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What the Market? - May 9 2022
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What the Market?
Sometimes bad news can sound better if it’s delivered in a good way so here’s George Harrison with some relevant background music.
Despite an early-week rally, Mr. Market’s slump continues. The short-lived “relief rally” fueled by the Fed’s interest rate hike was hastily quashed as markets fell Thursday and Friday and the US 10 year note surged over 3% (highest since 2018). The week ahead will provide some needed insight into the economic backdrop with CPI, PPI and Consumer Sentiment data along with a plethora of earnings releases.
What’s driving the market?
Is the economy booming or not? 2022 appears to be the year of bearish indecision. Whether it’s good news (like last week’s job’s report) or bad news (like the rampant inflationary pressures), investors seem to be uncomfortable no matter what information they are given. It’s hard to blame them really - we’re at a point where even good news can carry with it negative consequences if not managed with pinpoint precision.
The April Jobs report: revealed that 428K non-farm jobs were added vs. an expected 380K while the unemployment rate remained at 3.6%. The economy has regained nearly 95% of the 22M jobs lost during the height of the Pandemic and there are roughly 2 job openings for every unemployed worker. Sounds great right? A recovering economy, jobs available for those in the labor force, what are investors worried about? With demand rising across sectors, wage pressure continues to mount in tandem. The April survey showed that average hourly earnings were 5.5% higher than a year ago but with inflation at 6.6%, folks are still losing purchasing power. This environment of low unemployment can carry additional consequences that impact market productivity.
Wage Inflation fuels Inflation Inflation: With a shortage of workers employers have fiercer competition for workers and will raise pay standards. Remember the increase on your paycheck is also an increase in costs for the business. Let’s not pretend like the business won’t pass on that increased cost onto consumers to preserve profitability. On top of the labor market, let’s drip a bit of oil on inflation at $110 a barrel (remember when it oil went negative in 2020 LOL?). Anyways, not all industries can handle wage inflation rising above the natural pace of inflation the same. Sectors such as industrials and consumer discretionary or small cap firms don’t have the margins to deal with rising wages or simply cannot transfer the higher prices to consumers due to the price elasticity of demand (how much more can I charge a customer before they switch to another brand or product?). Furthermore, the revenue per employee is likely lower, making it difficult to pay higher wages and remain competitive (think Russell 2000 companies).
The churnining (we made up a word but at least we didn’t call it the “great churnining”): In an environment where job-seekers hold greater leverage, churn typically accelerates to the point that we must ask, are we really becoming more productive? Not only are those who are unemployed seeking work but those currently employed are also jumping ship to secure higher pay, hint: it’s not a bad time to ask for a raise (well, well, well, how the turntable). Again, this doesn’t make things any easier for small caps.
The Output Gap: An output gap occurs when the productivity generated by a new job does not outweigh its cost, meaning an economy is becoming inefficient. This is a scenario investors would normally consider when an economy has hit its production capacity. However, given the drastic pandemic-induced global contraction, this does not appear to be the case today as there is plenty of demand for increased production in the market today. Perhaps we need to explore new technologies to push our productivity curve?
Bottom line: A strong labor market is great news. It is much better to have unemployment at 3.5% than 10% (duh). A good jobs market allows for economic activity, which creates more jobs, and so forth. The not so great news is that an economy that is too hot will exude inflationary pressures. More demand for labor, and higher wages are naturally a higher cost for any company and it will most certainly be passed onto the consumer where ever possible.
What’s next? If the economy, and particularly the jobs market remain strong, the Fed is expected to trim off some excess demand and take a more aggressive approach to tackling inflation and stabilizing the whacky economy we currently have. After raising interest rates 50bps (largest hike since 2000), Fed Chairman Powell indicated that another 50bps increase is on the table for the next meeting if “economic and financial conditions evolve in line with expectations”. This is heavy on the mind of investors who want to see rapid growth from their investments. If the economy is being slowed down and inflation continues to run rampant (stagflation scenario) it’ll be awfully difficult for companies to excite investors (keep an eye on the plethora of earnings releases coming out this week). The Fed is hoping that the $2.5T on consumer savings and booming capex orders will keep the economy afloat for a few months (or years) ahead while trimming down the excess demand that is currently pushing prices up. Let’s hope for everyone’s sake that the Fed is right.
What’s an investor to do?
Playing defense is the way to go, as you continue rotating your portfolio towards safer investments in higher-quality/less speculative assets. Consider corporate bonds with short durations that will help fend off inflation while limiting your exposure to risk and market volatility.
For those with a stronger stomach and multi-year horizons, it may also be a good time to double down and funnel more cash into the market. Many companies are flirting with historical lows as a result of the macro environment. Major warning - you may have to sit in the red for a long time before realizing potentially outsized gains when the economy begins a new cycle of healthy expansion. In these cases, don’t try to time the market. Also consider not making direct eye contact with your portfolio for a bit after you make these purchases.
Additionally, consider avoiding small caps or highly speculative stocks for the time being that haven’t set up strong foundations to thrive in the macro environment (e.g., product-market fit, high growth, strong and secure margins).
Keep an eye on the economy
Consumer Sentiment: In addition to keeping an eye out for this week’s CPI and PPI data, take a close look at how consumers are feeling this Friday. The index is flirting with decade-low figures, and is expected to continue declining this month as COVID seems to be making a seventh(?) comeback. Furthermore, inflation keeps mounting, war in Europe continues and supply chains remain glitchy. How come demand is still so high?
Earnings Reports: A plethora of reports are coming out this week. Keep an eye on investors reactions and sentiments as well as commentary on industry performance in the macro environment by each company.
The Curious Investor
No deep-dive this week
Emerging Ideas: Nothing new this week
3D Systems, AMC, BioNTech, Lemonade, Palantir, Zynga, XPO, Occidental Petroleum, Allbirds, Coinbase, EA, Hyatt, Peloton, Roblox, SoFi, TradeDesk, Warner Music Group, XL Fleet, Disney, Beyond Meat, Bumble, Rivian, Toyota, Affirm, Aurora Cannabis, Constellation Energy, CyberArk, DuoLingo, Six Flags, Squarespace, Toast, Honda
What we’re vibing:
Radical Focus by Christina Wodtke. A book for Biz Ops, product, and team leaders looking for a way to focus your teams on the right objectives, define the strategy and metrics to achieve them. Wodtke delivers a a guide to implementing OKRs in the form of a narrative story of a tea startup. Delving into both the why and how of OKRs and examining what can go wrong. It may be a bit slow to get to the points (recommend listening on Audible and turning up the speed) but the book delivers on improving your understanding of OKRs.
Dr. Strange and the Multi-Verse of Madness: At this point, if Marvel makes it, we will see it, but this movie kicks ass. Super hero movie meets horror film meets Dr. Strange. We’re not linking the trailer because 1. there are too many spoilers and 2. you don’t need it. There are two types of people in this world, Marvel people and non-Marvel people. Regardless of which you are, go see this super fun movie.
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