The slowing economy: Q2 2022 market analysis
Economic activity is clearly slowing and many of our recession indicators are flashing yellow. Spiking inflation coupled with higher interest rates is weighing on the consumer. We had the Great Recession in 2008-2009. We had the Great Moderation from 2010 to 2019. We’re in the middle of the Great Resignation. And now we are starting the Great Slowdown. Given the rapidly changing data, we think the Great Slowdown theme includes a high probability of a mild, short-lived recession.
Inflation and interest rates
Spiking inflation remains in the limelight. While it’s too early to call for peak inflation, there is evidence that core inflation is starting to abate. The swift spike in inflation has led to a strong reaction from the Federal Reserve, causing its narrative regarding interest rates to change swiftly. These big shifts have shaken consumer confidence. So far, the Fed has continued to modify its rate expectations higher, but a decision to pause or lower rates can happen just as quickly and becomes a possibility once the economy slows and inflation starts to subside.
Numerous economic variables are now waiving a yellow flag, suggesting the probability of a recession is 50%. However, some variables are sending mixed signals and only suggesting an economic slowdown.
Consumers continue to be nervous about inflation. Higher energy prices, food prices and mortgage rates have changed consumer’s purchasing patterns. Consumer confidence indices, along with business confidence, continues to plummet, increasing the likelihood of a recession.
On the other hand, the manufacturing data has been shown mixed signals. New Orders, a leading indicator, has dropped below the critical 50 level suggesting a recession is on the horizon. Yet other manufacturing data remains robust and suggests the Fed may be able to orchestrate a soft landing it is hoping for and avoid a recession.
The all-important labor market has yet to flash a warning sign. Unemployment at 3.6% and payroll growth above 4%, both remain resilient and reinforce the argument that a recession is not imminent.
Risk of recession
The Great Slowdown we’re facing will more than likely morph into a short-lived, mild recession sooner than we anticipated, perhaps by the end of this year or early next year. Given the mixed data, we think the probability of a recession is a coin toss. In addition, the National Bureau of Economic Research, the official recession caller, has changed its definition of a recession. It’s no longer as simple as two consecutive quarters of negative GDP.
Outlook for what’s ahead
This year, while GDP should remain positive, we expect it to fall somewhere between 1.5% and 1.9%, a Great Slowdown from last year. The data leads us to believe that we will see some type of recession toward the end of the year or in early 2023. Unemployment will likely remain around 3.6% this year. Fed Funds expectations have risen to 3.50% this year. However, the 10-year treasury hit 3.50% earlier in the year and may trend lower by the end of the year. Historic data tells us we could see a rally in stocks, which could get us to somewhere between a -5% or maybe a 0% rate of return for the calendar year.
Inflation and the Fed
Inflation continued to surprise on the upside during the second quarter, with headline CPI hitting 9.1% in June. Core measures of inflation (excluding food and energy) have moved slightly lower over recent months, but remain stubbornly higher than the Fed’s target (2.0–2.5%). Gasoline and grocery prices are consuming a super-sized portion of the average family’s monthly spending, and are threatening to begin crowding out purchases of other goods and services. The Fed is now forced to address the painfully high headline CPI numbers in an aggressive fashion, and its tone turned even more “hawkish” at the end of the quarter.
The Fed moved overnight rates up by 0.75% in June, to 1.75%. Along with this aggressive move, the Fed’s forecast for the next 18 months moved substantially higher. They now estimate that overnight rates will reach 3.50% by year-end, and then move even higher in early 2023. This was a sharp upward revision to previous estimates, and a clear signal that they are willing to risk severely dampening economic activity in order to reign in Inflation. This new assertiveness from the Fed put a cloud of heightened uncertainty over the financial markets. As market participants struggled to discern whether we are headed toward a soft landing or a moderate recession, interest rates continued to grind higher, and bond returns, again, turned sharply negative for the quarter.
We continue to believe that inflation will move modestly lower towards year-end, as supply and labor constraints begin to moderate. Food and energy prices tend to move in rapid cycles—leading us to expect them to soften over the next few quarters. However, housing costs have become a big driver of the inflation story. Housing and rent prices are considered to be “sticky”—moving up and down in longer, more sustainable cycles. It is unlikely that housing cost pressures are going to abate over upcoming quarters, and this will make it unlikely that inflation will fall smoothly to the Fed’s target of 2.0-2.5%—it may become stuck in the 4.0-4.5% range.
If inflation is trending lower, the Fed may be able to pause rate increases and soften its messaging about future moves. This could be a welcome boost for market participants late in the year.
The probability of a mild recession has increased, we believe there is a 50% chance of a recession.
