Brian Dress – CFA, Director of Research, Investment Advisor
If you follow news even casually, whether political or financial, you will know that this week’s headlines have again been dominated by the ongoing War in Ukraine. Our hearts of course go out to the innocent people affected by this brutal battle raging in Eastern Europe and the refugees driven from their home country.
Beyond the humanitarian toll of the conflict, many first and second order economic effects are in evidence as we take our weekly look at the financial markets. The most consequential impact we have seen has come through a harsh regime of sanctions against the Russian economy. This has a material influence especially on world commodity markets, given that Russia is one of the most important exporting nations not only for oil and gas, but also for many important industrial commodities, such as palladium, titanium, steel, aluminum, and fertilizers. These sanctions, however justified, will have a crucial impact on the way companies around the world do business, borne out by sharp rallies in commodities over the past two weeks. We saw oil prices rise by more than 15% over the five days covered by this report. The move in commodities has a chance to cause real economic damage considering already elevated levels of inflation present, as the world struggles to cope with pandemic disruptions.
However, Ukraine is not the only financial development worth considering. We are winding down towards the end of this quarter’s earnings season. The pattern has been companies who exceed estimates receiving limited support for their stock prices, while companies who miss estimates seeing their stock prices absolutely brutalized. We think we may be seeing things turn a bit, in that regard, this week, but we still saw a few breathtaking earnings-related downdrafts in growth tech stocks like Snowflake (SNOW) and Veeva Systems (VEEV).
We received more news about the health of the US consumer from earnings reports from Best Buy (BBY), Target (TGT), Dollar Tree (DLTR), Nordstrom (JWN), and Kroger (KR). Though there have been some notable exceptions in earnings season, like Home Depot (HD), consumer-related companies have generally reported solid earnings. We find this news intriguing, especially in the context of weakness in the Consumer Discretionary Select Sector SPDR Fund (XLY) since the beginning of 2022. Weakness in XLY seems to suggest that market participants are pricing in a recession later in 2022, which is a possibility especially given that the US Federal Reserve and other Central Banks around the world look poised to start raising interest rates off the zero lower bound.
Speaking of the Fed, we saw more news from the Fed this week, as Chairman Jerome Powell testified to Congress on Wednesday and Thursday. Markets rallied on the news that the Fed is likely to raise rates by 25 basis points (or 0.25%) at its meeting this month. Of course, the inflation in gas and other prices complicates matters for the Fed, which has been slow to remove monetary stimulus deployed in the early days of the pandemic.
With that all being said, let’s get into it!
In the table below, you will note the performance over the last week of the key indices and other selected data for the five trading days between 2/25/22 and 3/3/22:
The basis of our “What’s Working?” and the “What’s Not Working?” segments in our weekly post is our Jarvis securities evaluation system, in which we track nearly 1,000 stocks and more than 300 ETFs on a weekly basis. We use the patterns we see in that data to determine where we see pockets of strength and weakness.
This week we saw a near carbon copy of what we noted in last week’s post, which is profound strength in commodity-related sectors. Topping the list of relative strength in this week’s market were ETFs that directly reflect the price of commodities, including Brent Oil Fund, LP (BNO), Invesco DB Commodity Index Tracking Fund (DBC), United States Natural Gas Fund, LP (UNG), and VanEck Vectors Steel ETF (SLX). Note also that Russia exports roughly 50% of the world’s palladium supply, which is used in a number of industrial applications, including catalytic converters and airplane spark plugs. As such, the Aberdeen Standard Physical Palladium Shares ETF (PALL) gained over 15% in value in just the past five days of trading.
We understand the redundancy of the Best Performing ETFs from last week to this week, so we are going to dig deeper down the list for some other areas of interest. Among the top performing ETFs outside the commodity space this week were Invesco Aerospace & Defense ETF (PPA), poised to benefit from the inevitable buildup in munitions in the coming months. We also saw a 4% increase in the First Trust NASDAQ Cybersecurity ETF (CIBR) based on Russia’s reputation for accompanying physical military attacks with cyberattacks. This has been borne out in the early days of the conflict, albeit less than was expected by experts in the field. That being said, the threat remains real.
What is not Working?
Despite the fact that major market indices were up slightly overall for the week, we continue to see poor performance in the traditional “risk on” measures that we often identify in the letter. Those who have followed us for some time now will be able to connect with previous letters the fact that this pattern has had strong staying power for months.
Semiconductor stocks have performed extremely well over the past 2 years, with an undersupply of computer microchips one of the biggest drivers of the supply chain crisis worldwide. This week we received interesting news from President Joe Biden’s State of the Union address, that Intel (INTC) is planning to increase its investment in an Ohio production facility from $ 20 billion to $ 100 billion. This was an important reminder that semiconductors are historically a cyclical business and that considerable supply may be ready to come online sooner rather than later. As a result, the VanEck Vectors Semiconductor ETF (SMH) was one of the worst performing ETFs in our list this week. Looking at the 5-year chart of SMH (below), there is certainly plenty of room for this sector to pull back, after dramatic outperformance in recent years. That’s not a prediction, just an identification of risk.
Other sectors showing weakness this past 5 days were other risk on sectors like iShares Biotechnology ETF (IBB), Consumer Discretionary Select Sector SPDR Fund (XLY), Robo Global Robotics and Automation Index ETF (ROBO), and Invesco Alerian Galaxy Crypto Economy ETF (SATO). Proponents of crypto as an investment will point to the asset class as a potential hedge in times of strife. The picture is clearly mixed whether crypto is fulfilling this function during this current period of crisis.
Is the Consumer Strong?
With the pandemic beginning to wind down, we know that consumers are eager to get back out to spend excess savings, which they had compiled over the past two years. As restrictions fall away, we expect to see plenty of consumer activity this summer and in the coming few quarters. From our point of view, this narrative makes common sense. With that being said, market participants do not appear to be in agreement with this idea. Take a look at the Year-to-Date chart of the Consumer Discretionary Select Sector SPDR Fund (XLY), which contains many of the most prominent retailers in the US. XLY has been one of the worst performing ETFs this year:
However, as we often say, the stock market is just a market of stocks. The same holds true for a sector ETF like XLY. Over the past week, we got a slew of positive earnings from consumer-focused companies, including Target (TGT – blue), Best Buy (BBY – orange), Dollar Tree (DLTR – yellow)and Kroger (KR – teal). Take a look at the 5-day chart below showing the explosive post-earnings moves from each of these leaders in retail:
We think it s at least possible that recent selling in the consumer discretionary (retail) space has been overdone. Seeing such positive earnings results, forward guidance, and earnings reactions suggests to us that the negativity in this sector is over the top. On the other hand, we acknowledge that forward-looking investors may be anticipating recession in the context of inflationary pressures, which would curb the consumer’s ability to spend. In our view, we think the trajectory of retail could be a harbinger for the broader market in 2022.
Takeaways from this Week
Plenty of market-moving news came across the wire this week. Besides the obvious with the war in Ukraine causing sharp spikes in the commodity space, we also saw extreme volatility in the bond markets. Between the flight to safety trade into treasury bonds and the Federal Reserve Chairman’s comments, the 10-year treasury rate had an extreme range between 1.68% and 2.01% in just a 5-day period!
Risk on measures like biotech and semiconductors struggled again, which has been a consistent theme in the first 2 months of 2022. Consumer discretionary stocks have also suffered in 2022, but this week gave us some key signals that this dynamic may be changing.