goldblum
On behalf of McIver Capital Management
Your Model Performance (net-to-client, third-party audited):
The comments and opinions expressed in this newsletter are solely the work of McIver Capital Management, not an official publication of Canaccord Genuity Corp., and may differ from the opinion of Canaccord Genuity Corp’s. Research Department. Accordingly, they should not be considered as representative of Canaccord Genuity Corp’s. beliefs, opinions or recommendations. All information is given as of the date appearing in this newsletter, is for general information only, does not constitute legal or tax advice, and the author McIver Capital Management does not assume any obligation to update it or to advise on further developments related. All information included herein has been compiled from sources believed to be reliable, but its accuracy and completeness is not guaranteed, nor in providing it do the author or Canaccord Genuity Corp. assume any liability.
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