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Are Soft Markets Ignoring Hard Evidence

Are Soft Markets Ignoring Hard Evidence

Published on May 16th, 2022

Since the Federal Reserve met eight days ago on May 4, the U.S. stock market as measured by the S&P 500 has declined by over 8%, bringing its total decline for the year to about 17%.  We believe the market has declined this year because of a confluence of events; raging inflationary aftereffects from the CARES Act and related monetary stimulus, the Russian invasion of Ukraine, and more recently COVID-related lockdowns in China relating to its zero-tolerance policy.  As a result, we believe that investors perceive a heightened probability of recession in the next 12 to 18 months. Historically, recessions have been associated with bear markets that begin some months in advance of the economic decline. At present, recession risk may be elevated because the Federal Reserve is rapidly tightening monetary policy to fight inflation. Unfortunately, the Ukraine conflict and the Shanghai lockdown compound this risk, by introducing additional inflationary pressures while also slowing global growth.

In recent days, U.S. consumer and producer price inflation data for April suggested that inflation may be slowing from a peak in March, but more modestly than expected. On the margin, we believe this drove investors to forecast even more stringent monetary policy and higher recession risk in the months ahead, further weighing on stocks. In Ukraine, the fighting continues, while EU member states discuss curtailment of Russian oil purchases, in our view thereby reducing the chances for near-term de-escalation of the war. And Shanghai remains locked down, while maritime congestion builds in its harbor, creating future risk of logistics bottlenecks when the city finally reopens.

Nevertheless, we believe the case for long-term investment in stocks remains intact. The U.S. has added over 400,000 new jobs monthly for the past 12 months, an unprecedented streak that creates a lot of momentum for consumer spending, the key engine of the U.S. economy. While a total measure of the economy declined in the first quarter, we believe this is a misleading headline because the core measure of real final domestic demand grew at a healthy pace. (The core measure excludes inventories and trade, the two volatile swing factors that dragged down the headline figure.) In aggregate, first quarter corporate earnings reports have reflected this strength, with companies exceeding Wall Street consensus expectations, and analysts revising future earnings estimates higher once factoring in the results. In our view, the evidence on the ground in the U.S. economy is far removed from the recessionary fear taking hold in the capital markets.

The combination of stock price declines and positive earnings revisions has left the stock market more attractively valued, in our view. The market discount may be justified at present given stubbornly high inflation and risks raised by the conflict in Ukraine and lockdowns in China. But we suspect these issues may prove transitory over the next 6 to 12 months, and when they finally subside, it will likely be a relief to investors and as a result, may provide support to a stock market which we believe is technically oversold at present. With respect to inflation, recent readings have slowed across many measures1,; capacity additions may address shortages and bottlenecks2; and slowing growth may tamp down demand2. We believe China must eventually reopen, with priority given to economic strongholds. like Shanghai. Finally, it is our current view that the Ukraine conflict will persist, but we also acknowledge how challenging it has been to forecast events there, and so we have the humility to allow for the possibility of a more rapid de-escalation than expected.

Outside of recession risk, some investors have expressed concern about systemic risk arising from an institutional failure. Several key financial conditions have tightened this year: interest rates have increased, the dollar has strengthened, and stock prices have declined. This creates the possibility for a poorly positioned institution to suffer losses or even fail if sufficiently leveraged, with potential cascading effects in an interconnected financial system. In our view, this type of event is unlikely. We observe solid financial health across banks, consumers, and corporations.

After the global financial crisis in 2008, banks were forced by regulators to hold significant amounts of excess capital, a situation which persists today.  Consumers were aided by stimulus funds and home price appreciation, and corporations took advantage of financial conditions to lower debt burdens and refinance debt at lower interest rates. Against this backdrop, we believe the financial system can easily weather a potential future default on Russian sovereign debt, or the possible failure of a cryptocurrency to hold its value, both of which are too small and too disconnected to pose a systemic risk, in our view. Finally, we note that when these types of events occur outside of recession, the typical stock market decline is comparable to what has been experienced already, suggesting that fear of such an event may be already priced into the market, to a meaningful degree.

Looking ahead, we expect volatility to persist in the coming months, as the Federal Reserve further tightens policy, and the overhang of risks related to Ukraine and China continue to weigh. But we also believe the market decline has priced a considerable degree of investor fear into stocks. Over the next six months, evidence may emerge that inflation has peaked and began to recede; that important economic centers in China may reopen; or even that hostilities may de-escalate in Ukraine. We believe some combination of those events, were they to unfold, might catalyze a rally, with investors racing to reprice stocks more in line with the encouraging outlook for the U.S. economy and corporate earnings. Conversely, events in Ukraine and China could place further inflationary burdens on the U.S., thereby raising the required tempo of Federal Reserve action and heightening the risk of recession.

Whichever scenario develops, consistent with our portfolio management philosophy and process, we will seek to position the portfolio in a way that we believe appropriately balances the risk of downside and the ability to participate in a rising stock market. 

Source: Bureau of Labor Statistics. “Employment Situation Summary.” May 6, 2022.
Source: Bureau of Economic Analysis. “Gross Domestic Product, First Quarter 2022 (Advance Estimate).” April 28, 2022.
Source: Factset. “Earnings Insight.” May 13, 2022.
Source: Bureau of Labor Statistics. “Consumer Price Index Summary.” May 11, 2022; “Producer Price Index News Release Summary.” May 12, 2022.

As of May 12th, 2022

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