1. Many investors and analysts appear to become “comfortably numb” when exposed repeatedly to the same narrative. It is unclear rather often what scenarios are priced into financial markets.
2. The U.S. has become the world’s “safe-haven” after Russia’s invasion of Ukraine and the continuing war (war). The U.S. dollar (USD) has appreciated substantially since then and its appreciation has accelerated even more rapidly over the past couple of weeks.
3. The headline negative Q1 U.S. real GDP obscures the strong U.S. demand for goods and services. Economic data and surveys released this week showed an expanding U.S. economy in general, but perhaps with somewhat slowing growth. Future outlooks were often uncertain and even sometimes pessimistic.
4. There were many positive and negative surprises in this week’s earnings releases. The stock trading reactions were somewhat unpredictable. Managements’ guidance of future results and discussions of profit margins proved to be determinative, as expected.

The Upshot: We understand that many investors and analysts have become “comfortably numb” to the extent any narrative is constantly repeated, such as elevated inflation concerns, likelihood of a recession, supply chain issues, China lockdowns, repercussions from the war and related Russian sanctions, and a hawkish Fed. Every now and then, certain people are awakened from their “comfortably numb” state when they are “surprised.” Volatility can be expected to increase during such times. As the many variables have increased dramatically subsequent to the onset of the war, we suppose it has become increasingly difficult to decipher what is priced into the financial markets. We will continue to examine sentiment indicators, as well as economic data and surveys to aid us in forecasting the probabilities of possible scenarios. We continue to assume that volatility could persist across virtually all financial markets. Additionally, we maintain our conviction that a U.S. recession will not begin in 2022. It is our opinion that no economic information released this week will change the Fed’s hawkish monetary policies to aggressively rein in inflation. This should be made even clearer at the Fed’s meeting next week. We continue to be amazed that there is very little discussion about USD strength and its effects on inflation, economic growth, and earnings of various companies depending on their exposure to foreign countries. Our basic investment approach remains constant as expressed in our most recent weekly commentaries. We maintain our preference for a diversified portfolio of high-quality stocks with at least some commodity exposure.

What’s Priced into Financial Markets? – “Comfortably Numb”

It is our contention that becoming overexposed to something could make someone desensitized or “comfortably numb” to whatever that something is. We all have seen images of the many horrors from the Russia-Ukraine war. The more one is physically distant from the war, the more one can assume that it will either end relatively soon or not descend into something worse. Whatever the effects from the war and sanctions against Russia have caused, many people could assume much the same effects to persist as we have experienced so far. As expressed by the group Pink Floyd, many people could have become “comfortably numb” but are still able to function in a normal manner. Likewise, we suppose that many financial market participants and analysts have become “comfortably numb” about the markets as they believe that markets have mostly priced in even the most extreme outcomes. We doubt that a 2022 recession or that a Russian nuclear offensive is priced into the markets. But we believe a very aggressive Federal Reserve (Fed) tightening monetary policy is priced in – at least to some extent. However, we don’t mean to imply that every extreme event should be reflected in financial market pricing of assets or securities. Many various events can possibly occur. Each investor should try to decipher whether markets are reflecting probabilities to the same extent as he or she sees them, and whether this might provide investment opportunities. We also understand that the longer something persists, the more likely we are to assume that it will continue. As we have indicated in many of our commentaries, the Fed now wants to rein in inflation as quickly as possible so that elevated rates of inflation do not become entrenched, which could lead to wage-price spirals. We have been surprised many times when equities trade lower or bond yields trade higher as the market thinks that Powell or the Fed has indicated a more hawkish approach. Our surprise is based on our own interpretation that Powell is using different words to indicate what should have been clear already. But the market has chosen not to “listen.” To paraphrase from Pink Floyd’s song, Powell has been “only coming through in waves” with his “lips moving” but the market “can’t hear what [he’s] saying.”

