Running Out of Steam
The opening paragraph of my 2022 Outlook, titled “Running into the Wind,” included this phrase: “As a runner, and one who actually prefers to run in less than ideal conditions because it feels like more of an accomplishment afterwards, I can’t help but think that the investor in 2022 will face similar challenges to a runner in inclement weather.” Now, I do like running in the rain, but a torrential downpour is another story. Perhaps I should’ve been more specific.
First Half: Glad it’s Over
Admittedly, I was foreseeing something along the lines of a disruptive thunderstorm, but what we had in the first half was more like a series of destructive tornadoes. We knew we were facing an inflation problem, but we didn’t yet know it was this big of a problem. We also knew we were heading into a monetary tightening cycle that would challenge risk assets and investor sentiment, but we didn’t expect a war to erupt and create even more fear and uncertainty. I think I speak for many investors in saying I’m glad the first half is behind us. The second one has to be better by comparison…right?
The Nasdaq first entered bear market territory (-20% or more) on March 7th and remains there today. The S&P 500 took a bit longer, finally falling into bear territory on June 13th, and has bounced in and out of it since, remaining close to that -20% line. These numbers are painful to look at, but we can also frame this as progress on valuations.
Since March 2020, rates sat at zero and markets were pumped with liquidity, allowing multiples like the price-to-earnings ratio of many stocks to soar to rather unthinkable levels. Although it was a fun ride to the top, we all worried that the dreaded “mean reversion” trade would have to take hold at some point. Valuations were well above historical averages, and we were on the precipice of a rise in rates. One of the positives we can take from this is that we’ve made quite a bit of progress on bringing valuations back down to palatable levels.
The last thing I’ll highlight about the first half is the bond market, although there aren’t many “highlights” to speak of. The spread between 2-year and 10-year Treasury yields is a widely watched indicator of economic fear, with the dreaded inversion (when the 10-year yield falls below the 2-year yield) as the harbinger of rough waters ahead. We saw two instances of inversion, although shallow and brief, which further fueled the recession debate.
It’s safe to say, the first half was fraught with reasons to worry. Here’s what I think the second half could hold:
Second Half: Bottoms and Bounces
Much of what the market has struggled with is the macro environment and policy shifts that have presented a new, and challenging, environment for consumers and corporations alike. A 40-year high in inflation, aggressive Fed rate hikes, and a new all-time low in consumer sentiment is the set-up we begin the second half with. It could be better, but it also means we’re confirming the economic slowdown that was necessary to cool inflationary pressures.
One Thing Leads to Another
We’ve known for some time that the biggest problem our economy faces is inflation and that problem worsened in the first half. The Consumer Price Index reached 8.6% year-over-year in May, its highest reading since Dec 1981. Although there is much debate over whether this is a demand problem or a supply problem, I’ll settle on saying it’s both, and the only thing the Fed can affect is demand. The real conundrum is how quickly inflation will actually fall before becoming entrenched in the economy and completely resistant to policy tools.
In order for inflation to show “clear and compelling” (in the words of Jerome Powell) evidence of cooling, demand and economic activity need to slow. We’ve seen the start of this in weaker housing market data, retail inventory buildup, a decline in consumer sentiment, and a negative Q1 GDP print.
The Inflation Elephant
Prices haven’t fallen yet, but I’m optimistic that they will — not down to the Fed’s 2% target, but at least below 8% and possibly below 6% by the end of the year. Weaker data points should continue to roll in — the sooner bad news materializes, the more of a bite it can take out of demand, and the faster inflation can fall. Oddly, I welcome the negative headlines for a while.
One way to measure the market’s expectations for inflation is to look at breakeven rates (the rate that makes an investor indifferent between nominal-yielding bonds and inflation-protected bonds of a similar maturity). Even though we want to see these fall further, inflation expectations have already fallen considerably over 2-, 5-, and 10-year horizons. As econ data weakens further, these should drop in response.
If a drop in expectations is coupled with three or more month-over-month declines in CPI data, the Fed is likely to retract its claws. Until then, however, we are on this tightening path and I don’t see the market finding a reason to believe the Fed isn’t a threat until later in summer or early fall.