High-yield (HY) assets were rocked by the same risk-off sentiment that hit the equity market during 2Q. Returns turned sharply negative, as the aggressive Fed commentary forced investors to price in the possibility of a recession. HY spreads moved out sharply, but not in the magnitude that we typically see before oncoming recessions. Consumers and the economy appear to be on strong enough footing to expect, at worst, a mild and short-lived recession, if one were to occur. For those reasons, we continue to maintain allocations in the HY sector, as part of an overall neutral exposure to risk assets.
Bond market forecast
Despite the new outlook from the Fed, our forecast for the 10-year treasury rate is only 3.00% for year end 2022. The bond markets are indicating that the Fed’s fight with Inflation is nearing an end, and longer-term interest rates are pointing to lower inflation and modest economic growth in 2023 and beyond. We believe long-term rates will move only modestly higher through year-end, and will settle around 3.00%, well below the overnight rate. Yields are now substantially higher than when the year started. With rates moving only modestly higher from here, we now expect bonds to start producing positive returns during the second half of the year.
Equity markets: A historically tough start to the year
U.S. stocks continued to fall in the second quarter, prompting the S&P 500’s worst first-half performance since 1970. Much of the losses were driven by spiking inflation and the policy response from the Fed, leading the S&P 500 to tumble 20% YTD, while the tech-heavy Nasdaq Composite index declined 29% YTD.
Inflation’s impact on equity markets
How does inflation impact equities? We focus on three types of inflation; input inflation, wage inflation, and consumer inflation:
- Input: Higher input inflation increases prices of inputs to the production process, like raw materials, labor and overhead. Due to higher prices for inputs, companies experience lower profit margins, which negatively impacts stock prices.
- Wage: Higher wage inflation pressures corporate earnings. We are starting to see a slowdown in hiring, which means less wage growth and would be positive for corporate earnings. So far, it’s encouraging to see lower wage growth without the need for massive layoffs.
- Consumer: Consumers are facing rising food and energy prices, which eventually reduces demand for goods and services. This lower discretionary spending in-turn reduces corporate earnings.
While inflation has been a headwind all year, we’re starting to see some signs of moderation in things like commodities, a positive sign for stocks.
An economic and earnings slowdown/deceleration is mostly priced into equity markets. Even though headline GDP is negative, nominal GDP (which is not adjusted for inflation) should remain positive and help drive revenues. Moderating wage growth should also help keep margins elevated, meaning even if the economy slows revenue can still grow. All of this supports a potential back-half of the year rally in stocks.
Equity markets forecast
While valuations have already compressed due to higher inflation, there is some good news. Commodity prices have been coming down, stocks do well when inflation decelerates and even if we do enter a recession, stocks tend to lead the economy and historically, stocks generate robust returns following recessions.
Therefore, we have an optimistic outlook for a strong rally in the back half of 2022.
Our 4,500 year-end price target for the S&P 500 implies a -5% total return for the year but includes a 20% rally in the back half of the year. While a strong rally may seem like a big ask, history shows that robust rallies can happen quickly, especially around recessions, or when inflation stabilizes.
Inflation and Fed: Interest rates
- Spiking inflation continues to be one of the biggest threats to the market and economy.
- The top dark blue line is headline inflation, the Consumer Price Index, CPI. Year-over-year headline inflation is up 9.1%, a 40-year high.
- The Fed prefers to look at core inflation, shown by the light blue and the green lines. These measures of inflation remove the two most volatile categories—food and energy prices.
- While it’s too early to call for peak inflation, core inflation is trending lower, with both core CPI and core PCE trailing off over the last three months. Numerous commodity prices have decreased in the past few months, such as oil, copper, lumber and wheat.
- The overall trend may be turning in a more favorable direction. However, all inflation measures are still well above the Fed’s target zone.
- Consumer expectations for 3%+ inflation indicate a concern that the Fed may have trouble getting inflation down to their target of 2.5%. The University of Michigan survey of inflation expectations (on the left) illustrates that consumers are more concerned about inflation, but still believe it will come down from currently elevated levels.
- Market inflation expectations are shown on the right. These are 5-year forward Inflation expectations from the bond markets.
- Market inflation expectations have risen lately, but remain well anchored near the Fed’s target zone (orange lines).
- Consumers and the markets are suggesting lower inflation in the next few years.
- While the Fed has retired the word “transitory” from its vocabulary, they’ve added “flexible.”
- Shown in dark blue is what the Fed calls its “flexible” inflation components. This includes items like food, energy, automobiles and travel. Flexible components have started to roll over, with things like auto, travel and leisure prices starting to fall.
- On the bottom, in light blue, we show the sticky components of inflation. Unlike flexible components, sticky components continue to rise, mostly driven by the cost of housing.
- There is a reasonable chance that inflation abates but could easily be stuck well above the Fed’s comfort zone of 2-2.5%
- Energy has one of the most consistent boom-bust cycles, and while it is difficult to forecast the duration of each cycle, these cycles have been intact for decades and are unlikely to change.