Of course many outcomes are possible with regard to the war and inflation, as well as the extent and ramifications of China’s “zero COVID-19” policies and the ensuing “lockdowns.” We judge that the market tries to price in the present events and the most likely future outcomes. But the market really cannot effectively price in any binary possibilities. This personally reminds me of a relatively inconsequential trading example from many years ago. In the middle of a “hostile takeover” situation, publicly traded options were listed suddenly. The option makers who determined the opening prices for the relevant options just saw a relatively stable stock price for a couple of months and so they drastically underpriced the options. They did not realize the binary outcomes possible – successful takeover and much higher stock price or no takeover and a plummeting stock price. I did not hesitate to take advantage of this drastic mispricing of options. This example is meant to show how “comfortably numb” we can become to a situation that seems relatively constant and so we can be led to believe that financial market prices reflect properly the risk/reward potential. We will try to evaluate the current economic and financial market backdrop to better evaluate properly the risk/reward of possible entry prices for investments. But unfortunately, our analysis will only yield an “educated guess” as to what is priced into financial markets.

Consensus Expectations in General

We understand that in general, consensus financial market expectations are that the U.S. will avoid a recession for at least the next twelve months, that inflation will dissipate into year end, that the war will end in the not-too-distant future without too much further damage to world economies, that China will somehow lessen its lockdown policies, as well as that supply constraints and disruptions will be resolved mostly during the balance of this year. Many market participants and analysts are “comfortably numb” with this scenario. This is all possible, but is it likely? We conclude that a great deal of market volatility is caused by swings in the perceptions of the likelihood of these various outcomes.

No Place to Hide

Prior to the Russian invasion of Ukraine on February 24, 2022, many investors could rotate into stocks or sectors that they believed would outperform the more general market. We have not felt comfortable favoring any one sector since that day given the increased uncertainties posed by the war. In a well-diversified portfolio, we have stressed a preference for quality stocks, with good balance sheets, steady cash flows and relatively stable profit margins combined with some commodity exposure. We suggested that all sectors should be examined to discover such securities. This could result in overweighting some sectors while completely omitting others.

U.S. as “Safe Haven” and USD Strength

Perhaps the most notable change in our forecasts since the war is that the U.S. has attained the status as the “safe haven” of the world because it was least affected by the war. The USD appreciation has been dramatic since then and appears to have accelerated recently. The Japanese yen is now at a twenty year low versus USD, the Chinese yuan has shown a quick and very noticeable decline over the past two weeks versus USD after many months of stability. The rate of decline of the euro and the British pound has also accelerated more recently. A strong USD has a tendency to reduce U.S. inflation as imports become “cheaper” and compete more effectively with U.S. products. It also reduces the value of foreign earnings since those earnings have to be translated back to USD. The opposite effects could be expected in many foreign countries. Since most commodities are priced in USD, a strong USD has a tendency to depress commodity prices, since foreign demand can be expected to diminish as prices rise in terms of their respective currencies. To the extent that foreign demand is inelastic and more money is spent on commodities, money spent on other items will diminish and slow their economies even further. We postulate that a persistently very strong USD in the current world economy, could increase recession risks in many foreign countries. This could lead to a diminishing demand for U.S. goods and services that could eventually increase recession risks for the U.S. economy.

Weaker Yuan and China Policy Responses

In last week’s commentary we highlighted that the sudden depreciation of China’s currency would probably lead to China adopting more targeted fiscal and monetary policies to help bolster its economy. We presume that targeted approaches would not be as effective as a more general monetary policy easing. The People’s Bank of China (PBOC) left little doubt this week about its concern of the rapid depreciation of the yuan. The PBOC announced this week that effective May 15, it would cut its foreign exchange deposit requirements “in a clear signal to stabilize the yuan.” According to the South China Morning Post on April 25, this move was “aimed at enhancing capabilities of financial institutions in managing foreign exchange funds.” CNBC then divulged on April 27, that China’s President Xi Jinping announced another infrastructure expenditure plan to help boost China’s economic growth. He called for an “all-out” effort to construct infrastructure. In doing so, Xi opened up China’s old playbook. We see this approach as one of increasing China’s debt while providing little long-lasting economic benefit.

According to Bloomberg on Friday, the Politburo of the Chinese Communist Party, which is the principal decision-making body of the Communist Party and headed by Xi Jinping, announced its continued commitment to its 5.5% 2022 GDP growth target, while still adhering to its “zero COVID-19” policy. Leaders “vowed to guarantee ‘supply chains in key sectors’ and smooth transport logistics, pledging to ‘positively respond’ to demands from foreign-invested companies for a smoother business operating environment.” The Politburo also voiced support for the high-tech platform economy, as it announced that it would “introduce specific measures to support the standardized and healthy development of the platform economy.”

