Mid-Year Outlook: Putting the Inflation Genie Back in the Bottle. Can the Fed Engineer a Soft Landing?

By: W. Kirk Taylor, CFP®

Executive Summary:

As we enter the second half of 2022, investors will continue to face a myriad of economic cross- currents. These include persistently high inflation, the prospect of rising interest rates, economic contraction and falling corporate profits. While it’s too soon to say with confidence… these are the hallmarks of stagflation; an economic scenario that investors have not seen since the 70s.

Clearly, the Fed has its hands full as it attempts to engineer a soft landing. Investors have doubts about the Fed’s ability to do so, as evidenced by growing forecasts for a recession in late 2022 or early 2023. The Fed has backed itself into a corner and their track record for engineering a soft landing is dubious at best.

As we entered 2021, the S&P 500 was trading at 22 times forward earnings, well above the 50-year average of 16.5 times earnings but below the all-time high P/E ratios seen just prior to The Great Crash in 1929 and the Tech Bubble of the late 90’s. Stock valuations are more compelling today at roughly 16-17 times earnings, but the outlook for corporate earnings is quite uncertain at present. If corporate earnings disappoint in the coming quarters as some expect, investors should be prepared for the prospect that stock prices will overshoot to the downside.

According to Stock Trader’s Almanac mid-term election years are characterized by above average volatility, particularly during the summer months. The silver lining is that mid-term corrections generally end by late summer or early fall, ahead of the November election. This period generally marks the start of an extended rebound in stock prices.

In short, investors should brace for more volatility and uncertainty over the next several months, while being prepared to take advantage of the next great buying opportunity that lies ahead!

Roller Coaster Ride

The first half of 2022 was bumpy to say the least, with the tech laden NASDAQ falling 30.3% through June 30th (it’s worst quarter first half since 2008), and the S&P 500 flirting with bear market territory as denoted by a 20% or more, peak-to-trough decline. It was the worst six month start for the stock market in decades. [1]

In what can only be described as classic bear-market action, the broader market year-to-date, has experienced multiple rallies of 8%-10% before giving way to even lower prices. This kind of action is often referred to as the “slope of hope”.

The cause? Persistent inflationary pressures, brought on by a “one-two punch” of the Fed’s excessively easy monetary policy and massive COVID-induced government spending in the trillions combined with supply shortages brought on by pandemic shutdowns and Russia’s invasion of Ukraine. Collectively, these forces, along with the prospects of much higher interest rates and a have investors on edge. 

The Inflation Genie

Clearly, the “inflation genie” is out of the bottle, and the Fed has it’s back against the wall. Putting a genie back in the bottle is no easy feat… which you know, if you ever watched the sixties sitcom I Dream of Jeannie.

Recent Consumer Price Data (CPI) and Producer Price Data (PPI) indicate that inflation is running at levels not seen in over four decades. The Fed has stated its commitment to bringing inflation down from 8%, and closer to its 2% target, but its own admission monetary policy is a blunt tool.

Monetary policy can’t fix supply chain problems and it can’t cool off one area of the economy where inflation is extra hot without cooling off areas where inflation is less intense. I guess you can call this the “law of unintended consequences.” We can hope for a soft landing, but history tells us that such an outcome is very hard to achieve.

While “goods” inflation and commodity prices might be on the verge of peaking as COVID-driven supply chain issues appear to be subsiding, wage inflation is still very prevalent in corporate America, especially with unemployment at historically low levels. The JOLTS survey tells us that employers still can’t find enough workers to meet demand, so one must assume that wages won’t slow until the economy has cooled dramatically.

It’s hard to imagine that the same Fed that kept interest rates too low, for too long, has the ability to rein in inflation without causing a recession.

The Interest Rate Outlook

With higher inflation comes higher interest rates. The two are undeniably linked. Simply put, higher interest rates translate into higher borrowing costs for both corporations and consumers. In turn, higher interest rates translate into lower corporate profits for companies and less disposable income for consumers. For example, in just six months, Home Depot’s cost to borrow funds over a year period soared from 1.875% to 3.25%. Wildly unpredictable inflationary pressures on corporations clearly explains downbeat corporate earnings, as well as the recent uptick in credit delinquencies for consumers.

Higher interest rates are having a significant impact on the residential housing market as the double-whammy of soaring housing prices and interest rates, have led to a plummeting in the housing affordability index, i.e., housing is the least affordable it has been in decades. Over the past 18-24 months, the 30-year mortgage rate has surged from roughly 2.75% to over 5%.

Consumer spending, of which housing is a significant portion, can only slow given these forces. Hence, consumer spending rose at its slowest pace in 2022, as consumers struggled to manage the higher food, housing, transportation and energy prices.

Rising Treasury yields, in turn, are cascading throughout the economy in the form of higher borrowing costs, squeezing households and businesses alike. Car loans, credit cards and corporate debt all stand to get more expensive as rates rise. [2]

The Earnings Wildcard

According to FactSet, “on a year-over-year basis, the S&P 500 is reporting its lowest earnings growth since Q4 2020. During the upcoming week 175 S&P 500 companies are scheduled to report. In aggregate, both revenues and earnings are set to come in well below the long-term averages. As noted earlier, P/E ratios have contracted to levels that are more realistic given the significantly. At the end of day though, market prices will directly reflect the direction of earnings. If earnings fall, so will broad market averages. Fortunately, the reverse is also true. [3]

It’s the Economy Stupid

About 90% of investors expect the U.S. to enter a recession before the end of 2023, and 72% of investors surveyed said they expect the S&P 500 to fall further before it stages a sustained recovery. according to a survey published Thursday by Deutsche Bank.

At the beginning of 2022, the average interest rate on a 30-year mortgage hovered above 3%. Today it stands at 4.72%, according to Freddie Mac.

Higher rates will make monthly mortgage payments—already at the least affordable level since November 2008—even less so. A median American household needed 34.2% of its gross income to cover mortgage payments on a median-priced home in January, according to the Federal Reserve Bank of Atlanta. That is up from 29% a year earlier. [4]

The Good News!

While an economic slowdown likely awaits investors, the good news is that consumer balance sheets are relatively strong, the banking system is on solid ground and any contraction in the economy is likely to be limited. The broader market may move lower over the coming months, but we are not likely headed for another 1999 bubble bursting or for a Great Recession seen in ’08-’09.

The best advice for investors at present, is to be defensive but on the lookout for a great buying opportunity. We are watching every day for evidence of a turn!

Footnotes:

[1] S&P 500 Posts Worst First Half of Year Since 1970, The Wall Street Journal June 30, 2022, https://www.wsj.com/articles/global-stocks-markets-dow-update-06-30-2022-11656487667-11656574533?mod=hp_lead_pos1&mod=hp_lead_pos5 

[2] Cooling Consumer Spending Points to Further Economic Slowdown, The Wall Street Journal June 30, https://www.wsj.com/articles/inflation-consumer-spending-personal-income-may-2022-11656531317?mod=article_inline 

[3] S&P 500 Earnings Season Update, Factset July 22, 2022, https://insight.factset.com/sp-500-earnings-season-update-july-22-2022

[4] Interest-Rate Surge Ripples Through Economy, From Homes to Car Loans, The Wall Street Journal April 8, 2022, https://www.wsj.com/articles/interest-rate-surge-ripples-through-economy-from-homes-to-car-loans-11649426081?mod=series_stockmarket

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