There has been a lot of news and economic data driving financial markets in recent weeks: first quarter economic growth and corporate earnings, unemployment and inflation reports, another Federal Reserve meeting, and of course, continued geopolitical events such as the war in Ukraine and continued COVID-19 that is currently most severe, from an economic standpoint, in China.
First quarter GDP
The economy shrank in the first quarter by 1.4% on an annualized basis due to less money spent by companies building inventories and a widening trade deficit. However, the headline showing contraction is misleading because consumer spending – the engine of the U.S. economy –was solid at 2.7% and actually accelerated from 2.5% in the fourth quarter. Inventories grew substantially in the fourth quarter of 2021 and needed less rebuilding early in 2022, which detracted from growth this year. The fact that domestic consumer demand was considerably stronger than overseas demand weighed heavily on the trade deficit. It’s further evidence that the U.S. continues to be ahead of the rest of the world as we (hopefully) move to the endemic stage of the virus. The war is also weighing on European growth.
First quarter earnings season is largely behind us now and the results were solid. Earnings were expected to grow at 4.6% for the quarter, but actually grew by just over 9% year-over-year and in-line with the 10-year average earnings growth rate of 8.8%. This growth was fueled by strong revenue growth of 13.3%, which far surpassed the 10-year average revenue growth rate of 4.0%. This is a reminder that equities can be a great hedge against inflation. Net Profit margins are still near peak levels and companies have so far managed to control expenses and pass rising prices on to consumers and perform quite well. The bottom line is that equity valuations are much lower now, as stocks have fallen but earnings have risen.
The U.S. unemployment rate held steady at 3.6% and is about the lowest in history. This is a double-edged sword because most consumers are largely employed and this creates inflationary pressures on demands for goods and services. Nevertheless, the healthy employment backdrop is mostly what is driving consumer spending and why the U.S. economy is close to firing on all cylinders. Just over 1 million fewer people are at work now compared to before the pandemic. We have seen 12 straight months of job creation of at least 400,000 and will eclipse pre-pandemic levels if the trend continues through the summer. Wages are increasing 5.5% year-over-year, which is manageable and just behind the inflation rate from the last year.
Inflation and the Fed’s hiking cycle
Upcoming inflation reports may be the most critical metric and driver of economic growth and financial markets in the months and years ahead. The theme of peak inflation has picked up steam, but it is taking longer than most expected for inflation to truly roll over. The inflation rate did fall for the first time in 8 months last week, as inflation edged down to 8.3%, but remains close to the fastest pace in 4 decades. The decline came primarily from gas prices. Prices are still increasing for groceries as well as dining out and airline travel and other services. The pandemic trend of spending more on goods has finally abated, which should help ease supply chains and inflation on goods. Unfortunately, the recent inflation report did not ease investor concerns that the Fed may have to follow through with planned rate increases this year and even into 2023. Investors were hoping for better results.
The uncertainty surrounding the Fed’s plan to raise rates is the single biggest driver of financial markets at this time. The Fed raised rates by .25% in March and 0.50% in May. Rate hikes of 0.50% are expected in June and July. The hope is for smaller 0.25% increases in September, October and December meetings, but nobody really knows – not even the Fed. The Fed needs to be data dependent right now and the best news would be cooling inflation in the months ahead to allow the Fed to slow down or pause the rate hiking cycle at some point.
The big picture
There is a lot of talk in the press about a Fed hard landing, a soft landing or even a “soft-ish” landing, as Chair Powell stated in his comments after the recent Fed meeting. Economic growth and earnings will likely slow, as they are impacted by rising interest rates that should cool consumer demand. But, rate hikes are largely priced into markets and financial conditions have already tightened considerably, which should put downward pressure on inflation. For instance, stocks and bonds are down. Housing prices will likely stop increasing and could decline based on mortgage rates that have doubled. The U.S. dollar has surged against most currencies to levels not seen since 2002, which puts downward pressure on commodities like metals, grains and energy since these goods are priced in U.S. dollars.
In 2021, the U.S. economy grew at the fastest pace since 1984. The fed funds rate needed to rise from 0%. The Fed needs to normalize monetary policy. The U.S. economy is strong and should be able to withstand a manageable level of rate increases. There is a chance for a soft landing still – although perhaps it will be soft-ish, or somewhere closer to hard-ish. Inflation will need to moderate throughout the rest of the year to accomplish any kind of soft or soft-ish landing.
It is important for investors to realize that markets are forward looking. Higher inflation, rate hikes and slowing growth are partially priced into markets now. The S&P 500 now trades at 16.7x forward earnings, down from 24x in 2020, and just above the median of 16x that we’ve seen this century. The small company S&P 600 is valued at only 11.3x forward earnings, far below the median of 16.5x during this same timeframe.
There has been a revaluation of asset prices. This is reminiscent of 2000-2002, when growth stocks were battered and the rest of the market not so much. Most recently, we’ve seen the air come out of the most highly speculative corners of the market – the high-flying growth stocks, the pandemic winners, the meme stocks and the crypto currencies. Many of these companies are traded on the Nasdaq Exchange, which was down close to 30% through May 12th.
The path of least resistance may be down. We suspect there may be more chop and downside ahead until we get more certainty regarding inflation and the Fed’s plan to raise interest rates. However, equity valuation is the best we’ve seen in years and bond yields are now respectable. Thus, intermediate and long-term expected returns are higher now than just months ago. It is frustrating to see current asset prices lower, but investors must maintain a 3-7 year time horizon when investing in risk assets.
At APW, we reduced risk to neutral across the board at year-end. We will be ready to take advantage of opportunities as they present themselves in the coming months. Please follow up with any questions.