Jittery Market on Muddied Outlook
Investors have turned more bearish since the end of the first quarter and perhaps not without justification. The S&P 500 has fallen over 10% while the yield on the US 10-year treasury has risen over 78 bps to 3.12%. Market participants certainly have a lot to weigh and are expressing their worry by selling the most expensive parts of the market. Economic statistics have provided fodder for investor angst including a surprising -1.4% print on first-quarter GDP and the lowest productivity since 1947. The Federal Reserve is largely seen as behind the curve in reducing inflation which continues to run at multi-decade highs. While the concerns are understandable, there are still many reasons to be constructive on the path forward.
Reasons for Optimism
The key reason we feel this may be a short-lived downturn is labor market strength. The latest JOLTS report shows nearly two job openings for every unemployed person. The April employment numbers showed an additional 428k jobs created leaving the unemployment rate at 3.6%. Incomes continue to rise although at a slower pace which is positive for the inflation outlook. While the COVID crisis is essentially behind us, it still affects parts of the US workforce but to an ever-decreasing degree. The labor market is likely to only grow more constrained over the coming months, bringing the unemployment rate to all-time lows
The consumer’s financial position is another reason for optimism in the outlook. Debt loads near all-time lows, excess savings of over $2T above pre-pandemic level, and higher incomes make for an engaged consumer. Travel in the first quarter has exceeded pre-pandemic levels by some measures despite higher gas, hotel, and rental car prices. There are signs that higher prices have dampened retail spending, but that is a positive sign for the inflation outlook. Gas prices are a fly in the ointment as they tend to have an outsized effect on sentiment. Prices would have to surge to almost $6/gallon to reach the highs in real terms we saw in 2008. We realize this is of little comfort for anyone filling their tank, but it points out that we have weathered much rougher waters.
The business environment is holding up well despite the pressure of higher wages and input costs. Corporate earnings and profit margins remain at all-time highs. We could see a slowing given all the growth to date but it is not showing up in the forward earnings estimates. Both ISM surveys (manufacturing and services) are solidly in growth territory, although slower than last year. Balance sheets are healthy with debt levels at their lowest level going back to 1990 when the data started. Companies have invested heavily over the past few years in technology and capital equipment to become more resilient to future shocks. In summary, corporate America is positioned to weather the challenges which we will discuss below.
Reasons for Concern
Inflation continues to be our top risk for the economy and markets. Headline rates are at levels not seen since the Volcker years of the early 80s. Higher food and gas prices have dampened consumer sentiment in the latest surveys despite being upbeat about expectations for higher future wages. There have been some positive signs that the worst could be behind us. First, the growth rate of inflation has slowed over the past three months as prices have stabilized or fallen in critical categories. Additionally, investors are pricing in much lower inflation over the next 5-10 years than over the next two years. Historically the opposite has been true with most participants expecting inflation to increase in the future. Inflation is primarily a psychological phenomenon so knowing expectations is key to predicting its future level.
Largely related to inflation risk is the Federal Reserve’s rate path. They are under intense pressure to bring down inflation that many blame them for allowing to run too hot. We would argue that excess fiscal stimulus combined with a supply shock caused most of the damage, but we leave that to the academics to resolve. The Fed has a poor track record for engineering a soft landing, but it has been done. Our expectation is that inflation will slow demand enough to bring prices back in line while the Fed moves slowly back to a more neutral rate.
The final concern is the future path of interest rates and how they affect equity valuations. We have been calling for and positioning client portfolios for higher rates over the past 18 months. While rates can be a concern if driven by poor fiscal discipline, they also can be in response to an economy with a higher nominal growth rate. It is a sign of a healthy market for interest rates to compensate investors for duration and credit risks. The conclusion is not to worry about higher rates at current levels.
Economic indicators mostly point to a growing economy and estimate the chance of a recession to be less than 30% over the next year. We expect further market volatility as we transition from a zero to a more neutral Fed funds rate. Strong consumer and business balance sheets should provide the ballast needed as inflation begins to trend lower. We have taken several steps to reduce risk in the current environment, including lowering equity exposure and fixed income durations in balanced accounts and reducing growth shares in our equity portfolio.