- S&P500 companies finished reporting Q1 2022 earnings, which averaged +3.2% year over year (Y/Y), excluding Energy on revenue growth of 9.8%. Estimates for Q2 through Q4 declined, which may lead to further equity price weakness
- Equities declined:
- S&P500 declined by 5.6% as of this writing. Small capitalization companies performed somewhat worse, declining 6.1%
- Value stocks outperformed Growth stocks again with a decline of 2.4% in the month, while Growth stocks declined by 10.1%
- We saw mixed signals from the US consumer:
- Monthly retail sales increased by 8.2% (Y/Y), stronger than the March growth rate of 7.3%
- However, there were also signs of the US consumer weakening, including weaker than expected results from Target, Walmart, and Kohl’s, and a fairly weak reflection of consumer sentiment from the University of Michigan survey
- Jobs remained strong at +428,000
- Inflation remained fairly high at 8.3% (Y/Y) in April, down marginally from +8.5% in March
- The Federal Reserve (Fed) raised the Federal Funds Rate by 50 basis points (bps)
What We Are Watching for in June:
- June 3: Jobs day. US Bureau of Labor Statistics will release its monthly Employment Situation report. Will new jobs continue to be created over 400,000? Will unemployment remain in the 3.6% range? Will average hourly earnings growth accelerate to near inflation levels?
- June 10: CPI. The BLS will release its monthly Consumer Price Index report. Will we see inflation begin to soften (ex-energy)?
- June 15: Fed announcement. Both we and the market expect another rate raise of 50 bps, but in recent days various Fed officials have been playing down the certainty of an additional 50 bps at the July meeting, which had seemingly been a sure thing only a few weeks ago. Will the Fed continue to soften and backpedal a bit regarding expectations for the July meeting? The Fed hasn’t done back-to-back 50 bps hikes since 1989—do they really want to add a third 50 bps hike in July and risk a 1990-style recession?
If economic growth is slowing, then cash flow becomes more valuable.
For the past month or two, the market has rotated away from the primary concern being inflation to the primary concern being growth. You can see this across a variety of measures, including Treasury Inflation Protected Securities (TIPS) and the relative performance of stocks vs bonds.
Inflation expectations for the 10-year Treasury bond have declined from 3% to 2.6% (above), while the S&P500 has underperformed the Barclays Intermediate Government / Credit Index since the end of March (below).
At F.L.Putnam, our investment team is also increasingly concerned about growth. After analyzing S&P500 earnings reports for the first quarter, we note that earnings estimates for the remaining quarters of 2022 have declined. Economists’ forecasts of US GDP growth in 2022 have declined as well, from 3.1% at the beginning of May to only 2.7% today. The evidence supporting a slowdown is broad-based.
What is causing the growth slowdown? The combination of inflation not only in food and energy prices, but also broader categories, is crimping the ability of the US consumer to continue spending. Both headline CPI and Core CPI remain fairly high. The recent Fed interest rate increases have piled on to this, accelerating a slowdown that may well have been already underway. We expect inflation to begin to wane after the second quarter, but we do not expect it to return to the sub-2% level consistently experienced since the Great Financial Crisis of 2008. The Fed may very well pause after the expected June rate increase, but the cumulative impact of tighter monetary policy will continue to amass.
In a slowing growth environment, we are rotating toward quality across the board. This applies to growth stocks, value stocks, and fixed income. If economic growth is slowing, cash flow becomes more valuable.
When analyzing growth stocks, we continue to stay away from low-profitability and long-duration growth stocks; e.g., those companies whose cash flows are far out in the future. In high-quality growth stocks that are generating substantial cash flow today however, we see an opportunity to buy these securities at much more attractive prices than have been available for several years.
Similarly, when analyzing value stocks, we draw a sharp distinction between those with high free cash flow and those that we would describe as lower quality. Many “value” stocks are carrying significant debt and are using a substantial portion of their cash flow to pay interest on that debt. Conversely, many value stocks are inexpensive but generating high cash flow, which we find most intriguing in this environment.
We are also scrutinizing a specific subset of value stocks: high-dividend-paying stocks. Some of these stocks have high dividends because the stock price has declined as the market has penalized those companies due to their weak balance sheets – these are not stocks that we want to own. We are also increasingly wary of some economically sensitive areas that are heavy weightings in the value indices, such as industrials and some financials.
In fixed income, we are generally reducing high-yield exposure using the same reasoning: many high-yield companies are lower quality and have weaker cash flows. We are increasingly focusing on both balance sheet quality and overall cross-cycle business durability and profitability when looking at bonds. We still find inflation protected securities attractive but given the significant increase in long-term yields over the past few months, Treasury securities are becoming interesting investments as well. We are carefully selecting some floating-rate securities, identifying those at the higher end of the credit quality spectrum.
Time will tell whether the Fed will be able to successfully engineer a so-called “soft landing,” in which they slow the economy sufficiently to bring inflation down from current elevated levels, but do not over-tighten financial conditions so much that it causes a recession. In the current environment, we continue to increase quality while keeping a sharp eye on economic and corporate indicators.