News & Insights

The S&P 500 barely avoided a 20% drawdown, the recognized threshold for entering into a bear market. After a recent bounce, it is currently down 15% on the year. The more volatile NASDAQ 100 is down 23%. Despite this year’s weakness, both indices remain well above their pre-pandemic highs, even in real terms adjusted for significant inflation. Bulls can take heart that the stock market has made good progress despite the unimaginable stress and uncertainty of the past three years, while bears may believe that stocks still have plenty of room to fall back to reality.

Who is right? Have we seen the bottom or not? The only reliable answer is maybe. FactSet’s John Butters notes that based on estimated forward earnings, the S&P’s P/E ratio is below 18 for the first time since the pandemic started. From a pure valuation perspective, we have come full circle. That said, stocks tend to carry lower P/E’s when interest rates are higher and also when economic conditions are softening, both of which are currently true relative to pre-pandemic levels. On the other hand, inflation tends to push stocks higher, and expectations for a new normal of somewhat higher inflation rates would support higher stock valuations.

After taking extraordinary measures to counter the impact of the pandemic, the Fed can reasonably claim “mission accomplished” as it relates to the full employment component of its dual mandate. The March report showed employers added 431,000 jobs while the unemployment rate dipped to 3.6% from 3.8% the prior month. This was only slightly higher than 3.5% registered in February 2020, representing a 50-year low. Job gains were also revised higher for the first two months of this year. Employment has rebounded sharply, with the economy now possessing just 1.2 million fewer jobs than in February 2020, a far cry from 21.6 million fewer jobs at the trough two years ago.

Labor force participation continues to run below pre-pandemic levels but is recovering. In March it inched up to 62.4% versus a recent low of 60.2% in April 2020. There are multiple drivers leading individuals to rejoin the workforce including declining household savings, as well as lower Covid cases, allowing workers who were home with children during school or caring for sick family members to return to the workforce. It would be helpful if this trend continues given there are currently more job openings than unemployed workers. Also reflective of the tight labor market, workers are quitting their jobs at near record rates, often for better opportunities. Fed Chair Powell has even expressed concern that the job market may be overheating, feeding higher inflation. Average hourly earnings grew 5.6% in March from the prior year, though this remains below most measures of inflation.

Vladimir Putin’s attack on Ukraine jarred global financial markets. Western democracies have responded with financial sanctions against Russia and its citizens, causing the ruble to suddenly lose roughly one-third of its value relative to major foreign currencies. Global investors are rushing to divest their Russian assets, but their efforts are frustrated by a lack of natural buyers and by the fact that the Russian stock market has been closed since February 25th. Nobody knows what Russian financial assets are currently worth.

Commodity prices and defense stocks jumped after the invasion. In the midst of a broad stock market selloff, Merrill Lynch sardonically proposed a new list of FAANG assets replacing the old investor favorites of Facebook, Amazon, Apple, Netflix, Google. The new FAANG according to Merrill? Fuels, Aerospace, Agriculture, Nuclear, Gold.

The evidence continues to grow that the Federal Reserve was caught wrong-footed by how rapidly the economy has recovered. Unemployment has fallen more quickly than expected and wages have moved higher. The healing of the labor market and emergence of higher inflation has resulted in a shift in the Fed’s focus towards tackling inflation, a dramatic change from recent years when it was more worried about inflation persistently running below its targeted 2% level. In less than a year, the Fed has transitioned from forecasting no rate increases before 2024 to now expecting as much as a half-point rate hike in the next month. To be fair this wasn’t easy terrain to navigate, as the Fed was reacting to a multitude of highly variable factors such as how quickly the virus receded and how quickly supply chains healed. Still, for an entity that claims to be “data dependent” the Fed seemingly disregarded earlier signs we were headed in this direction.

The January CPI showed inflation of 7.5%, a 40-year high that was ahead of already elevated expectations. Core prices, which strip out volatile food and energy, advanced 6.0%. Supply and demand imbalances related to the pandemic continue to contribute to higher levels of inflation; however, price pressures have broadened, and inflation tends to be sticky. A stronger economy is pushing up rents and wages, which appears likely to keep inflation elevated even after supply-chain disruptions ease. Despite downward pressure on inflation as supply chains normalize and base effects take hold, it seems rather presumptuous to believe inflation will cooperate by gently trending lower to the targeted 2%.

