07.08.2022 Market Recap: No Place to Hide
It all started with inflation. Fueled by a combustible blend of monetary stimulus and unprecedented government support during the pandemic, inflation broke out of its 40-year downtrend and surged to levels not seen since the Reagan Administration. Throughout 2020 and 2021, the US government doled out more than $10 trillion in unemployment benefits as part of an even larger pandemic relief package. By year-end 2021, the inflation rate hit 7 per cent year over year, fueled by a 50 per cent rise in unleaded gasoline and a 6.4 per cent hike in food. Inflation continued to nudge higher, reaching 8.8 per cent in May.
This 1980s-style inflation got the Federal Reserve’s attention. Chairman Jay Powell quickly pivoted his view on inflation from “transitory”, implying the inflation spike is temporary and will gradually subside, to “persistent”, meaning we face an increased risk of a wage-price spiral without swift central bank intervention. In a world of investment risk taking, the valuations of whatever one invests in – whether stocks, bond, commodities or currencies – rely on interest rates, the universal discounting mechanism. So, when yields rose at the beginning of the year, nothing was safe.
Rates climbed nearly two percentage points across all maturities, sending bond investors scrambling. The yield trajectory was the steepest in decades. The investment-grade bond market was punished, plunging 5.9 per cent in Q1 and 4.7 per cent in Q2, leaving an historically stable asset class more than 10 per cent smaller as of the end of June. In fact, Q1 and Q2 represented two of the worst quarterly returns for bonds since 1980.
Though credit conditions deteriorated slightly this year, the yield premium lenders required to extend loans to weaker borrowers was relatively quiescent when gauged against the change in yields.
Higher yields and a Federal Reserve hell-bent on beating down inflation weighed on equities. It was a rude awakening for an asset class that spent more than a decade basking in an easy money environment. From the beginning of 2020 through the end of 2021, the S&P 500 expanded 48 per cent, more than double the rate of earnings and dividends growth over that timeframe. Pressure had been building from the beginning of this year, but it was Russia’s invasion of Ukraine that proved to be the last straw that sent stocks reeling. Large caps plunged nearly 20 per cent over the first six months of the year, dragged down by a 33 per cent pullback in consumer discretionary; technology and communication services were each off nearly 30 per cent. Energy, the only sector in the green, surged nearly 30 per cent as crude oil spiked to over $120/bbl. Growth companies, a sector that feeds off low rates, gave back one-quarter of their value over H1, while value stocks and dividend payers fared relatively better.
Notwithstanding the speed and magnitude of the selloff, the equity market’s reaction was nearly perfectly in lockstep with the two per cent rate rise and the change in earnings growth expectations. From that perspective, the selloff appeared more like a correction than a bear market. A two-percentage-point increase in rates corresponds to a roughly 20 per cent decline in equities, given the market’s price/earnings (P/E) ratio at the beginning of the year. Moreover, volatility, while higher, has remained remarkably contained throughout the selloff. The CBOE Market Volatility Index (VIX) briefly touched 36 in early March, but spent the first half of the year below 30, on average. It wasn’t long ago – March 2020 – when the pandemic-induced selloff spiked the VIX to 80 in March 2020. Equity holders have maintained an orderly decline and have generally not sold out of their positions. The number of shares outstanding for largest S&P 500 exchange-traded fund (ETF) has remained relatively constant during the selloff, with about five per cent fewer share outstanding compared to the beginning of the year, suggesting that holders are standing pat.
Today’s inflation is the result of crimped supply resulting from global pandemic-related lockdowns and the war in Ukraine converging with excessive demand fueled by pandemic-related monetary and fiscal stimulus. Unfortunately, the Fed has only one tool, interest rates, to moderate economic activity. Crimping demand is their only arrow for targeting inflation. They can’t, for example, address supply. The average price of a gallon of unleaded is $4.81, up from $2.50 pre-pandemic. Overall wages are rising 5.2 per cent, their swiftest pace in decades. Economists fret the immense demand destruction required to rein in food costs, energy prices and wage growth to pre-pandemic levels could send the economy into recession. While investors estimate how much the Fed will need to tighten, one thing is certain: the monetary policy authority has effectively wrung out speculation. Cryptocurrencies, a primary beneficiary of liquidity-addled point-and-click investors, plunged as the Fed drained the liquidity swamp. Bitcoin (BTC), which kicked off 2022 at over $46,000, had plunged nearly 60 per cent by the end of June to $18,731.
We are already seeing evidence that higher rates are inhibiting demand. Housing activity, now saddled with higher mortgage rates, is rolling over. The spike in mortgage rates will make homes less affordable. We estimate that “fair” value for the median home price will fall to $335,000 from $419,000 as of the end of last year. Mortgage activity, for both purchases and refinancing, has skidded.
