Last week’s selloff was the 10th negative week out of the last 11. Starting on Monday and continuing through the Fed’s announcement on Wednesday, traders expressed serious concerns that the Fed is making a monetary error by raising the overnight rate so quickly.
But, as we’ve seen over the last few weeks, there are some silver linings amidst the gray skies. Let’s start with the latter.
The issue is that raising interest rates to slow inflation also slows growth. If the Fed raises rates too quickly, growth will turn negative, and the U.S. economy will enter a recession. If you exclude the energy sector, analysts already expect the earnings growth rate to be negative this month. The Atlanta Fed estimates that GDP in the second quarter will be 0.00% — just on the razor’s edge of a recession.
On the bright side, if we evaluate the Fed’s progress towards their goal of reducing inflation, it looks like they are making progress. Key measures of inflation are falling (if you exclude food and energy) and because mortgage rates are higher, shelter costs (the average costs for a consumer to house themselves including rent or mortgage) are also rising much more slowly. We know that a slowdown in housing sounds like bad news, but shelter costs are roughly 30% of overall inflation. If the rate of growth slows, then it will have a big impact on the inflation rate.
If you have tried filling your car at the gas station this month, the most obvious source of inflation is energy costs, which brings us to the most important news to watch this week. Gasoline and oil prices started to fall last week as investors started pricing in a recession.
We know that it sounds bad to say that energy prices are dropping because investors expect a bad economy, but this could turn out to be a good thing. If gas prices continue to drop, it will reset expectations for the Fed’s rate hikes later this year. Sentiment is a fickle thing, and a bearish market can reverse easily if there are signs that the Fed may not have to keep raising the overnight rate as fast to bring inflation down.
Looking Ahead
- Monday, Jun. 20
The banks and markets were closed yesterday in honor of the Juneteenth National Independence Day, which gave traders some time to settle after last week.
- Tomorrow and Thursday, Jun. 22-23
This week, Fed Chairman Jerome Powell will testify to the Senate Banking Committee and the House Financial Services Committee on Wednesday and Thursday, respectively. We expect legislators to grill Powell about inflation and the Fed’s plans.
We don’t know yet what kind of tone he will take, but if he acknowledges that there has been some progress made fighting inflation, stock prices could pop back up.
What You Should Do
We think there is a realistic chance that the market may break its losing streak this week, but the upside is limited. Chart-based traders would estimate a maximum of 5% upside potential in the S&P 500, which is good. However, that’s probably the max until earnings reports start to come out the middle of next month.
For now, the best idea is to focus on risk control. We think the probability of falling energy prices is so high right now that it makes sense to leave those stocks off any buy lists or reduce your portfolio exposure to the sector.
However, for investors willing to accept a little extra risk for a high potential return, we think consumer stocks are at a surprisingly low valuation right now. If inflation slows this month, stocks like that could jump 15-20% over the next month.
The bottom line is this: The market is dropping because investors think the Fed will raise rates so fast the economy will go into recession. However, this week there is a good chance that investors will turn bullish if energy prices continue to fall proving that the Fed is making progress and may not have to keep raising rates as quickly.
