Scotsman’s Latest Market Thoughts – Monday, June 27, 2022

QUICK RECAP

Markets had their third positive week in the last 13. Gains were highest in the unusual trio of Health Care, Real Estate and Consumer Discretionary. Commodities fell along with rates as recession fears increased.

DETAILS

Markets had a strong week and rallied robustly into the closing bell on Friday and ended near session highs. All sectors were in the green. The top three sectors on Friday were Materials, Financials and Consumer Discretionary. Earlier in the week, Defensive sectors like Healthcare, Utilities and Real Estate showed relative strength, but everyone joined the party on Friday, even Energy which was still down for the week. The University of Michigan Consumer Survey showed new record lows in consumer sentiment on Friday morning. According to the Survey, consumers across many different categories now expect economic weakness. While inflation expectations for the year ahead remain at the elevated level of 5.3%, the crucial long-term inflation expectations moderated significantly to 3.1%. This is an encouraging sign for those who fear inflation expectations are becoming unanchored. Earlier in the week, during his testimony, Chair Powell referred specifically to this figure in the last report as “quite eye-catching.”

The Purchasing Managers’ Index for June was only just expansionary at 51.2. A reading below 50 indicates that activity is contracting. Nearly 80% of surveyed consumers expected bad economic times in the year ahead. This June reading was only slightly lower than heights experienced in the 2008-2009 Financial Crisis. Similarly, business confidence came in at a low level usually suggestive of an approaching recession.

Jay Powell was bashed with rhetorical cudgels from partisan members on both sides of the aisle as he delivered his semi-annual report on monetary policy. His testimony overall was mixed. While he seemed to acknowledge that geopolitical risks would increase the difficulty of engineering a soft-landing, he also mentioned that it was possible inflation might come down faster than many economic models forecast. Some may approach that with a “boy who cried wolf” sentiment, and that is understandable. However, it is very possible that many of the factors leading to the Fed underestimating inflation in the post-pandemic period could actually become a double-edged sword and lead to the inverse outcome occurring in coming months.

It appears markets have certainly been worried about inflation but now the possibility that we are already in or are quickly approaching a recession is rising according to many economists. Economists in both America and Europe, which is reeling from an Energy supply crisis, have revised their economic outlooks dramatically. Goldman Sachs economists, for instance, doubled their probability recently that the US will enter a recession this year from 15% to 30%. Over a two-year horizon it is nearly 50%. Moody’s Chief Economist Mark Zandi also suggested the risk for a recession is rising. He put it at about 40% within the next 12 months. A Federal Reserve economist named Michael Kiley also wrote a paper ” Financial and Macroeconomic Indicators of Recession Risk” published on June 21, 2022 suggesting that the probability of recession eclipsed 50% in the next 4 quarters. Kiley postulated that imbalances in the markets for goods and services suggest such an outcome. The paper showed historically when there is high inflation and low unemployment economic contraction has followed.

There are no shortages of things that could go wrong in today’s markets. Exogenous risks like further supply chain dislocations and a raging conflict in the heart of Eurasia are formidable negative catalysts. Until the third week of July, we will be most likely experiencing a lack of corporate news therefore macro headlines will dominate and may push markets in either direction. If there is suddenly a Russian peace deal and some of the trade barriers associated with the war decline, we could see the consumer’s confidence return. However, their wallets have been squeezed by high prices at the pump and the grocery store.

In Ukraine, the war rages on. In my opinion, if the conflict stops soon, which seems highly unlikely, the trade barriers and sanctions may not be reduced meaningfully enough to have the effect on supply that some would hope. A frozen conflict with an effective economic siege of Ukraine preventing it from exporting its considerable resources to the rest of the world does not change much from the market’s perspective even if the shells stop flying. The high intensity conflict going in Donbas and the rest of the country is of a ferocious nature that typically only ends when one side is completely exhausted. High-intensity conflicts throughout history have tended to escalate, not the other way around. This week Ukrainian leadership ordered their soldiers to retreat from Severodonetsk, the center of Russian offensive efforts over the last two months, to avoid being enveloped by the enemy. While this may be a slight symbolic victory for the Kremlin, it is also a Pyrrhic one. Despite suffering high casualties, the Ukrainians were able to slow Russian progress, avoid encirclement and by all accounts inflicted severe casualties on Putin’s invaders.

On the supply chain side, there has been a lot of progress since COVID entered a more endemic phase. But there are still potential tripping points like the International Longshore and Warehouse Union’s contract expiration on July 1st. Negotiations are ongoing, but clearly a strike at the West Coast ports, where most of the imported goods flow into the United States, could renew risk in this area which has been improving. The bottlenecks at ports are already reverberating through the rail supply chain, which is now struggling to keep up. With the rising prices of gasoline and diesel, using trucks is sometimes necessary but certainly not cheap. Containers have gone from piling up at the docks to piling up at major railroad junctions.

At the company level, we noted, Darden Restaurants reported earnings and beat on revenues and earnings per share during a particularly challenging environment. Their report validated some of the soft reports we have been receiving from analysts about food prices coming down. Importantly, the Darden executives indicated they thought higher costs for key inputs like chicken and dairy would be alleviated significantly in the not-too-distant future. In a surprise, sales at their more economic offerings like the Olive Garden were weaker than their higher end options. Given the pressure on consumers, one might have expected the opposite.

OUTLOOK

So, is it a glass half empty or glass half full environment today? The true answer to this question, of course, will only be told with time. The future is more uncertain than I can ever remember in my 36 years as an investment professional. Markets and data continue to churn and the ways many investors typically position themselves, at this point in the business cycle, are clearly less effective than normal. Many “instruction manuals” have been torn up. There is much uncertainty around demand, global growth and exogenous risks continue to stalk the markets. Nonetheless, it is more important than ever as investors to remain data driven and grounded in evidence-based principles of ESG equity research. With this backdrop, the Newday equity team continues to focus on our disciplined investment process which identifies authentic ESG companies exhibiting strong fundamentals. We believe the markets will reward these companies in these uncertain times.

This commentary is provided for information purposes only and is not an offer or solicitation of an offer to buy or sell any product or service. Unless otherwise stated, all information and opinion contained in this publication were produced by Newday Funds, Inc. (“Newday Impact”) and other sources believed by Newday Impact to be accurate and reliable. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and other sources may be required to make informed investment decisions based on your individual investment objectives and suitability specifications. All expressions of opinions about the financial markets, general investment strategy, or particular investments are not recommendations to clients and are subject to change without notice.

Investors should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Past performance does not guarantee future performance.