While Covid and politics still dominate the general news cycle, the financial news is focused on inflation concerns. Economic growth appears solid, but that is exactly when the Federal Reserve needs to act. In the words of former Chairman William McChesney Martin, the Fed’s job is “to take away the punch bowl just as the party gets going." The challenge is that the Fed failed to notice the party was in full swing for six months. Perhaps the reason it has fallen way behind is that it not only served as bartender but began imbibing its own concoction.

Inflation soared to 7% in 2021, a rate last reached 40 years ago. Even excluding the volatile food and energy sectors, so-called “core inflation” rose 5.5%, the highest in 31 years. Left unchecked, inflation can become imbedded in our cost structure through cost-of-living allowances in wages and Social Security. On top of that, flaws in the way housing is figured into the Consumer Price Index mean that recent increases in home prices and rents have yet to be fully reflected in inflation statistics.

The Federal Reserve operates under a dual mandate with the goal of fostering conditions that achieve both stable prices and maximum employment. Recent developments signal the Fed has pivoted from seemingly prioritizing maximum employment to combating inflationary pressures that could pose a threat to the recovery. The Fed’s move made in response to the pandemic more than a year ago towards easier monetary policy and significant stimulus has had the intended effect. Both U.S. and global GDP have recovered to the point that they have surpassed pre-pandemic levels. U.S. real GDP growth is expected to exceed 5% in 2021 with anticipated growth next year of approximately 4%. The pace of growth from here is contingent upon many factors, including the course of the virus and potential future variants. Early indications for the Omicron variant suggest it is more transmissible but has lower severity. While not exactly an ideal development there is some optimism that can be gleaned from that combination.

Democrats are making a late-year push on tax and spending increases but have struggled to find a strategy that unites the party. Some of the more ambitious revenue (tax) measures have been eliminated, which is probably good for American business. Ironically, government dysfunction usually is.

Pfizer had a good month. The FDA authorized the company’s Covid-19 vaccine for children as young as 5, while its oral antiviral for already-infected patients demonstrated excellent trial data, following on similarly strong results from a Merck antiviral last month. Meanwhile, the wave of infections associated with the Delta variant appears to have peaked across the nation, although trends vary by region. There appears to be a strong seasonal component underlying the infection statistics. Once we get past the winter cold and flu season it seems reasonable to expect that we will start to put Covid behind us.

Covid-19 statistics have improved recently for our country as a whole, although trends differ by region. About 65% of U.S. adults have been vaccinated according to the Mayo Clinic. For those over 50 years old the vaccination rate is higher than 80%. Covid-related fatalities are very rare for vaccinated people. Further good news comes in the form of a new antiviral pill from Merck which improved outcomes dramatically in a placebo-controlled trial, stoking hopes that future waves may be easier to treat. Life is gradually getting back to normal. International travel restrictions are loosening, and most schools have reopened for in-person instruction.

Life is also getting back to normal in Washington DC, where division typically rules. A spat over the debt ceiling looks like a small skirmish in the larger battle over ambitious spending and tax increases. Centrist Democrats hold a lot of power in the Senate and appear to be taking full advantage of their political leverage.

U.S. Covid statistics have lately shown a frustrating rebound. Total infections are running at about two-thirds the previous peak, with total deaths about half their previous peak. Overall, the curve appears to have leveled off since late August. Some public health officials have predicted that Covid will continue to recede, and climb, and recede in a series of progressively weaker echo waves. This could prove to be the crest of a significant wave.

Life is getting back to normal across the pond. The United Kingdom has been a world leader in achieving vaccine access and popular acceptance. The data we have seen argues that serious outcomes are very rare for vaccinated persons, and the UK’s numbers agree. A recent resurgence in cases has been accompanied by a much lower fatality rate compared to the United States. The UK’s health minister recently proclaimed that no more lockdowns are expected for this wave or future waves.

The economy is at a stage when comparisons to year-ago quarters frequently produce ridiculously high numbers because last spring and early summer were depressed. The same observation applies when reviewing results for companies. Increasingly, we compare 2021 figures to 2019 on a two-year “stacked” basis. We found it more productive to bridge over 2020 as problems last year were widespread, not representative, and generally not a company’s fault.

Many economic figures are reported on a year-over-year basis and must be understood in the context of the “base year” (the prior year against which current figures are being reported). Inflation appears to be running hot at the moment, with the Consumer Price Index (CPI) rising 5.4% in both July and June compared to the previous year. However, inflation ran well below the Federal Reserve Board’s 2% target last summer. On a two-year stacked basis, the CPI was up 3.2% (annualized) in July and 3.0% in June. This suggests increasing price pressure.