- West Texas Intermediate (WTI) crude prices were approximately $50/barrel before The Great Recession in 2007. By mid-2008 WTI had spiked to $140/barrel. Yet by the end of 2008 it was back down to around $40/barrel…a classic boom/bust cycle.
- Just two years ago oil prices were briefly negative…sellers were paying buyers to take oil off their hands. But very quickly oil went from virtually $0 to $125/barrel…a bust/boom cycle in the extreme.
- While we don’t know the duration of this cycle, we do feel that supply constraints will ease, allowing oil prices to trend lower —easing inflationary pressures.
- The spike in inflation has led to a strong reaction, causing the Fed to dramatically change its verbiage around what it’s planning for overnight rates.
- The Fed moved rates up by 0.75% at the June meeting, bringing overnight rates up to 1.75%. They now expect overnight rates will move up to 3.5% by the end of this year before taking it higher again in 2023.
- Given the potential slowdown we’ve discussed, The Fed may already be lowering rates by the time we get to the early part of 2024.
- This significant change in the Fed’s outlook caused an increase in volatility in the financial markets. We are now grappling with the probability that the Fed’s aggressive stance could cause a mild recession.
- The “slope” of the treasury curve (10-year rate minus 2-year rate—light blue line) has a good historical record of inverting before recessions.
- While we recently saw the 2-year and 10-year slope invert, historically the inversion has occurred up to 24 months in advance of the next recession.
- The Fed prefers the 3-month and 10-year slope, shown in dark blue. This measure of slope also tends to invert before a recession, but in a more timely fashion, typically 3-9 months in advance.
- While the 3-month and 10-year slope has not inverted, it has been flattening. This sends a cautionary signal and is something we believe points to rising risk of a potential recession.
Economic fundamentals and recession risk
- The six-month rate of change in the Leading Economic Index (LEI) is one of our favorite recession indicators because of its almost perfect track record of predicting an oncoming recession.
- Historically, when the six-month rate of change crossed below -3.5%, a recession was soon to follow. Recently, the LEI index crossed below this threshold and now sits at -3.7%, increasing the odds that a recession may be near.
- While the LEI calculation uses 10 different leading indicators, weak consumer expectations was a big driver of this recent drop.
- Consumer confidence is critical to economic activity. The Conference Board’s Consumer Confidence Index (dark blue) is more focused on the labor market and the University of Michigan’s Consumer Sentiment Index (light blue) is focused on household finances.
- Both are trending lower due to stimulus programs terminating and spiking inflation. With both indices headed lower it suggests we will experience a steady slowdown, and hints that a recession may be coming. As they continue to move lower, the chance of a recession in late 2022 or early 2023 continues to increase.
- One area that suggests we are not in or near a recession is the labor market.
- Unemployment remains stuck at 3.6% for the past four months. Typically, you see the unemployment rate go up months before a recession as businesses implement layoffs to protect their margins.
- Another supportive variable is payroll growth. In Q2, payroll growth averaged 375,000/month, a stellar 4.3% growth rate, rebutting any idea of a recession.
- Typically, payroll growth slows prior to a recession. When growth slows to 1%, a recession is looming.
- Initial jobless claims have moved slightly higher, edging up from the 54-year low reached in March. There is plenty of room for this measure to move higher before triggering recession warnings.
- The firm labor market gives ammunition to the Fed to continue to increase interest rates.
- The top pane is the ISM Manufacturing Index. Prior to recessions, the manufacturing data starts to weaken. The orange arrow on the far right, shows manufacturing slowing down, which does cause us concern. However, 50 is the critical level, above 50 suggests an expansion and below 50 indicates a contraction.
- The New Orders Index is shown in the middle pane. We think this variable is the most leading indicator. You can see New Orders unfortunately broke below the 50 number, suggesting increased risk of recession.
- We also look at Non-Manufacturing or Service data (bottom pane). Similar to the Manufacturing Index, it continues to come down, but it remains at a very elevated level of 55.3.
- All of the data suggests a slowing economy. New Orders is hinting of possible recession, but the other manufacturing data suggests the Fed may be able to orchestrate the soft landing they are hoping for avoiding a recession.
Financial markets: Equity
- The charts on the left show two examples of business cycle downturns.
- In each time period, a similar pattern emerged, equity markets declined first, the economy worsened a few months later and then equity markets bottomed (circled in orange) while the economy was still getting worse (circled in green).
- The two examples we show are not rare, the same pattern emerged as we looked through all of the most recent downturns.
- So, while history doesn’t always repeat itself, it certainly appears that same trend could be happening again today, with the S&P 500 already falling more than 20% YTD while the U.S. has slowed but not yet entered recession.
