Economy forecasted to bend, not break, this year
Inflation, Fed rate hikes may hamper GDP growth
Shawn NarancichJune 16th, 2022
For the first time in more than two decades, the Dow Jones Industrial Average declined for eight consecutive weeks into late May, the longest since 1932. Similarly, the S&P 500 and NASDAQ dropped for seven straight weeks — the first time since 2011 and 2012, respectively. In light of the material correction we have witnessed across most asset classes, we share our current economic and capital markets outlook.
While the Federal Reserve has only just begun to raise rates, the “bond market vigilantes” are already discounting a substantial tightening cycle.
To that end, while our central bank has only raised the federal funds rate 0.75% year-to-date, interest rates set by investors are up much more. For example, we have seen the 10-year U.S. Treasury yield increase to about 3% today from 1.5% at year-end 2021. This move created a meaningful increase in mortgage rates, which now reside above 5%.
As a result, new fixed-rate mortgage payments on a median priced Spokane-area home—one purchased with a 20% down payment—are now over 30% higher than they were at beginning of this year.
In addition to making housing more expensive to finance, these higher interest rates also have impacted equity markets adversely and have led to a reduction in the current price-to-earnings multiple—a measure of value of the S&P 500—to 17 from 21, which is close to the long-term average.
While it is impossible to predict a market bottom, our assessment of the macroeconomic environment leads us to conclude that the worst of the selloff related to anticipated Fed tightening is behind us.
Inflation has peaked but is persistent. We believe the 8.5% annual increase to the headline consumer price index for the month of March will be the high-water mark for this inflation measure in the current post-COVID economic cycle.
The volatile energy sector propelled this measure of headline inflation to 40-year highs in March as energy markets priced in heightened geopolitical risk and supply constraints associated with Russia’s invasion of Ukraine.
The April CPI reading contained a sequential and welcome moderation in energy prices. However, the “stickier” services sector that includes rent and housing costs continued to trend higher.
The structural undersupply of housing in the U.S. is contributing to the momentum driving prices. At nearly one-third of the headline CPI weighting, housing-related costs will have considerable influence on overall inflation.
While we believe inflation has peaked, it is likely to remain elevated until the forecasted interest rate hikes by the Federal Reserve can induce their intended slowdown in economic activity and aggregate demand.
Though we are confident that inflation will be trending down from its March numbers, it remains to be seen whether the pace of deceleration will be sufficient to approach our current estimate of CPI falling to near 3% by year-end 2023.
We believe the economy will bend, but not break, amid stubbornly persistent inflation and a Fed interest rate hiking cycle. As expected, GDP growth is now slowing following the sharp move higher from the 2020 recession, the recovery from which was fueled by easy money and fiscal stimulus.
Our expectation is for GDP growth of 2% in both 2022 and 2023. Of important consequence to stocks, corporate earnings growth is expected to be a robust 10% for calendar 2022.
In addition, the U.S. consumer who accounts for 70% of the economy is gainfully employed and has been utilizing excess savings to spend vigorously on goods and increasingly now on services.
In short, coupled with a still-elevated index of leading economic indicators, this is not a backdrop suggesting imminent recession. In our view, it would take an unforeseen external shock to the system or a policy mistake by the Fed to tip the economy into a recession this year. Given that the Federal Reserve under Chairman Powell’s leadership has been deft at altering course when economic circumstances have changed, we remain constructive on its ability to extend the current expansion.
Because corporations generate profits in part based on prevailing prices, their revenues are positively correlated with inflation; those with sustainable competitive advantages and effective cost control can parlay that top-line growth into higher earnings.
As such, blue-chip equities serve as an important inflation hedge for investors.
Meanwhile, alternatives such as real assets—timberland, agriculture, and infrastructure—and private real estate represent ownership of finite, income-producing property and land. Because of those attributes, such assets tend to index with inflation and protect portfolios against rising consumer prices.
To that end, alternative investments have been the only asset class with positive returns so far this year.
On the other hand, bonds are not an effective way to protect portfolios from inflation as the value of fixed interest erodes as inflation increases, since the coupon payment is usually fixed.
Historically, mid-term election years coincide with market corrections in the first half of the year that are then followed by substantive market rebounds.
We foresee such a scenario playing out again this year.
Shawn Narancich, a chartered financial analyst, is executive vice president of equity research and portfolio management with Ferguson Wellman Capital.