The global equity market struggled to advance last week as investors continued to fret about recession fears. The MSCI World Index slipped 0.9% while the S&P 500 fell by 0.9% and the NADSAQ tumbled 1.6%. Non-U.S. markets also finished the week lower with Japanese stocks retreating 1.5% and European stocks falling 1.7%. Emerging market stocks performed the worst with the MSCI Emerging Market index dipping 3.7%. The 10-year U.S. Treasury yield closed the week 16 basis points lower at 2.92%.
Following the 9.1% consumer price index (CPI) print in July, investors began to consider a 100 basis-point rate hike from the Federal Reserve at the end of July. However, several Fed speakers have suggested that a 75 basis-point rate hike still seems the most likely.
Away from inflation, bank earnings and nominal retail sales suggested that imminent recession fears might be overdone. That said, recession fears are likely to linger heading into 2023. A potential silver lining is that commodity prices, including gasoline prices, have been coming down in July.
Citi’s Global Investment Committee (GIC) decided to de-risk further by bringing down its overweight to oil field services while increasing its weighting to investment grade preferred stock. There was several other smaller portfolio changes as well as the GIC continues to seek out both quality stocks and quality fixed income amid a challenging backdrop.
Last week, former Fed Chair and current Treasury Secretary Janet Yellen called inflation “unacceptably high” and said that it should be Washington’s top priority. That is not exactly earth-shattering news with inflation having run hot for well over a year now. Even prior to the conflict between Russia and Ukraine, the U.S. consumer price index (CPI) was 7.9% higher year-on-year. Yes, the war it has made it worse, but this problem was already at our doorstep before that. Massive fiscal and monetary stimulus amid broken supply chains was a perfect storm for inflationary pressures.
Clearly, inflation is of the utmost importance to financial markets right now because it is driving monetary policy. As a result of the June inflation print, which showed headline inflation unexpectedly rising from 8.6% to 9.1%, markets started to price in an even bigger rate hike. Possibly as much as 100 basis-points from the Federal Reserve at the end of July. However, those expectations have eased after Christopher Waller, who is a voting FOMC member, stated that he still sees 75 basis-points as the most likely. Atlanta Fed President Raphael Bostic also backtracked on his “everything is on the table” comment and indicated he too thought that 75 basis-points was still the most likely.
Away from the inflation print, retail sales also surprised to the upside with nominal retail sales advancing 1.0% month-on-month. While most of the gain was due to rising prices and not a stronger consumer, the “non-drop” in nominal sales was viewed as a sign of resilience in the economy. The result was that recession fears faded a bit and the market posted solid gains on Friday. Though we did find it interesting that the market largely ignored the weak industrial production print that occurred on the same day and brought down the Atlanta Fed’s GDP Now tracker for 2Q22 real gross domestic product (GDP) from a potential minus 1.2% to minus 1.5% (see figure 1).
