This morning there were two differing economic reports from the U.S. government. At 8:30 A.M. (EDT), the Labor Department reported that initial weekly jobless claims for the week ending March 19th came in at 187,000, a huge improvement from the previous week. However, the Commerce Department said durable goods orders fell 2.2% in February, which was worse than the consensus expectation calling for a 1.0% decline and was a sharp reversal from the revised 1.6% gain recorded in January.
Neither of this morning’s economic reports were expected to move the needle much for the equity market, and the equity futures did not change much on the data. However, yesterday’s disappointing report on February new home sales (the figure came in at an annualized rate of 772,000 versus the previous month’s tally of 788,000 and a consensus expectation calling for 805,000) unnerved investors a bit, as it may be an indication that higher borrowing costs are starting to have a negative effect on home purchases and maybe on growth of the overall economy.
With the earnings and economic news on the light side this week, the attention of Wall Street has been on the Federal Reserve and, in particular, the latest commentary from Chairman Jerome Powell. This has made for a choppy performance for stocks so far this week. The major equity averages fell yesterday, but the equity futures are indicating a partial retracement of that selloff at the start of today’s session, continuing this week’s roller-coaster ride for investors.
The recent volatility stems from worries about stubbornly higher inflation, and the growing possibility that it may force the central bank to raise the benchmark short-term interest rate more aggressively than had been expected this winter. On Monday, Chairman Powell said that the lead bank will take the necessary steps to ensure a return to price stability, and that may include raising the federal funds benchmark rate by more than 25 basis points at a forthcoming meeting if prices continue to remain elevated. Historically, stocks don’t perform as well during periods of more-restrictive monetary policy.
Last week’s rally following the Fed’s announcement of the first 25-basis-point interest-rate hike since late 2018 seems to suggest that the market has yet to price a 50-basis-point increase into stock valuations. So if inflation data continue to run hot, and there is more talk of a more aggressive interest-rate hike, we would not be overly surprised if the major averages retested some of their late-February 52-week lows. Based on this concern, we would recommend that investors continue to take a more cautious near-term investment stance. Our asset allocation model can be found in the Selection & Opinion section of The Value Line Investment Survey.
Further to interest rates, the inflation worries, which have been exacerbated by the higher oil prices resulting from disruptions to global supply due to the war in Ukraine, along with the Fed’s decision last week, are putting some upward pressure on Treasury market yields. The coupon yield on the benchmark 10-year Treasury note, which was at 1.71% on March 1st, recently climbed to nearly 2.40%.
A rise in bond yields is not a great scenario for the higher-growth stocks, most notably those of the unprofitable technology companies, many of which were big winners during the height of the pandemic. The stocks of those companies are valued more on future profits. Thus, higher rates mean that earnings years from now (discounted back to present value) are worth less today and investors are less likely to pay premiums for positions in those companies. In this environment, we think those investors still wanting to maintain a stake in the technology sector may be best served looking at the more-established names that provide earnings growth potential and significant free cash-flow generation. Shares of technology behemoth Apple (AAPL) have rallied notably over the last week, likely on that view.
On the other hand, the value names, including some of the materials (e.g., metals producers), energy and financial stocks, may also be a wise option in a rising rate environment triggered by inflation. These companies, many of which are witnessing increased profit margins and generating positive free cash flow may be better positioned to weather a prolonged stretch of higher borrowing costs. A number of the energy companies currently fit the bill. Conversely, the homebuilding stocks have struggled mightily in 2022, given the rise in lending rates (the rate on the Freddie Mac 30-year fixed-rate mortgage is up nearly 35%, year to date) and more-hawkish talk from the Federal Reserve. Not only do higher borrowing costs affect the builders as they borrow funds during construction, but increased rates for buyers’ mortgages may threaten homebuyer affordability and ultimately demand for housing. On point, Los Angeles-based homebuilder KB Home (KBH) reported disappointing February-quarter results yesterday afternoon, and the stock is trading lower in pre-market action.
– William G. Ferguson
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.