Is Recession the Only Cure?
The answer is, no. But it’s becoming increasingly likely. I say that bluntly to just get it out of the way and hopefully make readers and investors less afraid of the dreaded r-word. Fed hiking cycles tend to lead to recessionary conditions. Add the rise in oil prices, stubborn inflation, worsening credit conditions, more than one yield curve inversion, weak consumer sentiment, and the case for a recession is mounting. Not to mention we’re already halfway to the technical definition of one, which is two consecutive quarters of negative GDP growth.
I’ll stop short of assigning a probability to the chance of recession. It is worth noting, however, that oftentimes we don’t find out we were in a recession until it’s already over. There’s a chance this time is similar. It’s also worth noting that some Q2 GDP estimates are much lower than the consensus of 3%; in particular, the Atlanta Fed expects a number closer to -2.1% growth. Second quarter GDP results will come on July 28th and market eyes will be watching closely to find out if we’ve actually been in a recession this whole time.
If we have, it’ll go down as a weird one — with a labor market historically tight and still 5.5 million more open positions than unemployed persons, home prices still growing at 20% year-over-year, and corporate earnings showing 10%+ growth expectations for the second half. I tend to think the riskiest fallacy we could fall into is thinking that if we are in a recession now, it absolves us from having another anytime soon. In fact, since this one would be so “unconventional” I think it could be a head fake, with a more classic recession (one where the unemployment rate rises, consumer spending contracts, and corporate earnings turn negative) still possible in the next 12 months. That’s what would be called a double-dip recession and is something we haven’t experienced since the early 1980s, but it did help solve the inflation problem in that period.
Searching for Bottom
Despite many efforts by investors and pundits to call the bottom, pick the bottom level, or time the perfect buy signal, the chances of getting it right are slim. Not to mention, there are a number of different bottoms we need to see as signals that the worst is behind us — namely, a market bottom (which usually happens first), a bottom in corporate earnings growth (which usually follows a market bottom), and a bottom in economic data (which usually happens last).
We still can’t be sure we’ve seen the low in markets, but I feel confident in saying we still haven’t seen the low in earnings or economic data. Despite some downward revisions, corporate earnings expectations are still calling for growth of 11.8% in Q3 and 11.0% in Q4, with full year estimates at 10.8%.
Even if we manage to avert recession, the inflationary picture and sharp contraction in capital markets make these estimates feel too optimistic, and I expect downward revisions across multiple sectors in coming months.
Although that would be a “normal” part of a slowing economy, markets may see further downside on the news because it starts to beg the questions: When does it stop? And what will it hit next?
What it’s likely to hit next is the labor market. It’s no secret that we’ve had a shortage of labor supply in the U.S. since reopening began, and that remains the story today. The last JOLTs report showed 11.4 million open positions, and the last unemployment report showed 6 million unemployed persons. But as corporate profit margins get squeezed by inflation pressure, changes in consumer behavior, and lower stock prices, we are more likely to hear about hiring freezes and layoffs in some industries, and the labor market will loosen. This part takes time, and as mentioned above, falls in the group of economic indicators that tend to be last to crack.
Still Running, Still Windy
When we started the year, uncertainty was a 10/10. It’s been a rough ride so far, but at least we’ve done some work. Although my commentary above about earnings needing to come down, the economy not yet bottoming, and the impossibility of calling a market bottom accurately probably wasn’t the best pep talk, it does indicate that we’re closer now to some of these bottoms than we were in January. I believe this summer season will hold some of the most important months of data, and the fall can hold more promising moves as a cooling economy begets cooling inflation. The remaining wild card will be the Fed and whether its tightening cycle will prove to be effective at bending, but not breaking, the economy.
The market falls first and the market bounces first. The first couple months of the second half may still be a time to cherish your cash positions, but make sure your list of long-term buys is ready and get prepared to start shopping. If I’ve learned anything as an investor, and as a runner, it’s the long run that’s most rewarding.
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