|Date||Major Releases||Gross Domestic Product||Real Personal Consumption Expenditures||Equipment||Intellectual Property Products||Real Private Fixed Investment in Nonresidential Structures||Real Private Fixed Investment in Residential Structures||Government Expenditures and Gross Investment||Net Exports||Change in Private Inventories|
|27-May||GDP Gross Domestic Product(5/26), Pers IncPersonal Income/PCD, NIPA National Income and Product Accounts Tables, Adv Econ Advanced Economic Indicators||1.9||3.17||0.16||0.38||0.05||-0.28||0.30||-0.27||-1.59|
|24-JunJune||New Home Sales||0.2||1.81||0.02||0.40||-0.05||-0.50||0.15||-0.11||-1.50|
|27-JunJune||Advance M3 Manufacturing||0.3||1.81||-0.02||0.40||-0.05||-0.50||0.15||-0.11||-1.42|
|28-JunJune||Advance Economic Indicators||0.7||1.81||-0.17||0.40||-0.05||-0.50||0.15||0.35||-1.27|
|30-JunJune||GDP Gross Domestic Product(6/29), Pers IncPersonal Income/PCD, NIPA National Income and Product Accounts Tables||-1.0||1.17||-0.8||0.39||-0.05||-0.50||0.14||0.35||-2.44|
|1-JunJune||Construction Spending, ISM Manufacturing||-2.1||0.51||-0.25||0.38||-0.18||-0.60||0.11||0.38||-2.42|
|5-JulJuly||M3-2 Manufacturing, Auto Sales||-1.8||0.72||-0.21||0.38||-0.17||-0.59||0.11||0.38||-2.44|
|6-JulJuly||ISM Non-Manufacturing Index||-1.8||0.74||-0.20||0.38||-0.17||-0.59||0.11||0.38||-2.44|
|8-JulJuly||Situation, Wholesale Trade||-1.2||1.29||-0.11||0.40||-0.14||-0.46||0.07||0.19||-2.48|
|13-JulJuly||Consumer Price Index, Monthly Treasury Statement||-1.3||1.29||-0.11||0.40||-0.14||-0.44||0.07||0.19||-2.56|
|14-JulJuly||Producer Price Index||-1.1||1.29||-0.12||0.40||-0.13||-0.39||0.08||0.19||-2.46|
|15-JulJuly||Retail Trade, Import/Export Prices, Industrial Production||-1.5||1.02||-0.13||0.40||-0.13||-0.44||0.07||0.18||-2.50|
|Maximum Forecast of Real GDP Growth|
|17-May||Retail Trade, Industrial Production||2.5||3.28||0.49||0.35||0.06||0.06||0.28||-0.80||-1.21|
|Minimum Forecast of Real GDP Growth|
|1-JulJuly||Construction Spending, ISM Manufacturing||-2.1||0.51||-0.25||0.38||-0.18||-0.60||0.11||0.38||-2.42|
Despite the possibility for two consecutive negative GDP prints, we are still in the camp that believes a U.S. recession could possibly be avoided with labor markets slowing, but still expanding and leading economic indicators having yet to fall into a range that is consistent with recession (see figure 2).
While the Fed continues to try and “micromanage” the economy through monetary policy and by reacting to backward-looking individual monthly data points, we still think that the Fed may reconsider its aggressive stance should employment begin to weaken heading into 2023. Please see our Weekly Market Update | Can the Fed Stick the Landing? for a more detailed discussion on the potential path for labor markets.
The Fed reminds us of Aesop’s fable of the tortoise and the hare. The Fed is currently behaving like the hare because it wants to get ahead of the curve after falling behind, but at some point, the Fed may want to be more like the tortoise to avoid tripping up and experiencing an accidental hard landing. A steady, slowing in the pace of inflation would likely go a long way towards creating this policy flexibility.
The June CPI report certainly did not provide the Fed with a greenlight to dial back, but there were at least a few components that are trending in the right direction. We fully acknowledge that inflation appeared to be broadening with energy prices up, food prices up, shelter prices up, and medical care prices up. However, energy prices alone accounted for ½ of the 1.4% month-on-month rise in the CPI. When excluded, year-on-year headline inflation did not change.
It has been steady at 6.6% for three months now and may have peaked back in March at 6.8% (see figure 3). And now, energy prices are coming down due to fears of recession with regular retail gasoline prices dropping about 9.3% nationally in July (see figure 4). With a CPI weighting of about 5%, a 9.3% decline, if it holds throughout the month, would potentially trim off 0.5% from headline CPI in July. This may be a key component of why the University of Michigan’s 5-year consumer inflation expectations index ticked down from 3.1% to 2.8% in July. Several other items are also trending in the right direction with durable commodity prices for things like couches, appliances, etc. down from 11.4% year-on-year to 8.4% year-on-year and used car prices falling from 16% year-on-year to 7.1% year-on-year in June.
