Bear Market Rally or New Bull Market?
US stocks have rebounded sharply from the June lows, with the S&P 500 Index soaring over 15% the past eight weeks, continuing the extreme volatility that has persisted throughout 2022. The key question for investors following the recent upturn is whether the strong positive returns are sustainable and mark the beginning of a bull market, or if relief is temporary and will ultimately end up as a “bear market rally.” Our view is that based on the path of inflation, incoming economic data, and equity valuations, there is no obvious answer as to which of these two scenarios is most probable.
The positive case anticipates a decline in inflation sufficient to satisfy the Federal Reserve and consequently prompt an end to the current rate hiking cycle. Critically, this decline in inflation must occur while the US economy remains resilient enough to support a healthy consumer and maintain corporate earnings growth. Optimists cheered the most recent CPI report, which showed inflation peaked in June and fell slightly month over month in July. The July jobs report boasted a 528,000 rise in nonfarm payrolls and an unemployment rate of 3.5%, matching a 50-year low. Second quarter corporate earnings have been better than expected; on June 30 the aggregate estimate was for 4.0% year-over-year profit growth but has since been revised higher to 6.7%.
The negative case is predicated on inflation staying persistently high and the Fed continuing to raise rates in response. Pessimists point to weak or weakening economic indicators to show the economy is already under duress: consumer confidence has plummeted to all-time lows, housing market data have cooled, and the latest PMI services reading showed a contraction. With a slumping economy, higher interest rates will result in individual buying power evaporating, liquidity drying up, and business profits turning negative. Already, corporate earnings excluding the energy sector fell in the second quarter. In addition, some members of the Fed have stated categorically that a deteriorating economy is a tolerable side effect in the battle against the major adversary: high inflation.
In our opinion, current US stock market valuations appropriately reflect the uncertainties regarding these opposing scenarios. Even the Fed is broadcasting confusion; in its July meeting minutes, members stated concern for both being too hesitant about raising future rates (thereby permitting inflation to continue at an unacceptably high level) as well as being too aggressive in interest rate hikes (thus damaging the economy too much). We think the Fed is being pragmatic in adopting a data-dependent strategy rather than committing to a predetermined course. Similarly, investors should resist the temptation to make major portfolio changes until the picture becomes clearer.
Marietta Returns to “Money Life with Chuck Jaffe”
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The Risk of Recession is Rising
Yesterday, the US Department of Labor reported that inflation in April remained very high at 8.3%. While the headline measure of rising consumer prices pulled back from March’s peak of 8.5%, it was both higher than forecasted and at a level that is unsustainable for continued growth. The core measure, which is favored by the Federal Reserve to guide policy, came in at 0.6%, also higher than expected and double the rate in March. This all but guarantees another 50 basis point rate hike or greater next month and a faster tightening path at subsequent Fed meetings than they have previously indicated for 2022.
We wrote in April that we did not expect a recession in the US this year. The Federal Reserve planned to raise interest rates to cool off the heated economy but there was room for error to navigate a soft landing. However, the persistently high level of inflation will likely take a heavy toll. Economic conditions are already worse now than at the start of the quarter. The initial measure of the economy for the first quarter showed a declining GDP of –1.4%, the first contraction since the start of the pandemic. Still, the consensus expectation, which we agree with, is for a rebound in the second quarter to just under 3% growth. So while the risk of an imminent recession is rising, we think it is still more likely that the economy will be able to avoid recession this year.
The market will continue to respond to the path of inflation, which is very difficult for investors to predict. The positive case for the economy and the market is that inflation has peaked. That’s not impossible, especially considering developments already at work in the economy. The Fed’s 50 basis point hike, which occurred at the beginning of the month, coupled with the expectation of more hikes coming, could already be dampening upward price pressures. Certainly, the declines in the stock market will slow consumer demand to some degree. The alternative is continuing high inflation that further harms the economy. In this case, the Fed is behind the curve and will have to catch up with faster rate hikes that threaten a prolonged recession and bear market.
