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Over the years, we have occasionally checked in on the net movement of dollars into and out of stock funds (“fund flows”) as a loose, very imperfect sign of sentiment, on the theory that they give some insight into how people feel about stocks from week to week—particularly when they are at extremes. Yet they are generally pretty noisy and not all that conclusive. But bond flows have been a bit more interesting. While normally positive, they have had three distinct negative stretches in the past five years: in late 2018 – early 2019, as rising rate chatter spooked investors; during the worst of 2020’s lockdowns; and now.
Exhibit 1: Sentiment Clues in Bond Fund Flows?
A bevy of economic data came out recently—to a fairly consistent negative reception. But in our view, sour sentiment tied to the ongoing correction is causing many investors to underrate economic conditions today. Here are the major releases from the developed world that hit the wires last week and our thoughts on what they signal.
One item gaining many headlines: US productivity, which suffered its biggest fall in 75 years. While that perhaps sounds alarming, it is just a twist on Q1’s GDP report, and the -7.5% annualized decline was simply a function of math.[i] Productivity, as the US Bureau of Labor Statistics defines it, is output per hour. Take it apart, looking at the denominator first. Workers’ hours rose at a 5.5% annualized rate last quarter, suggesting growth created more work and jobs.
Meanwhile, output—as measured in this data series by GDP excluding government, nonprofit and household sectors (i.e., private sector business production)—fell -2.4% annualized.[ii] But as we detailed earlier, private sector inventories mainly drove Q1 GDP down. The inventory drawdown came after massive stockpiling in Q4 to counteract supply chain problems. Stripping out inventories, business spending and investment rose 9.2% annualized in Q1, a historically strong rate. Bigger picture, productivity measures are backward-looking, and they normally fluctuate during an expansion.
The R-word hogged headlines once again Thursday, this time in the UK. While the Bank of England (BoE) raised its benchmark interest rate again to 1.0%, the main story was its 112-page Monetary Policy Report, which contains its updated economic forecasts. Headlines will tell you the BoE is forecasting a British recession and 10% inflation, which is a rather oversimplified summary, as we will discuss. In our view, there are so many ifs in the report that, from an investing standpoint, it is almost meaningless. It will probably impact sentiment, and markets may pre-price weakening economic expectations, but we don’t view these forecasts as reason to avoid UK or global stocks.
The BoE, to its credit, doesn’t release precise quarterly GDP forecasts as if they are a fait accompli—that is the trap too many supranational forecasts fall into, in our view, pretending they can pinpoint a growth rate down to the decimal point. The BoE does release top-line forecasts like this, which is how its “forecast” for a -0.25% GDP contraction in 2023 came to dominate headlines, but that is just the central figure in a fan chart of various possible outcomes, with probabilities assigned by the BoE’s models. As a general rule, models are only as good as their inputs. The BoE’s inputs are:
US stocks tumbled on Thursday, reversing Wednesday’s big surge, as the correction continued amid extremely dour sentiment. There is no question such swings, particularly coming back-to-back, can be confusing and challenging for investors. But, hard as it may be—particularly during a correction’s throes—it is critical not to overthink day-to-day moves. The fast track to allowing markets’ swings to cause you to lose your mind is, in my view, to read and believe the theories about what “explains” daily market movement. This week is a case-in-point, as illustrated near perfectly by coverage of the Fed’s “supersized” 50 basis point (bp, or 0.50 percentage point) hike.
As our commentary yesterday noted, in the immediate wake of the Fed’s widely watched move, markets didn’t materially respond, alternating between small dips and modest gains. But as Fed head Jerome Powell took to the podium and poured cold water on the notion a 75 bp hike may loom at the next meeting, they soared. Instead, he noted that a series of 50 bp hikes may be what follows. Nothing here said anything clear about the path forward for hikes. Nothing provided vast insight into the economic outlook. So commentators drew their own conclusions.
As stocks soared, pundits assured readers the 50 bp hike and Powell’s subsequent chatter was bullish—it curtailed fears of an even more hawkish Fed ahead. “‘It was a relief rally on the back of the 75s being taken off the table.’”[i] Another observer argued that despite the big hike, “The Fed’s messaging, however, helped put investor anxiety at ease … ‘There’s a feeling they’re heading into the right direction,’ he said. The central bank, he said, has shown it is taking inflation seriously, but not giving the impression that it will surprise investors with the size of subsequent rate increases.”[ii]
Wednesday, as widely expected, the Fed raised the fed-funds target range by half a percentage point to 0.75% – 1.0%, its first rate hike larger than a quarter point since 2000. It also confirmed it will start letting assets roll off its balance sheet in June, starting at a cap of $47.5 billion per month and jumping to $95 billion in September—basically following the blueprint unveiled in March’s meeting minutes. And for the first half hour or so, stocks did about what you would expect when there is no big news: a whole lot of nothing, waffling between small gains and small declines. But then the S&P 500 jumped—apparently as Fed head Jerome Powell said the Federal Open Market Committee isn’t “actively considering” a 0.75-point hike. Never mind that he also said “additional [half-point] increases should be on the table at the next couple of meetings”—evidently, what everyone really cares about is a three-quarter-point move. It is all quite arbitrary, yet it is also hard to complain, considering the late surge put the S&P 500 up 2.99% on the day.[i] But also, if this doesn’t prove investors are irrationally obsessed with the Fed, we aren’t sure what would.