Looking out over the next few quarters, we anticipate slower economic growth, lower inflation and weaker earnings, creating conflicting signals for risk takers. We believe the Fed will quell inflation, but at what cost? The path and magnitude of each factor will determine the course of stock prices. Bond investors are already bracing for recession. The 10-year Treasury yield, which peaked at 3.5 per cent in mid-June, cascaded below three per cent as the yield differential between 2-year and 10-year Treasury notes slipped into negative territory. Each of the last six recessions dating back to the 1970s was preceded by a curve inversion like today.
Small business owners also echo bond investors’ concerns. The National Federation of Independent Businesses measure of small business optimism fell in May to its lowest level since the depths of the pandemic. Hiring plans, however, appear to have stabilized, perhaps reflecting the talent shortage.
Meanwhile, equity investors hold a more sanguine outlook, at least with respect to earnings expectations. Analysts’ forward estimates for S&P profits have not only held in recent months, but have climbed even as stock prices have fallen. Collectively, analysts are currently expecting nearly 11 per cent earnings growth over the next four quarters, a tall order given higher costs and lower growth expectations.
The path of profit growth depends on the trajectory of economic growth. A Cresset study of earnings growth uses the Manufacturing Purchasing Managers’ Index (PMI) as a business activity proxy. History suggests year-over-year profit growth could fall 20 per cent or more during economic recessions. While we expect a recession sometime over the next 12 months, we’re not anticipating a profit pullback of the magnitude of 2008 or 2020, when earnings growth plunged between 20-30 per cent. That said, we wouldn’t be surprised if earnings growth were flat for the next few quarters. Even that outcome would require analysts to ratchet down their expectations.
This year’s 20 per cent decline in most equity asset classes has helped create favorable valuations, at least by historical standards. Most equity markets are currently situated in the bottom decile of their 15-year historical range of trailing P/E ratios. The exceptions are US large caps and US small caps, although the small-cap index is somewhat distorted due to a higher allocation to lower-quality companies.
Before we can ring the buying bell on equities, we need to have more confidence in the direction of the 10-year, BBB bond yield, a key component of equity market valuation. Historically, the S&P forward PE moves in lockstep with the corporate bond yield, because the corporate bond yield is a good cost of capital proxy for most stocks. The yield on the 10-year, triple-B bond is a function of two ingredients. The first of these is the inflation outlook. The Treasury market is currently pricing in a slow retrenchment of inflation. So far, however, inflation has been more persistent than we or the market anticipated. Next week’s CPI reading will be a critical input into our thinking on interest rates. The second ingredient of the BBB bond yield is the credit spread – the premium bondholders require to take on incrementally more credit risk than holding “full faith and credit” Treasury notes. This year credit conditions have been remarkably tame, although spreads have widened a bit. Like their equity market counterparts, lower credit lenders have remained relatively sanguine that any economic slowing, or the potential for a recession, would probably not result in widespread downgrades or defaults.
Outlook: Quality Should Remain a Key Consideration in Major Asset Classes as Current Cycle Plays Out
Eventually, our inflation scare will abate as shortages and excesses will find their proper balance and our economy will revert to business as usual, begging the question: what will “business as usual” look like? Our economy sits at the crossroads of two conflicting secular trends. First, the disinflationary benefits of globalization have run their course. Global supply chains optimized the cheapest sources of production, even though the pandemic exposed the vulnerability of sourcing supply from faraway places. Marginally lower-cost benefits and reshoring will eventually put upward pressure on prices. Additionally, domestic workers are emboldened, putting upward pressure on wages. At the same time, aging demographics and technological disruption tend to keep inflation subdued. We expect technology and innovation to more than offset the inflationary forces of reshoring and higher labor costs, ushering in an investing environment like the one we experienced between the financial crisis and the COVID pandemic, typified by low growth, low interest rates, excess savings and high-quality growth companies leading the equity market. The next generation of FAANG will share a growth mindset, be relatively insulated from the vagaries of the economy, and possess a high market capitalization per employee, meaning they won’t be susceptible to rising labor costs.
In the meantime, we expect our current cycle to play out over the next six to eight quarters, during which growth and rates moderate and the Fed begins to lower rates. Bond investors are beginning to price in Fed easing next year. In such an environment quality is paramount for both equity and bond holdings. Remarkably, quality as a factor currently trades at its biggest discount to the market in years. We prefer holding high-quality companies with track records of consistent and expanding dividends as we navigate the current cycle.
A comparison of our current bear market to other recession-induced bear markets suggests we’re in the middle of the pack historically speaking, with the median pullback at -18% with 9 months to recover the previous peak. Given that we’re already more than six months into the downturn, we don’t expect the S&P 500 to recover its December 2021 level by the end of September.