It will take time to see enough data to determine with confidence whether we have brought inflation under control and stabilized the economy. We are unlikely to see an end to the volatility for some months. However, volatility includes sharp moves upward as well. In a market like this, positive indications will have a large reaction in stock prices. We caution against making short-term decisions that will miss out on the eventual recovery rally. That said, we don’t expect the market to start a consistent rise until we can see inflation come down significantly and remain at lower levels.
In this market, investors should balance the current high levels of volatility and uncertainty against the opportunity brought by the recent market declines. The next few months will likely continue to see large swings in the market but, historically, following big declines stocks have generated better than average returns. Investors with a short-term investment horizon or who are more sensitive to high volatility should consider implementing a more defensive position. For a long-term horizon, equity investments appear attractive in this market and these investors should consider holding or even adding to equity positions.
Economic and Financial Market Outlook 2022 Q2
Entering the second quarter, the outlook for the global economy is uncommonly uncertain. The result is above average volatility in financial markets and rapidly shifting investing trends. In the US, the key issue is rising inflation and the response of the Federal Reserve as it attempts to pilot a soft landing (raising interest rates without causing a recession). In our March 2 blog and January 13 Outlook, we expressed confidence that the Fed would be successful. We still adhere to this view but acknowledge that inflation has proved to be more intractable and economically disruptive, which makes the Fed’s task more difficult. In addition to rising inflation, international markets will need to cope with the negative economic consequences of the Russian invasion of Ukraine as well as potential hurdles impeding a pickup in China. Although our forecast carries less conviction than usual, the most probable scenario is that 2022 US GDP will remain positive in the coming quarters, inflation will gradually subside below 5.0% by year-end, corporate profits will rise around 10.0%, and the S&P 500 will be higher at year-end than it is now.
The US economy currently faces persistently high inflation. Monthly readings of core CPI (ex-food and energy) have risen each month since last September, with the latest reading at 6.5%, the highest in 40 years. In response, the Fed has indicated that it is ready to push through faster rate hikes and balance sheet reductions, which will slow the economy in hopes of dampening upward price pressures. We are intensely focused on the success of this course of action. Achieving a soft landing will enable the economy to continue its growth trajectory and prolong the post-pandemic recovery. However, if inflation continues at a high pace without relief, consumers and businesses will have to curtail spending and the Fed will take even more aggressive measures, increasing the likelihood of recession.
The exceptional strength of the US economy has thus far blunted the negative impacts of high inflation. The unemployment rate of 3.6% has only been lower once in the past 50 years (3.5%, Oct. 2019). GDP grew 5.7% in 2021, the fastest year since 1984. The US consumer, the backbone of the economy, is solid; balance sheets are healthy, credit utilization is low, and wages are rising. Household cash exceeds debt for the first time since the early 1990’s. Nevertheless, two recession indicators occurred in the first quarter: a spike in oil prices and the inversion of the yield curve (when short-term rates go above long-term rates). Of these two, we are less concerned about oil as it has already stabilized well below the peak. The yield curve inversion, on the other hand while a more reliable predictor, has in the past delivered false signals and on other occasions preceded recession by as long as three years. The robust US economy, in particular the consumer, provides some room for error to navigate a soft landing or, at worst, fend off recession for at least 12-18 months. We expect GDP growth to remain positive every quarter this year, measuring 3.5% for the year.
US stock markets swooned in the first quarter in response to escalating threats to the burgeoning economic expansion. Major benchmark indices are still mired in a correction, with the S&P 500 producing the first negative quarterly returns in two years. The forward P/E ratio of the S&P 500 index has dropped to 19.0 from the 21.3 recorded at the end of last year, with growth stocks experiencing an especially large multiple contraction. This indicates that current equity valuations are not alarmingly high considering the expected double-digit rise in 2022 corporate profits. If investors gain confidence in the resilience of corporate earnings and/or a successful soft landing, stock markets should make a sharp advance. However, if the Fed makes a policy error and leads the US toward recession, additional negative returns can be assumed before equities begin a new bull market cycle.