We still think stocks are likely to do well this year despite the early correction (sharp, sentiment-fueled drop of -10% to -20%), so we would love to tell you that Powell’s remarks helped reduce uncertainty and the clarity created some massive bullish tailwind. But, dear readers, experience tells us that would be a load of codswallop. If we were to jump on that bandwagon, we would implicitly argue Fed forward guidance actually predicts Fed moves. (It doesn’t.) And that Fed people always do what they say they will do. (They don’t.) We would also be making an argument that the speed and magnitude of rate hikes in this context matters, as if there is some meaningful distinction between, say, raising rates half a point at each of the next few meetings and sneaking a 0.75-point hike in there at some point. Or, if the Fed hiked half a point each in June, August and September and, say, an additional quarter point in October, that is mathematically the same as hiking half a point in June and August and 0.75 point in September. The Fed doesn’t have some big cartoon lever with a bright red “danger zone” warning at the 0.75 percentage point marker. As we write, the gap between 3-month and 10-year yields is still a mite over 2 percentage points.[ii] What matters is whether the Fed inverts the yield curve, not the path they might take en route to that error. Whether they do it with a handful of major hikes or with 17 straight quarter-point hikes, as they did in the mid-2000s, the result would be the same.
Some observers argue it isn’t the rate hike plans themselves that soothed sentiment, but rather the implication that inflation won’t be bad enough for long enough to warrant the first 0.75-point hike since 1994 (after which, we would add, the S&P 500 soared 31.2% over the next 12 months).[iii] Well, ok, but that is tantamount to arguing the Fed is a brilliant economic forecaster that manages inflation perfectly. But these are the same folks who thought deliberately flattening the yield curve with quantitative easing would stimulate the economy after 2008’s financial crisis, and couldn’t fathom why their GDP forecasts proved too optimistic. The same folks who were dead sure the right choice in 2008 was to mystify investors and markets by forcing Lehman to fail.[iv] The same folks who are now trying to control supply and energy shock-induced inflation by slowing money supply growth. Newsflash: If inflation isn’t caused by monetary factors, then monetary measures aren’t likely to fix it.
If rates go up, won’t stocks fall? That is the operating theory from many financial commentators lately, which shifted up a gear after Fed head Jerome Powell recently intimated a larger-than-usual 50 basis point rate hike could be in the offing next at tomorrow’s meeting. This, as inflation-adjusted bond yields turn positive for the first time since early 2020’s lockdowns, has many expecting higher yields to hoover money out of stocks. But not so fast. This relationship isn’t what it seems, and we think the proliferation of false fears like this is bullish. Let us explain.
A cursory look back at the last time the Fed hiked a half point—May 2000—suggests watch out: The dot-com crash was just beginning then. However, this came at the end of the Fed’s rate-hike cycle, which notably inverted the yield curve. At the time, many were still in the grip of dot-com euphoria and dismissed this fundamental economic negative. Ignorance, it turned out, wasn’t bliss. Circumstances today are different. The Fed has only begun embarking on rate hikes. The yield curve—properly measured—isn’t near inversion. The spread between 3-month and 10-year Treasury yields stands above 2 percentage points.[i] That is its widest since 2016, thanks in part to the 10-year’s widely derided trip above 3.0%.
We think the mid-1990s’ rate-hike cycle is a more relevant comparison. From February 1994 to February 1995, the Fed raised the fed-funds target rate from 3% to 6%. This cycle featured three half-point hikes and even one three-quarter-point hike. Judging by today’s pundits, you might think such aggressive “tightening” would have sunk stocks, but it didn’t. The S&P 500 rose 0.7%.[ii] Nothing to write home about, admittedly, but consider a couple points. One, 1994 was a midterm year that featured unusually high uncertainty, coming amid former President Bill Clinton’s first term—and then-First Lady Hillary Clinton spearheading controversial healthcare reform that had many investors on edge. As we have noted, stocks often grind early in midterm years. But the S&P 500’s worst drop that year was just -8.5% from a February 1994 high to its April low.[iii] Two, stocks thereafter recovered—and then some—even as the Fed hiked rates through early 1995. Reacting to the hikes as if they were bearish could also have set you up to miss 1995’s 37.6% full-year rally.[iv]
A mere weekend has passed since we last checked in on global Energy markets, yet it seems like there is at least a week’s worth of news. How are US oil producers responding to higher European demand and continued fears of a supply shortage? Are EU member states united behind the idea of a Russian oil and gas ban? And what of Russia-reliant Japan? We will explore all three stories momentarily, but spoiler alert: The widely feared supply shock still doesn’t appear to be at hand.
