Kroger's Battle Against Rising Inflation Pays Off In Earnings Announcement

(Thursday Market Open) While Americans slept on the Fed’s rate hike, the Swiss National Bank (SNB) announced a surprise increase in its key rate and the Bank of England (BoE) also raised theirs. With central banks around the globe now raising rates, equity index futures fell dramatically with S&P 500 futures down more than 2.3% ahead of the opening bell.

Potential Market Movers

The SNB hike is its first since 2007, moving its benchmark from -0.75% to -0.25%. SNB also raised its 2022 inflation forecast to 2.8% from 2.1%. However, it maintained its economic forecast at 2.5% growth.  

The BoE was the first of all central banks to start raising rates and this morning’s hike was its fifth consecutive. The quarter-point increase took the BoE key rate up to 1.25%. However, three members of the BoE board voted to increase the rate by 50 basis points.

With three central banks raising rates in less than 24 hours and the European Central Bank (ECB) calling for a surprise meeting, it not only paints a picture of inflation that is much worse than global banks had originally forecasted, it also reflects the need of central banks to protect their currencies from the strength of the U.S. dollar. As the global economic picture worsens, investors were fleeing to greenbacks and Treasuries as a safe haven and reducing liquidity in other countries. Rising rates are likely to induce recession but rising inflation and the Fed are forcing the hands of other central banks to raise rates.

While the SNB may have prompted the selloff, the pullback in stocks is closer to what you might have expected from the Fed’s 75-basis-point hike instead of yesterday’s relief rally. The Cboe Market Volatility Index (VIX) rose more than 6% ahead of the opening bell climbing well above 31. When the VIX is above 30, nothing good happens and when the VIX is above 40, only bad things happen.

More negative U.S. economic news arrived this morning with building permits falling 7% in May and housing starts dropping 14.4%. The results reflect continued weakness in the housing market and particularly in new homes. The Philadelphia Fed Manufacturing Index came in at -3.3, a signal that economic conditions are getting worse. Analysts had expected the report to come in at 5.5. Finally, initial jobless claims were also higher than forecasted.

Earnings from Kroger (KR) beat on top- and bottom-line numbers and the grocer raised full-year earnings guidance. However, the stock fell 4.4% in premarket trading on the news that the company’s same-store sales guidance fell slightly. The supermarket chain has done a pretty good job of managing inflation though the company tightened its earnings guidance range, which may reflect new buying contracts that could help them fix some costs helping to protect them from inflation.

Reviewing the Market Minutes

The Federal Reserve met the consensus Wednesday with a 75-basis-point rate hike that will lift the federal funds rate to a range between 1.5% to 1.75%. Fed Chairman Jerome Powell told reporters afterward that the 75-basis-point hike isn’t expected to be a common increase and that the Fed will likely hike by 50-75 basis points in July and then return to increases in the 25-50-basis-point range thereafter.

Mr. Powell cautioned that all future moves will be “data-dependent,” and the Fed’s dot plot revealed that each Fed member sees the central bank’s overnight rate reaching 3% by the end of 2022 with the average projection at 3.4%.

Notably, the Fed chose not to change its plans to unload its balance sheet. In fact, during the day, the Fed began its $9 trillion balance sheet reduction by allowing $15 billion worth of Treasuries to mature off the balance sheet without replacement. Throughout the remainder of June, the Fed plans to unload a total of $30 billion in Treasuries and $17.5 billion in mortgage-backed securities. The amount of quantitative tightening (QT) will ramp up over the next three months to a monthly pace that will eventually rise to $60 billion in Treasuries and $35 billion in mortgage-backed securities.

The concern with QT is that it may add more volatility to an already volatile Treasury market. The Treasury market and the mortgage market are now losing one of their biggest customers and will have to rely on other institutions and investors to pick up the slack. Those replacing the Fed’s business may demand a higher rate of return, which could push yields even higher.

The Fed also adjusted its unemployment outlook higher as Powell noted that executing an economic “soft landing” has become increasingly more difficult. The Fed lowered their 2022 gross domestic product (GDP) to 1.7% down from 2.8%. Powell added that the central bank hopes that unemployment won’t move above 4.1% as rates do their work slowing the economy.

Stocks rose during the morning, and with most of the surprises already accounted for, they remained relatively unchanged after the announcement. After the press conference, stocks tried to stage another rally but were turned back. Nonetheless, the S&P 500 (SPX) finished the day 1.46%, while the Nasdaq Composite ($COMP) climbed 2.5% and closed higher for the second day in a row. The Dow Jones Industrial Average ($DJI) rose 1%. The 10-year Treasury yield (TNX) was also little changed after falling this morning from Tuesday’s spike—and finished at 3.395%.

Three Things to Watch

Lasting Value? As yields have been rising in anticipation of and reaction to the Fed’s rate hikes, investors have turned to value stocks to grow or maintain their portfolios. The S&P 500 Pure Value Index shows that investors who bought value stocks have likely maintained their portfolios’ value as the index has oscillated in a sideways trend since May 2021. In contrast, the S&P 500 Pure Growth Index has downtrended since November. Now that the Fed is feeling pressure to be more aggressive, will that trend continue?

The value index is still demonstrating relative strength compared to the growth index, which suggests that value is likely to outperform growth. However, this doesn’t mean that value stocks won’t fall as interest rates rise. We saw this starting last week when the value index dropped nearly 10% in four days.  

Valuing Value: As interest rates rise, fundamentally driven investors will use their valuation model to determine the intrinsic price of a stock. Value stocks tend to be less affected by these new valuations models spit out, but they are still discounted, which lowers their intrinsic value in a way that can drive their stock prices lower.

Another benefit that many value stocks offer is that they often pay dividends—many of which pay yields above the average growth stock and even the S&P 500 (SPX). However, the Dow Jones U.S. Select Dividend Index has fallen more than 10% in the last week.  

Hiking Map: The Fed’s projection of the overnight rate reaching 3.4% by year-end is nearly in line with the market. The 2-year Treasury yield, usually most in line with the Fed’s overnight rate, closed at 3.21% on Wednesday, down from 3.43% on Tuesday. Trying to break down the market projections are a little difficult. However, the market appears to have it right while the Fed still appears to be behind the curve.

With so much changing in the global economy, it’s difficult to determine where the Fed will end up going with rate hikes. While the probabilities in the CME FedWatch Tool are also subject to change, they provide give a read on what the market is expecting. Currently, the tool is projecting 75 basis points in July, 75 in September, 50 in November, and 50 in December.

Notable Calendar Items

June 20: Market closed for Juneteenth holiday

June 21: Existing home sales

June 22: Earnings from KB Home (KBH) and H.B. Fuller (FUL)

June 23: Initial jobless claims, U.S. manufacturing PMI, and earnings from FedEx (FDX), Accenture (ACN), and Darden Restaurants (DRI)

June 24: Michigan Consumer Sentiment, New home sales, and earnings from CarMax (KMX)

TD Ameritrade® commentary for educational purposes only. Member SIPC.

Featured photo credit: Wikimedia Commons

This post contains sponsored advertising content. This content is for informational purposes only and not intended to be investing advice.