Investing in international equity markets carries additional uncertainties and risks. In the EU, in addition to a more acute impact on consumption from higher energy and food prices, Russia’s invasion of Ukraine has dragged down sentiment, even while economies enjoy a boost from the lifting of COVID-19 restrictions. Alternatively, China is still imposing a “zero COVID-19” policy, which is negatively impacting growth. Encouragingly, however, China policymakers have pivoted to stimulating the economy and committed to achieving a 5.5% GDP growth rate in 2022. This stimulus may serve as the bedrock for a continuation of a strong global economic expansion. China and the US, in combination, account for 42% of global GDP. Our projection is that global GDP will slow to 3.8% in 2022 from 5.9% last year. The concern is that some economies may experience hard landings though the consensus view remains optimistic. The most recent forecasts cited in The Economist (04/09/2022) are encouraging:
Region 4Q2021 GDP 2022 GDP
China 6.6 5.5
Euro Area 1.0 3.3
Japan 4.6 2.8
Canada 6.7 3.8
If the forecasts are correct, policymakers will have avoided a hard landing scenario and equity markets will rise.
In the bond markets, the strong economy, surging inflation, and anticipation of aggressive Fed rate hikes has swiftly pushed yields higher. The benchmark 10-year Treasury rocketed from 1.52% at the beginning of the year to 2.77% on April 11. Many investors fear that high inflation will result in a further updraft in interest rates, which could result in negative real (inflation-adjusted) returns on bond investments. In our view, bonds still do not offer a competitive return profile compared to inflation and stocks, though if held to maturity they offer portfolios protection from volatility. We normally emphasize quality and short duration in bond selection, and we think this advice is especially relevant now in order to protect principal in these uncertain times.
Jonathan Smucker Named 2022 40 Under 40 Recipient
We are enthusiastic to announce that Marietta partner and portfolio manager, Jonathan Smucker, is a Milwaukee Business Journal 2022 40 Under 40 Award winner. The winners were announced in late January. The 40 Under 40 Awards recognize Milwaukee-area leaders with a strong record of innovation in their fields, outstanding performance in their business, and a clear track record of meaningful community involvement.
Besides Jonathan’s contributions at Marietta, he serves on the board of directors and is the chair of the marketing and communications committee at SecureFutures, a non-profit organization that empowers teens with financial education, tools, and mentorship. He is also involved directly in his community as a Shorewood Public Library board member. In addition, he aids another non-profit organization focused on youth leadership and development, Teens Grow Greens, through its advisory committee.
We congratulate Jonathan on this major accomplishment. To learn more about the 40 Under 40 Nominees, click this link to the Milwaukee Business Journal.
Economic and Financial Market Outlook 1Q 2022
Uncertainty and volatility dominate the 2022 outlook for global and US economic growth and financial markets. Investors agree that the major issues include inflation, COVID-19, central bank activity, labor and supply chain disruptions, the potential for international upheaval, and developments leading up to the US midterm election. What is hotly debated is how these issues will interact to impact the investment results for the year. The three most prominent scenarios currently debated in the media are highly divergent and range from strong optimism to alarming pessimism: moderate growth, hyperdrive economy, and recession risk. As the year progresses, we expect incoming data to change the prevailing viewpoint, resulting in sudden and dramatic shifts in financial markets. At this point, we do not think any one of the three scenarios warrants a greater than 50% probability for the year, and we advise against excessive reliance on any one of these investment narratives occurring comprehensively. Rather, our recommendation is that investors focus on their long-term strategy, exercise patience and discipline, emphasize quality and diversification, and avoid the temptation of market-timing or chasing short-term trends.
We assign a 50% probability to the moderate growth scenario, which most closely reflects our current US outlook of 3-4% GDP expansion, a 10-15% rise in corporate earnings, and an advance of 8-12% in the S&P 500 Index. The “Goldilocks” forecast, which we consider the most correct, anticipates meaningful progress in the COVID-19 battle in the first quarter; we do not expect the Omicron variant to significantly damage the economy for the rest of the year. This will permit a boost to employment, consumer and business spending, and corporate earnings. The most likely threat to the recovery will come from the potential emergence of a new virus variant. We also agree with the moderate growth scenario’s assertion that inflation will rise early in the year, but then stabilize. A modest decline in inflation could occur as supply chain disruptions are ironed out, pent-up consumer spending during the COVID-19 period is satisfied, demand shifts from products to services, the more restrictive policy of the Federal Reserve takes hold, extraordinary fiscal stimulus policies lapse, and a gradual decline in labor shortages reduces the risk of a wage/price spiral. A relaxation in the threat of runaway inflation will permit the Federal Reserve to initiate its highly awaited rate hike cycle in a gradual and non-threatening way to the stock and bond markets.