US Producers Step Up
Last Friday, Reuters reported on private US export terminal data showing some encouraging news: The US exported more crude oil to Europe in March and April, with much of it coming from Texas’ prolific Permian Basin. “At least 65% of U.S. crude shipped to Europe in March was identified as WTI Midland in U.S. Customs data on Refinitiv Eikon, a 63% increase from the same month last year. The cargoes, most of which are priced from the Magellan East Houston terminal, carried about 22 million barrels overall.”[i] Much of it went to Denmark, Italy, Spain and the UK.
What next? Stocks have spent most of this year in a correction, with the S&P 500 testing a new low on April’s final trading day. Now it is May, kicking off what many argue is a seasonally weak stretch of the year. The Sell in May and Go Away chorus isn’t as loud as usual this year, in part because some argue the correction is upsetting the normal pattern. In our view, that is a rather strange twist on seasonality that isn’t any more valid than the normal version. We are bullish, but this isn’t why—and whatever your expectations for stocks, we don’t think seasonality should be a factor. It just isn’t real.
For the (blessedly) uninitiated, Sell in May and Go Away stems from old beliefs about how markets work in the summer. In olden days, before computers and cell phones and the internet, liquidity would typically drop when brokers took their summer holidays. They would usually come back around the St. Leger Stakes—a mid-September British horserace—hence the original maxim: Sell and May and go away, and come back at St. Leger Day. These days, brokers have connectivity and backups, and liquidity tends to be flush during the summer, so it has morphed into a statement about seasonal stock returns. The six-month stretch from April 30 through Halloween, on average, is weaker than its opposite six months, so the popular iteration of that seasonal saw would now have people sit on the sidelines from now until October ends.
But the data supporting this proverb fall flat. It rests on one—just one—data point: The six-month stretch ending on Halloween is the S&P 500’s weakest half-year span. Meaning, the average 4.5% total return in these six months since 1925 is the lowest of all.[i] Now, eagle-eyed readers may have noticed there was no negative sign: That average return is still positive. It just isn’t as snazzy as the average 7.2% return between Halloween and April 30, which happens to be the best six-month span.[ii] Call us crazy, but sitting out 4.5% average returns year in, year out seems like a lot of compound growth to leave on the table.
Following US Q1 GDP’s surprising contraction last Thursday, Eurostat reported slower-but-positive eurozone Q1 GDP growth of 0.2% q/q on Friday—with output mixed across the four largest economies.[i] The report isn’t all sunshine and roses by any stretch. Yet rather than cheer the currency bloc’s resilience, headlines warned the slowdown could portend recession driven by the Russia-Ukraine war and high prices. Though eurozone Q1 GDP numbers don’t tell us much new on the economic front—and we aren’t dismissing the possibility of a regional recession—the reaction to them reveals how universally dour sentiment is in Europe today.
Of the 19 eurozone members, 7 reported Q1 GDP on Friday.[ii] Portugal (2.6% q/q) and Austria (2.5%) led the way, but most headlines focused on the four largest economies.[iii] While Germany (0.2%) and Spain (0.3%) grew, France flatlined (0.0%) and Italy contracted (-0.2%).[iv]
Exhibit 1: Change in Quarterly GDP for Eurozone Nations, Q2 2021 – Q1 2022
The EU and Russia’s ongoing economic battle over fossil fuels continues—this time with Germany signaling it is willing to support an EU ban of Russian oil imports. Or at least, that was the most common headline summary of the situation, but we think that is juuuuust a touch oversimplified. While we don’t dismiss the risk of sanctions—whether an EU embargo or Russian halt—causing a severe energy crunch and European recession, the likelihood of Europe implementing a sudden, recession-inducing ban still appears quite low.
Importantly, Germany did not suddenly bless an instant embargo. Rather, it said it would support a gradual, phased-in ban. It also argued against some of the other measures EU officials have posed, including tariffs, unilateral price cuts and forcing energy companies to place their payments to Russian suppliers in escrow, on the grounds that these measures could prompt Russia to ban all EU oil exports instantly. The debate among EU leaders is ongoing, and it remains to be seen what—if anything—they will agree on.
One big reason Germany is lobbying for a gradual ban with a long runway is largely the same reason an immediate cessation of Russian purchases risks causing economic harm: refining capacity. Not all oil is created equally. Different strains of crude have different densities (ranging from light to heavy) and sulfur content (ranging from “sweet” to “sour”). Russia’s Urals oil blend is a cocktail of light sweet and heavy sour crude. Russian imports fuel (pun intended) about one-fourth of daily EU oil consumption, which means somewhere around one-fourth of EU oil refining capacity—give or take—is likely geared to this rather unique blend.[i] At a high level, there are two ways to substitute this. Either the EU finds alternate sources of oil that have similar density and sulfur count as Urals oil, or Energy firms reconfigure their refineries to process either heavy sour or light sweet crude, depending on which producers they buy from (or, of course, some combination of the two).