U.S. Q1 Negative Real GDP Growth

The Thursday release of Q1 U.S. real GDP of a negative 1.4% quarter-over-quarter (q/q) annualized growth rate versus an expected positive 1% rate showed what can happen as the U.S. trade deficit reached record levels as imports far exceeded exports. The accounting treatment of imports is to subtract them in calculating GDP growth to assure that only domestically produced goods are counted toward GDP. On April 28, Goldman Sachs calculated that Q1 imports cut 2.5% from Q1 GDP and that lower than expected inventory investments cut another 0.8% from what was expected from inventory growth. These two factors presented a much weaker picture of the U.S. economy than its underlying components showed. On April 28, J.P. Morgan (JPM) highlighted that the U.S. trade deficit for Q1 was 4.8% of GDP while for the prior quarter it was 4.0%. The good news was that the large increase in imports could be a good indication of continued robust U.S. demand for goods and services. Although less than expected, real U.S. consumption rose at a still healthy pace of 2.7% q/q. This increase was due to a 4.3% increase in services spending as the U.S. economy was reopening, while spending for goods contracted by 0.1%. Another encouraging feature of the Q1 report was that business fixed investment spending rose 9.2% overall and equipment spending rose 15.4%. JPM further highlighted that tech spending for both hardware and software combined, accounted for over two-thirds of the increase in Q1 business capital spending. We expect to see increased inventory investments in future quarters to the extent that supply constraints and disruptions decrease. But as long as the war persists, we continue to forecast USD strength which could lead to ever larger U.S. trade deficits. We also suspect that many foreign countries will not be able to take full advantage of their depreciated currencies to increase their exports due to supply constraints and disruptions, as well as expensive raw materials.

   Source: J.P. Morgan North America Economic Research: Q1 GDP takes a spill (4/28/2022)

Mixed Economic Data

We viewed most of the economic data released this week and last Friday as mostly “mixed.” In general, the now familiar characterizations seemed to apply. Relatively strong but somewhat less robust current economic data is typified by supply chain issues, tight labor markets, high wages, high prices and typically diminished expectations of future business conditions to the extent of rising inflation concerns.

U.S. April PMIs

The S&P Global flash composite PMI for April released last Friday showed an easing of U.S. economic growth even as it continued to expand. But the surprise was that the services sector weakened as the goods sector strengthened. The service sector activity slipped to a three-month low as manufacturing sector activity rose to a nine-month high. This report speculated that services activity was dampened by “markedly higher” prices to consumers as the costs for services firms rose at the fastest rate since October 2009. The manufacturing sector was helped by export orders, which rose at the fastest pace in almost a year. Perhaps this was due to better access of materials for U.S. firms relative to their foreign counterparts. Nevertheless the degree of confidence in the manufacturing sector slipped to a six month low due to greater geopolitical uncertainty and inflation concerns. Concerns regarding inflation and the effect on their customers’ demand caused business confidence in the service sector to record its lowest level since October 2021. The service firms were still generally optimistic that their output would rise over the next year.

Eurozone April PMIs

In contrast, the S&P Global April flash composite PMI for the Eurozone showed an increase in economic activity as services activity increased while manufacturing remained only slightly in expansionary territory. “Prices charged for goods and services rose at an unprecedented rate in April amid another records rise in firms’ costs.” The escalation in services sector activity increased as coronavirus cases diminished, restrictions were relaxed and tourism activity expanded. As a reminder, Europe lagged the U.S. in the reopening of its economies. The manufacturing sector activity increased at the slowest rate since Q2 2020, as auto production was particularly hard hit. Supply constraints, longer delivery times, China lockdowns and the war were all cited in this context. Business optimism for the upcoming year improved somewhat in April but was “considerably gloomier” than the beginning of this year.

Brief Summary of Selected U.S. Business Surveys and Economic Data Released this Week

Dallas Fed April manufacturing survey: Texas manufacturing activity expanded at a moderate pace, but the company outlook index slipped to -5.5 – its lowest reading in two years. The outlook uncertainty index also rose. Prices and wages continued to increase strongly.

Dallas Fed April services survey: Texas services activity moderated as wages and benefits remained near record highs. Input prices and prices received remained elevated. The future business activity index decreased to its lowest reading since mid-2020.

