Caught in a Negative Feedback Cycle
As you most certainly have noticed, financial markets have been correcting through the first four months of 2022. The S&P 500 dropped 12.9% and international equity markets have likewise suffered 12% declines. Fixed income has not yet provided its typical safe haven as bond yields have risen dramatically resulting in bond declines of 6%-9% (depending on the index). Before discussing the reasons for the downdraft and what we should expect going forward, I thought I would add a little perspective.
Global equity markets (U.S. equities in particular) have had an excellent run over the last three calendar years. In fact, for the years 2019 through 2021, the S&P 500 gained 100.4%, or 26.0% annually while international developed and emerging equities gained 46.4% and 36.6% cumulative (13.5% and 10.9% annually). In this context, the current correction feels a lot better. I believe it is the correct lens through which to view the downturn. For added perspective, remember that most target asset allocations produce a negative year once in every four or five years. Again, quite normal.
So, what is behind the current downturn? Principally, the spike in inflation (exacerbated by the events in Ukraine) as well as the dramatic shift in the Federal Reserve mindset away from spurring employment towards fighting inflation through hundreds of basis points in expected Fed Funds rate increases. These fears are prompting equity markets to price in greater odds of recession.
The market feedback cycle works as follows: High Inflation -> Fed Funds rate increases -> Rising odds of recession -> Recession -> Falling Employment -> Falling Earnings. Usually, the timing of an equity correction happens somewhere in the middle of the feedback cycle – not actually at the end.
The Federal Reserve has a difficult problem to deal with. With inflation no longer “transitory”, the Fed needs to raise interest rates more than it originally intended. In an ideal world, the Fed would raise interest rates just enough to slow the economy down to ease inflationary pressures but not to engineer a recession – commonly termed a “soft landing” (basically cutting short the market feedback cycle before it gets to Recession).
The level and sources of the current inflation spike will make a soft landing very difficult to achieve this cycle. While rate increases can help slow the torrid housing and automobile industries, they will do little to handle agricultural inflation (we need more supply rather than less demand). Fed rate increases should only be partially effective in reducing energy inflation since slower economic growth can reduce energy demand but does nothing to improve energy supply which has been hampered by underinvestment and Russian war sanctions. Regarding inflationary pressure from supply chain disruptions, we do expect most to eventually prove to be transitory.
Beyond this, perhaps the largest current imbalance in the U.S. economy is in the labor market. We simply have too few workers to handle the record number of available jobs (more than 11 million job openings). A soft landing will not actually help resolve the labor market imbalance. If the economy only slows, the demand for labor (i.e. number of jobs available) will continue to exceed the supply of labor. While I would be shocked to hear any member of the Federal Reserve say this, it appears that the only way to bring the labor market back into balance would be to destroy labor demand. That is code for saying it is likely that the Federal Reserve will need to engineer a recession to get inflationary pressures back under control. As an inherent optimist, while I suspect that some recession is necessary, removing economic imbalances would then set up the U.S. economy for its next multi-year expansion which also bodes well for U.S. equity markets once we get through the messy feedback loop.
My overall point is that we are clearly in a more difficult economic and market environment than we have experienced for quite some time, but the news is not all bad. 1) Equity valuations continue to come down to more reasonable levels as equity markets are already pricing in increasing odds of recession. The Price-Earnings Ratio (P/E) of the S&P 500 on estimated 2022 earnings stands at 18X compared to 28X just 16 months ago. In fact, while the market has recently dropped, consensus earnings estimates have actually gone UP by 2.6% year-to-date. 2) Rising wages are not a bad thing. Higher wages equals higher disposable income and higher consumer spending – particularly for the lowest end of the income spectrum – as long as the overall inflation environment does not spiral out of control. 3) We continue to own great companies that should continue to thrive now and through the next expansion. 4) Short-term bond yields are finally getting more attractive and can offer an oasis in a volatile environment.
While it is difficult to predict exactly how long the challenging environment will last and while the odds of recession are definitely rising, we expect a multi-year U.S. economic expansion once we get to the other side. If so, we would expect U.S. equity markets to reach new highs once again during the next expansion, as they typically do. In the meantime, we will continue to maintain a disciplined approach to evaluating the companies you own and to take advantage of opportunities as they arise.
I am always happy to discuss the environment, your portfolio or anything else that may be on your mind.