News & Insights

In the wake of lockdowns and restrictions that throttled the services sector, the U.S. economy in 2022 needs to return to form without aid from the fiscal and monetary stimulus that carried many consumers and businesses through the pandemic. The data has been volatile and sometimes contradictory. GDP contracted -0.6% in the second quarter, markedly better than the first quarter’s revised change of -1.6%. Unemployment ticked higher to 3.7% in August, but for the best possible reason—employers hired at a rapid pace while workers came off the sidelines and returned to the workforce even faster. Labor force participation has remained stubbornly below its pre-pandemic average, causing fears of a permanently lower equilibrium. Those fears may be overblown.

Inflation has slowed thanks to retreating energy prices. After a flat July, August’s CPI report showed a 0.1% month-over-month increase. The uptick dashed hopes that the CPI would politely roll over and recede back to its old normal. Energy declined 5% month-over-month but remains up 24% in the last twelve months. Food costs rose 0.8% and are up more than 11% in the last twelve months, their fastest annual increase since May 1979. Core inflation outside of energy and food was 6.3% for the 12 months ending August. The report all but ensures another 0.75% interest rate increase at the next Federal Reserve meeting. Interest rates rose and stocks fell. The U.S. dollar strengthened apace.

Timing the market is futile. Recall March 9, 2009. Unemployment was skyrocketing, large banks like National City and Washington Mutual had been shut down, and GM and Chrysler were teetering on the edge of bankruptcy and threatening to take down the whole automotive supply chain with them. Things were bad and more bad news was ahead of us. What a foolish time to invest in stocks! Yet, that was the bottom. Why? Because the sellers had finished their selling. However, they don’t issue memos to let others know it is okay to invest again. But from that point, in fits and starts, the market recovered. Eventually, the economy recovered as well.

The stock market hit its recent low on June 17th with the Dow dipping below 30,000 and the S&P 500 reaching 3,636. Since then, stocks have staged a significant rebound despite negative sentiment in the business and investing communities. At recent quotes, the Dow and S&P have risen 13% and 18%, respectively, from their June lows but remain 8% and 11% below their all-time highs. The tech-heavy NASDAQ, once down 35%, has rebounded 24% but is still down 19% from its high.

These days being an investor takes fortitude. Since the start of 2022 stocks and bonds have each generated double-digit losses, upending the conventional wisdom that when stocks fall bonds rise, cushioning the blow to an overall portfolio. Further, elevated inflation levels not seen since the 1970s erode the value of holding cash and further exacerbate stock and bond market losses.

The economy continues to produce mixed signals regarding whether it will enter recession. Because the stock market looks ahead 6-9 months, its bear market performance has endorsed the recession argument. Further, after the Fourth of July the bond market joined the recession camp as the 2-year bond yield surpassed the 10-year rate to create an inverted yield curve. These stock and bond market signals haven’t always led to recession, but the odds now seem better than 50/50.

There are mixed signals as to whether or not the economy will soon enter recessionary territory, but the odds appear to be rising with every week that passes. The stock market seems to be screaming “yes,” but economic statistics are saying, “Whoa, not so fast.” The difference is that the stock market looks forward about six to nine months while economic stats reflect the past.

Retail sales increased for four straight months through April, though they took a step back in May. Likewise, industrial production has risen for four straight months. The Purchasing Managers Index reflects activity in the manufacturing and service sectors, and remains strong in both the U.S. and Europe, although it is down slightly from recent months. Yet, confidence surveys of consumers and small businesses are in the tank.

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.