- The double dip recession in the early 80’s had many similarities to today:
- Incredibly rare period where stocks, bonds and commodities all sold off
- Fed leaders battling decades high inflation
- Major commodity-producing country invaded major commodity-producing neighbor
- If ‘81-’82 acts as a general template of what we can expect now, the good news is we may have already experienced the majority of losses given the similar drop in both periods.
- While the extended rally may still be a little ways off, the chart shows opportunity is knocking. The Fed and markets often pivot quickly and you have to be in the market to capture these big moves.
- At the end of 2021, valuation multiples sat near 23x forward earnings. We’ve since seen these multiples drastically fall but we still have to consider where the bottom may be.
- What we have found is that over the last decade, markets have bottomed after reaching levels around 14–16x forward earnings.
- As we enter the second half of the year, the S&P 500 has already fallen close to that threshold on a market cap weighted basis, now sitting at 16.7x forward earnings.
- If you look on an equal weighted basis, shown in green, valuation multiples have already contracted even further and currently sit within the range of other valuation bottoms.
- What this tells us is while there could still be some additional downside, the downside is likely to be limited, given the sharp reduction in multiples we’ve already seen.
- Odds are increasing we could see some kind of mild recession over the next 12 months.
- Taking a look at the peak to trough declines for past recessions, highlighted in orange, you can see the median decline for stocks is 24% and avg. decline is 29%.
- The S&P 500 already declined 23% by mid-June. So, while the market could move lower, given how far the market has already fallen we’re likely getting closer to finding a bottom.
- If we are close to a bottom, looking at the green box we see that one-year later markets on average move 40% higher and the market typically keeps going up from there.
- This leads us to believe that now is not the time to be running away from the market. Instead, the market is providing opportunities for long-term investors.
- A pullback in commodities helps signal peak inflation and a slowing economy, and we’ve seen a drastic pullback across commodities over the last few months.
- Copper for example, a global indicator for manufacturing, has dropped more than 20% over the last two months.
- Lumber has also fallen dramatically, as rising rates and inflation have caused a slowdown in home builders and dropped lumber prices more than 50% in just a few months.
- Falling commodity prices should help bolster corporate earnings as input costs decrease, easing margin pressures.
- While it’s still too early to know if inflation has peaked quite yet, general consensus is that inflation will peak soon, if it hasn’t already, and continue moving lower.
- As you can see in the chart on left, the direction of inflation has a high correlation with the returns of the S&P 500.
- Historically, inflation that is unchanged or trending lower has been bullish for stocks.
- This is especially true if inflation is sitting anywhere from 6% or higher, like we are today.
- So, if we’re directionally correct and we see lower inflation, it should be a boost to S&P 500 returns.
Financial markets: Fixed income
- Historically, near the end of interest rate cycles the 10-year Treasury rate and the Fed Funds rate peak together, both in terms of level and timing.
- This pattern is highlighted on the chart, where the last three cycles all saw Treasury rates and Fed Funds rates peaking within a few months of each other.
- Treasury rates have been falling since early June. Historical experience would tell us that it may be too early to consider that this is the peak in rates. The Fed is projecting to increase rates for at least another year—history would tell us the peak in Treasury rates is yet to occur.
- The Fed projects overnight rate increases through 2023.
- Historical experience would tell us longer term rates will not peak for quite some time.
- While the peak in rates may still be well into the future, we do not believe they will move dramatically higher.
- The worst of bond market returns are likely behind us.
U.S. market performance: Equity and fixed income
- U.S. stocks continued to fall in the second quarter of 2022, prompting the S&P 500’s worst first half since 1970. Much of the losses were driven by spiking inflation and the policy response from the Federal Reserve, leading the S&P 500 to tumble 20% YTD, while the tech-heavy Nasdaq Composite Index declined 29% YTD.
- Declines impacted all sectors, but on a relative basis the more defensive consumer staples and utilities sectors outperformed. There were some notable decliners, Tesla endured its worst quarterly decline since it launched in 2010 and Amazon dropped almost 35%, the most since the Dot-com bubble burst back in the early 2000’s.
- We expect volatility to remain elevated as we navigate the back half of the year, however this does not mean we recommend selling stocks. While there could be some additional downside, the market tends to react quickly to positive data so it’s important to stay invested and maintain a long-term outlook.
- Persistent high inflation and aggressive moves from the Fed pushed rates higher.
- Higher rates again pushed returns sharply into negative territory for the quarter. YTD returns are severely negative, exacerbating the losses experienced in equities.
- We believe rates could move higher through year-end, but only modestly so. Returns are likely to be negative again for calendar year 2022.
- Yields have reached 3% for most sectors of the market. The forward outlook for bonds is improving. Income focused investors can now generate reasonable yields from their bond portfolios—a welcomed change from the last 10 years of near zero rates.
Real Gross Domestic Product (GDP)
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