We realize that calling for peaking inflation is becoming a bit like “the boy who cried wolf,”, but we still think there is at least some chance that we eventually get a downside surprise on inflation. It is not going to drop quickly with shelter prices likely to keep prices elevated into 2023, but supply chain pressures are easing (see figure 5), and demand is cooling which should eventually set the stage for inflation to trend lower.
Citi’s Global Investment Committee Asset Allocation Changes
While the energy sector was one of the best performing sectors for 2021 and much of 2022, one side effect of recessions is often weaker commodity prices. Even though oil prices have held up better than copper and aluminum year-to-date, if the U.S. does indeed slide into a recession, then oil prices will likely fall further (see figure 6). As a result, the S&P 500 Energy sector has been trending lower since early June (see figure 7).
While we do still see a narrow window in which a recession can be avoided, Citi’s Global Investment Committee decided to de-risk further by taking down our overweight on oil field services to neutral given its high level of volatility and overlap with our natural resources overweight. We also brought down our overweight in Fintech to neutral and added another full percentage point to China equities for a 2% overweight. When combined, this brings the GIC’s global equity weighting down to minus 2% when commodities are excluded.
In addition, we eliminated our overweight to high yield variable rate loans, reinvesting the proceeds in investment grade preferred stock. Since we eliminated high yield bond holdings in favor of loans in early in 2021, loans have returned -0.8% and high yield bonds -8.5%. Loans have benefited from their floating rate structure, with the Fed’s expected tightening cycle padding returns. However, we see risks shifting from higher rates to weaker credit, with highly leveraged firms at risk. Investment grade preferred securities have fallen 12% year-to-date, pushing yields toward 6.5%, far above bank common equity yields. With other small changes in portfolios, we were able to effectively raise our capital position within financials while adding substantially to yield. We also raised our overweight to intermediate-duration U.S. investment grade corporate bonds to +3.5%, investing in less volatile, lower risk fixed income at a yield close to 5%. Along with other small shifts, this raised our total U.S. fixed income overweight to +10.2%, including a 4.5% overweight to US Treasuries.
While economic risks are rising, our overall investment strategy remains unchanged. We believe diversified portfolios should focus on higher quality income in both fixed income and equities with our largest off-index position in equities is an allocation to consistent dividend growth equities (+3% overweight in the US, +1% non-US). In the US, these shares have fallen, but outperformed by nearly 900 basis points in 2022-to-date.Our largest industry group weighting is global pharmaceuticals, which have returned -1.5% this year vs -20% for global equities.
What Should U.S. Investors Watch in the Week Ahead?
Second quarter 2022 earnings will continue to grab headlines. Thus far, 60% of reporting companies of the S&P 500 have reported a positive EPS surprise and 60% have reported a positive revenue surprise. For the quarter, the blended growth rate for S&P 500 EPS looks to be on pace for about 4.2% growth year-on-year. While positive, the growth rate would be the lowest earnings growth rate since 4Q 2020.
The economic calendar will include housing starts and existing home sales for the month of June. Both are expected to show a continued slowing in the housing market (see figures 8-9). The leading economic indicator index will also be reported and is expected to show a further slowing.
|Index||Weekly Chgchange in percent||YTDyear to date change in percent||12 Months12 month change in percent||Div. Yield division yield in percent|
|Instrument||Weekly Chgchange||YTDyear to date||12 Months12 month change||Level|
|10-Year Treasury Yield (%)||-16 bps||140.5 bps||161 bps||2.92%|
|Index||Weekly Chg change in percent||YTD year to date in percent||12 Months12 month change in percent||Div. Yield division yield in percent|
The Week Ahead
|7/18||10:00||NAHBnational association of home builders Housing Market Index||JulJuly||65.0||67.0|
|7/19||8:30||Housing Starts||JunJune||1580k thousand||1549k thousand|
|7/19||8:30||Building Permits||JunJune||1650k thousand||1695k thousand|
|7/20||10:00||Existing Home Sales||JunJune||5.37m million||5.41m million|