Philadelphia Fed April nonmanufacturing survey: Although business activity continued to expand, indexes for general activity at the firm level, sales, revenues and new orders all declined but remained positive. Prices received and paid continued to increase and respondents continued to expect growth over the next six months.

Richmond Fed April manufacturing survey: Although the manufacturing index exceeded expectations slightly, the components were mixed. Shipments increased, new orders fell sequentially, order backlogs continued to increase, vendor lead times remained high, inventories remained low, prices remained elevated, and difficulty of finding qualified workers persisted. But the most troubling aspect of this report was that future business conditions were anticipated to deteriorate to a negative index level – only the third time in the history of this survey.

Conference Board Consumer Confidence in April: The present situations index which reflects current business and labor conditions decreased slightly but remained at elevated levels. The expectations index which reflects consumers’ short-term outlook for income, business and labor conditions ticked up, but remained weak. Vacation planning “cooled” but intentions to buy big ticket items such as autos and appliances rose somewhat. The report warned that inflation and war concerns posed downside risks to consumer confidence and spending plans.

New orders for U.S. durable goods in March rebounded from a decrease in February orders.

Both the Federal Housing Finance Agency (FHFA) and the S&P/Case-Schiller house price indexes for February increased almost 20% y/y and more than 1.5% m/m, which was roughly twice the rate of sequential rises one year ago.

New U.S. home sales decreased 8.6% m/m in March for the third straight month. February sales were revised significantly higher. The median sales price of a new home was 21.4% higher y/y.

Advance economic indicators for March released by the U.S. Census bureau: Record U.S. trade deficit of $125.3 billion versus $106.3 billion in February. Exports and imports increased to record levels, 7.2% m/m to $169.3 billion and 11.5% to $294.6 billion, respectively. Advance wholesale inventories rose 2.3% m/m and 21.5% y/y. Advance retail inventories rose 2.0% m/m and 11.0% y/y.

Source: U.S. Census Bureau Quarterly Residential Vacancies ad Homeownership, First Quarter 2022 (4/27/2022)

Source: J.P. Morgan US: 1Q real GDP growth now tracking 0.7% (4/27/2022)

Source: J.P. US: New orders for durable goods increase 0.8% in March (4/26/2022)

Source: U.S. Census Bureau and the U.S. Department of Housing and Urban Development: Monthly New Residential Sales, March 2022 (4/26/2022)

Selected Earnings Results

The U.S. equity markets were quite volatile this week amid a very busy week for earnings releases. Many companies beat expected earnings and revenue estimates, and guidance was rather mixed. Stock price reactions were somewhat unpredictable. The long anticipated earnings reports of Microsoft, Alphabet, Facebook (Meta Platforms), Apple and Amazon were all released this week. Microsoft announced good results along with positive guidance and traded higher. Alphabet disappointed and traded lower. Facebook traded much higher after it announced its earnings. It appeared that investors were pleased that Facebook showed a sequential increase in its daily users and that it showed some discipline in reining in its expenses. Facebook rose substantially even though it grew its revenues at the slowest rate since it became a public company. Amazon traded lower after it disappointed on its earnings, citing inflationary pressures on its margins. Amazon’s Q2 guidance was weaker than anticipated. Apple announced what appeared to be a stellar Q1 as well as an additional $90-billion buyback of its shares. It initially traded higher by more than 2% after hours but then later traded over 2% lower after it revealed that its Q2 sales could be as much as $8 billion short of expectations due to supply disruption issues from China related lockdowns.

Bottom Line

We assume continued volatility across virtually all financial markets for at least as long as the war persists. Furthermore, we continue to forecast higher interest rates as part of a volatile trajectory. We foresee that most global economic growth rates will be revised lower and that most inflation forecasts will be revised higher due to the war and Chinese coronavirus related lockdowns. Additionally, we assume that downward earnings revisions for many companies might soon reflect these patterns. Predictable margins should become increasingly important in evaluating appropriate investments. Managements’ guidance on future earnings and revenue could be a driving force behind stock market reactions during this earnings season. The strength of the USD could make forecasting even more difficult as the number of variables affecting investment decisions continue to multiply.

Our basic investment approach remains constant as expressed in our most recent commentaries. We maintain our preference for high quality stocks in a diversified portfolio with at least some commodity exposure.

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