The second scenario, which we accord a 35% probability, assumes that the economy becomes overheated, and inflation spirals out of control. As in the moderate growth scenario, the expectation here is that the virus situation ceases to impact negatively the economy. However, labor shortages and wage gains persist, and consumers and businesses adopt inflation as a major consideration in their decision making. Supporters of this scenario also point to the likelihood that a concurrent reopening of international economies will elevate commodity prices, including oil. The result will be a rise in both GDP and inflation, somewhat reminiscent of the 1970s. In the meantime, the Federal Reserve will confront a rising criticism that they have responded too slowly, too indecisively, and in short, that they are behind the curve.
The most pessimistic scenario, which we designate a 15% probability, projects the likelihood of a surprise recession and bear market. Here the thinking is that inflation will rise dramatically and prompt the Federal Reserve into aggressive and repressive rate hikes. This is a development which has punctuated the US economy several times over the past 50 years. While we think this scenario is unlikely, we are carefully watching recession indicators including the Treasury yield curve, the unemployment rate and initial jobless claims, the price of oil, corporate profit margins, manufacturing and services PMIs, consumer confidence, and housing prices.
Each of the three above scenarios is associated with distinctive investment style outperformance. If the moderate growth forecast is correct there will be a double-digit stock market gain and a modest rise in bond yields. Growth stocks in the technology and consumer discretion industry sectors will lead the market higher, much as they have over the past decade. The hyperdrive economy scenario will produce a surge in the economy and corporate profits. The tide will be strong enough to lift all equity boats, but the leaders will be value stocks in the financial, materials, and industrial sectors. In the recession risk scenario, the market could well drop 20% or more and the best place for investors to limit losses and avoid volatility will be in the consumer staples and utilities sectors. Our current view is that investors should stay diversified and emphasize stocks of industry leading companies with strong management, and attractive recent earnings momentum and future potential.
Conditions in the international economies and financial markets resemble the US. The IMF projects 2022 GDP to increase about 5.0% in both the developed and emerging country groups. We predict, however, considerable divergence as countries battle COVID-19 with mixed success. China and Europe will be the keys to the general outcome. The situation in China is worrisome: the government is taking ever more severe steps to impose its control over significant sectors of the economy, and at the same time, adopt restrictive policies to combat the virus. Also looming is a potential real estate crisis which could threaten a national financial upheaval. These myriad challenges are expected to slow the recovery and further exacerbate supply chain disruptions. On the other hand, if the government is successful in its virus containment measures and simultaneously stimulates the economy, there could well be a large boost to global demand. The stocks of Chinese companies were severely damaged in 2021 and we think a period of improved credibility is necessary to restore long-term investment prospects.
The economies and equity markets of Europe have been underperformers relative to the US for so long that it would be easy to dismiss the possibility of a renaissance. Yet, this may happen in 2022. European companies and economies are in the best position relative to the rest of their international competitors as they have been in years, sporting solid GDP growth, higher vaccination rates, strong corporate balance sheets, and healthy consumers ready to spend. The political authorities and the European Central Bank are determined to keep economies open and vibrant. European stocks, particularly in the financial, industrial, and consumer sectors, could well provide positive earnings and stock price surprises.
A major factor influencing all financial markets, in particular the bond market, will be the response of investors to the new policies of the Federal Reserve. We think that a key component of a moderate growth scenario will be a rise in bond yields, with the yield on the benchmark 10-year US Treasury Note topping 2.0%. In the hyperdrive economy scenario with higher inflation, the 10-year US Treasury Note could even top 3.0%. We do not consider these yields to be competitive with the total return potential of common stocks, and bonds with maturities more than 10 years could well experience a negative total return. The major attractiveness of bonds will be to provide portfolio stabilization in the event of a surprise recession and bear stock market.