April 2022 | Equity Commentary
Published on May 6th, 2022
The capital markets endured a difficult April. The S&P 500 fell -8.7% for the month, marking the index’s worst monthly decline since the pandemic-induced bear market in early 2020. Technology stocks bore the brunt of the selling pressure—the Nasdaq declined -13.2%—which pulled down overall returns for U.S. stocks. Pronounced selling pressure in technology stocks and other high valuation categories is almost certainly linked to the ongoing decline in the bond markets, which pushed the 10-year U.S. Treasury bond yield to 3% for the first time since 2018. For investors, persistent volatility is unsettling, but the upshot is that the U.S. stock market is more attractively valued today than it was at the start of the year. The S&P 500’s multiple has fallen from 21.4x at the start of the year to 17.5x by the end of April, while the consensus forward outlook for earnings has improved by 5.7% over the same period.
The big news for us in April was the surprise decline in U.S. GDP for the first quarter. According to the BEA report the economy contracted at a -1.4% annual rate in Q1 2022, marking a sharp turn from the 6.9% annual growth rate registered in Q4 2021. A surge of imports and a drastic swing in inventory investment were likely the main culprits behind the weak headline number. Inventory investment added 5% to the Q4 2021 headline number, but subtracted -0.84% in Q1 2022, marking a major swing that should not repeat in Q2. Government spending also fell at a -2.7% annualized pace as pandemic stimulus faded, which subtracted -0.48% from the headline figure.
There were some key bright spots in the Q1 GDP numbers, however. The biggest and, we believe the most relevant component of the U.S. economy, consumer spending, grew at a 2.7% annual rate, with spending accelerating from Q4 2021. Importantly, consumers shifted spending in Q1 from goods to services, with travel and hospitality as notable beneficiaries. U.S. hotel occupancy was at 65.8% in the last week of April, up from 49.6% at the end of January, and the Transportation Security Administration (TSA) reported that about 2.1 million travelers passed through security in late April, up from 1.4 million in January. A continued shift in spending to services could help ease inflationary pressures in the coming months.
Inflation continued on its upward trajectory in March, surging 8.5% year-over-year and fueled by rising energy and food costs. An encouraging note is that core inflation, which excludes food and energy prices, rose just 0.3% month-over-month, which marks a significant reduction from previous month’s rise in prices. Surging U.S. Treasury bond yields seem to signal the market’s acknowledgement that inflation could remain elevated. The Federal Reserve responded this week with a widely expected half-percentage-point increase in the benchmark fed funds rate. The Federal Reserve also announced plans to start shrinking its $9 trillion balance sheet starting next month. However, the Federal Reserve made it fairly clear that three-quarter percentage-point increases were largely off the table, at least in the near term. The market had previously been pricing-in a 95% possibility of a bigger rate increase in June, so the news factored as a positive surprise.
The global inflation picture continues to be complicated by the ongoing war in Ukraine and, more recently, by the Covid-19 outbreak in China. The war has generated a spike in prices for wheat, which is significantly produced in Russia and Ukraine, corn and soybean prices are approaching record highs, and fertilizer prices have soared. The World Bank anticipates that a broad swath of commodity prices will remain elevated for the balance of 2022 if not longer, as the war will ultimately reshuffle how commodities are produced, shipped, and traded. Energy prices appear likely to continue on a similar path, according to the World Bank, with expectations of a 50.5% year-over-year price increase. Food prices could jump 22.9% in 2022, which would follow a 31% increase last year.
China’s zero-tolerance approach to Covid-19 has added further pressure to supply chains. An outbreak of the Omicron variant has left Shanghai shut down for over a month, with millions of residents unable to leave their homes. Beijing, a city of about 22 million, has implemented restrictions and school closures but has so far stopped short of a full lockdown. These restrictions have resulted in a contraction in factory and service-sector activity for two straight months in China. Economists and market-watchers have been anticipating a strong policy response from the government and China’s central bank but have so far been disappointed—the People’s Bank of China cut banks’ reserve requirements but did not change interest rates, and no stimulus plans have been announced.
Another area of concern in the current environment is Europe. Eurostat reported slower-than-expected growth for the eurozone in Q1, with the GDP print showing 0.2% growth quarter-over-quarter. Europe has high exposure to war-related energy market disruptions, and debate currently centers around whether the EU should ban the import of Russian oil altogether. This outcome is far from assured, however, as Germany has voiced support for a gradual, phased-in ban, and garnering support from Hungary and Austria could be difficult.
Here in the U.S., despite the Q1 GDP figure, economic data remains on relatively strong footing and, in our view, is not signaling a recession is nigh. In the latest jobs numbers release by the Labor Department in March, U.S. employers added 431,000 jobs, with particularly strong hiring in services industries like restaurants and retail. The Labor Department also said that hiring in January and February was stronger than initially reported, signaling that the jobs market may be better today than most appreciate. The latest release was the 11th straight month where job gains totaled more than 400,000, which marks the longest stretch of consecutive gains of that magnitude dating back to 1939. Nonfarm employment is now very close to retracing all of the jobs lost in the pandemic.
U.S. corporate earnings season is also underway, and results have been mixed but largely positive. According to FactSet, with 55% of S&P 500 companies reporting Q1 earnings, 80% of them have reported a positive earnings-per-share surprise and 72% have reported a positive revenue surprise. These figures are high by historical standards.
Profit margins also remain quite strong for U.S. companies. According to FactSet, over the last 12 months, S&P 500 companies have reported a collective net profit margin of 12.18%, representing the highest after-tax corporate profits relative to GDP that have ever been recorded (records date back to the 1940s). There have only been three years since 1999 when corporate profit margins reached double-digits—2006, 2018, and 2019. In those three years, however, corporate profit margins never reached 11%. This strong profit outlook has led many analysts and companies to raise corporate earnings expectations for fiscal year 2022.1 Market historians would note that recessions typically accompany weakening and declining earnings, not strong and rising earnings.
As of April 30th, 2022