The 1% Move Report

Wealth Management — October 14, 2022

• The S&P 500 declined 2.4% Friday to close at 3,583 as 94% of the index's constituents were lower on the day. With the sell-off, the index has fallen 24.8% year-to-date. 
• All 11 S&P 500 sectors declined as Health Care (-0.8%) and Utilities (-1.5%) outperformed, while Energy (-3.7%) and Consumer Discretionary (-3.9%) lagged. 
• Mixed 3Q earnings results and a weak University of Michigan report for inflation expectations led equities lower and Treasury yields higher today. This followed yesterday's Consumer Price Index report which showed shelter inflation continues to accelerate. Additionally, recent commentary from Fed officials suggests a potential increase to the terminal rate and additional rate hikes.
• In the UK, Prime Minister Liz Truss confirmed the administration would abandon its corporate tax cut program while the Bank of England ended the emergency bond-buying program. By the close on Friday, 1.45 billion pounds of long-dated and inflation-linked UK bonds (gilts) were purchased.
• Global economic slowdown concerns continued. By the 4 pm close, WTI oil fell to $85.8 as while the US Dollar Index modestly improved to 113.2. The 2-year Treasury yield rose to the highest level since 2007 at 4.51%. The 10-year Treasury yield rose to 4.02%. 

• 3Q22 Earnings: Thirty-six S&P 500 companies reported third quarter results so far with 70% of them beating earnings expectations. In aggregate, for the companies that reported, earnings surprised by 3.5% while sales surprised by 0.6%, according to Bloomberg. For the S&P 500, bottom-up, blended 3Q22 earnings growth is anticipated to be +3.6% y/y as earnings from Energy companies are driving much of the growth, according to Refinitiv. Excluding Energy, third quarter earnings are expected to be down 3.1% y/y. Sixty-six more companies are expected to report next week. During company 3Q22 earnings calls, investors will be monitoring forward guidance as well as the impact of a strong US dollar, elevated/sticky inflation, higher rates, the shift from goods to services, the inventory glut, and slowing demand conditions. We expect these headwinds to weigh on revenues, margins, earnings, and valuations. 
• Monetary Policy: Following the September FOMC meeting, Fed Chair Powell announced a 75-basis-point (bp) hike and reiterated that the committee "will keep at it until ... confident the job is done." MS & Co.'s Ellen Zentner expects a 75-basis-point hike at the November 2nd meeting, 50-basis-point hike in December, and a 25-basis point hike in January 2023 to a terminal rate of 4.625% in January. Additionally, she anticipates that rates will remain steady at the implied 4.625% level until December 2023 when a first rate cut of 25-basis-point may occur. MS & Co. believes a 75-basis-point hike could be possible in December if core services remain under pressure. While the balance sheet reduction program doubled in September, Fed Chair Powell indicated that MBS sales are not expected any time soon during last month's meeting. Odds of a 75-basis-point hike at the November FOMC meeting are now 100%, and a 15% chance of a 100-basis-point hike (according to Bloomberg).

Today: 

• Retail Sales showed broad-based weakness for the month of September as consumer spending grew in six of the 13 categories compared to 10 out of 13 in August. The shift toward services related spending continued this month as a number of home-related goods categories showed declines.
• University of Michigan Inflation Expectations increased for the first time in seven months.
• University of Michigan Consumer Sentiment increased more than expected as respondents noted they felt it was a good time to purchase durables, perhaps as those polled felt that prices are going higher.

Calendar:

• 10/17: Empire State Survey
• 10/18: Industrial Production, NAHB Housing Market Index
• 10/19: Housing Starts
• 10/20: Leading Indicators, Existing Home Sales

With the Fed responding to 40-year highs in inflation through both rate hikes and balance sheet run-off in 2022, the GIC’s call for continued caution in the indices remains intact. Corporate earnings revisions are moving lower, and valuations remain rich, especially relative to the 10-year real interest rate. We recommend that investors focus on risk management through quality cash flows, defensiveness with regard to interest rate sensitivity, and attention to stock-specific valuations. Bear market rallies should be used for rebalancing and tax-loss harvesting. In fixed income, the challenge is two-fold: generating sufficient income, while also preserving capital in a rising-rate and higher-inflation environment. This requires diversified and active exposure, with our preference for core investment grade fixed income and dividend-paying stocks. Consider revisiting positioning in long-duration/growth equities, where there may not be adequate compensation for the risks of rising real rates, falling operating leverage and the strong US dollar.

For US equities, our June 2023E S&P 500 base case provides a target of 3,900. This scenario assumes earnings and revenue growth decelerates due to high cost pressures in a slowing growth environment. Our June 2023E bear case of 3,350 considers a slowdown in earnings growth rate, margin pressure, sticky inflation and a recession. Our June 2023E bull case of 4,450 corresponds to a soft-landing environment, where earnings growth slows but remains positive, inflation decelerates, cost pressures ease, and confidence improves. This bull case forecast embeds an estimate of 17.9x forward June 2024E earnings.

Market data provided by Bloomberg.

Dow Jones Industrial Average (DJIA): A price-weighted average of 30 blue-chip stocks that are generally the leaders in their industry.

NASDAQ Composite Index: A broad-based capitalization-weighted index of stocks in all three NASDAQ tiers: Global Select, Global Market and Capital Market.

S&P 500 Index: The Standard & Poor's (S&P) 500 Index tracks the performance of 500 widely held, large-capitalization US stocks.

US Trade-Weighted Dollar Index: A weighted average of the foreign exchange value of the 17US dollar against a subset of the broad index currencies that circulate widely outside the US.

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