The Economy and Markets after a First-Quarter Roller Coaster

A number of years ago, as part of a team-building exercise at an overseas conference, I got bullied into taking a ride on a particularly fearsome roller coaster.? For someone who suffers from vertigo and is an admitted control freak, the next 90 seconds were not pleasant.? Once the ride stopped, I stumbled out of the contraption.? However, I could not proceed with our merry band of team-builders until I had done a serious inventory of the state of the world, starting with some rather fundamental questions.

After a tumultuous first quarter of 2022, which included the rise and fall of Omicron, a new and terrible war in Ukraine, soaring inflation and a major rise in interest rates, many investors must be feeling much the same.? So it is probably worth taking an inventory of the fundamentals.? With so much going on, however, it is critical to do this in a structured way, starting with exogenous factors, then moving to the economy, then thinking about what all this implies for Fed policy and finally considering investment implications.?

So here goes:?

On the Pandemic:? Average daily cases, having fallen from over 800,000 in mid-January to 30,000 by mid-March have now stalled out at that level as the even more contagious Omicron BA.2 variant has grown to account for 72% of U.S. cases.? However, fatalities have fallen to between 500 and 600 per day and while that is still a horrific total, the risk of death is very low for most fully-vaccinated Americans who are not immunocompromised.? This being the case, COVID impacts on the U.S. economy are diminishing quickly.

On Fiscal Policy:? Concerns about inflation in an over-heating economy make it unlikely that Washington will pass any major fiscal stimulus before the mid-term elections, although some broad budget bill should pass before voters go to the polls.? For investors, this also reduces the risk of any major increase in corporate taxes.? History suggests that the President’s party will lose control of one or both Houses of Congress in November, sharply reducing the prospects of further fiscal action before the 2024 Presidential election.

On Ukraine:? Amidst appalling human suffering, Russian forces have failed to capture Kyiv, potentially setting the stage for a drawn out conflict in Eastern Ukraine.? Disruption to Russian and Ukrainian supplies of energy, food and other commodities have added to global inflation. However, despite outrage over Russia’s actions, Europe has not stopped importing Russian oil and gas and the willingness of China and India to continue to work with Russia could limit some of the long-term effects of the war on global commodity prices.

On Growth:? Retail sales data for March, due out on Thursday, should confirm a solid first quarter for consumer spending.? That being said, slower inventory growth and deteriorating trade numbers could cut first quarter real GDP growth to below 1% annualized.? The second quarter should see a continued opening up of the travel, leisure and entertainment sectors and, with more normal trade and inventory numbers, real growth could rebound to 3% or more. Thereafter, however, fading fiscal stimulus, rising interest rates, slowing employment growth and fading reopening effects should lead to a deceleration of growth to roughly 2.5% year-over-year by the end of 2022 and 2.0% year-over year by the fourth quarter of 2023.

On Jobs: Strong wage gains should bring some potential workers in from the sidelines with the labor force participation rate rising from 62.3% in the first quarter of 2022 to 63.0% by the fourth and 63.4% by the fourth quarter of 2023, surpassing the pre-pandemic quarterly peak of 63.3%.? However, even with this, the unemployment rate could drift down to a nearly 70-year low of 3.3% by the fourth quarter of this year and fall further to 3.1% by the end of 2023.? Notably, these numbers are below the Fed’s forecast of 3.5% at the end of both 2022 and 2023.

On Profits: The week ahead marks the unofficial start of the first-quarter earnings season with 14 S&P500 companies set to report their numbers.? After an exceptionally strong 2022, further earnings gains will be slower, reflecting stronger wage growth, higher interest costs and slower nominal GDP growth.? Overall, we expect S&P500 operating earnings to achieve high single-digit growth this year and low single-digit growth in 2023 following a 70% gain last year.??

On Inflation: Tuesday’s CPI report should show inflation soared to a fresh 40-year high of 8.2% year-over-year in March.? Although surging energy prices due to the Ukraine war will be the highlight of the report, broader inflation pressures are building.? While the growing outbreak of COVID in China poses a new threat to production, it is likely that supply chains will recover in the year ahead.? This, along with slower growth in consumer incomes, should tame inflation in the goods sector.?

Nevertheless, strong gains in wages, rents and inflation expectations should keep inflation stubbornly high with core consumption deflator inflation averaging 4.0% year-over-year by the fourth quarter of 2022 and 3.4% by the fourth quarter of 2023, well above the Federal Reserve’s long-term goal of 2%.

On the Dollar: The trade-weighted dollar has risen by roughly 4% year-to-date in a predictable reaction to both the uncertainty caused by the Ukraine war and the Federal Reserve’s more hawkish stance.? It should be noted, also, that since inflation is higher in the United States than in its major developed economies, the real exchange rate has seen further appreciation.? In the short run, a more hawkish Fed and solid U.S. economic growth could push the dollar higher.? However, U.S. trade numbers continue to deteriorate and the dollar could well begin to fall later this year or in 2023 as nominal GDP growth slows.

On the Federal Reserve:? The Fed clearly used the minutes of its March meeting, which were released last Wednesday, as a way to communicate its intentions with regard to its balance sheet.? This, combined with speeches of Fed officials and futures market pricing, suggests a further 2% rise in the federal funds rate by the end of 2022 with the Federal Reserve ramping up to a $95 billion monthly reduction pace in its asset holdings by mid-summer.?

By the end of the year, inflation is likely to be still running above the Fed’s targets while unemployment should be at generational lows.? However, provided inflation is easing, the Fed may decide to raise rates more slowly in 2023 as it seeks to avoid pushing the economy into recession.

Investment Implications:? Given all of this, how should investors adjust their strategy?

First, even with a major bond market selloff, real long-term bond yields remain negative.? This being the case and with the Federal Reserve just having embarked on a path of aggressive tightening, long rates could move up further, limiting fixed income returns.? That being said, any underweight to fixed income in portfolios should probably be more modest than at the start of the year, given higher coupons and a better potential for Treasuries to protect a portfolio if the economy were to tip into recession.? ?

Second, given the macro outlook of slowing nominal GDP growth and rising interest rates, U.S. equities overall look challenging particularly given a forward P/E ratio on the S&P500 that is still roughly 15% above its 25-year average.? However, within the market, value stocks carry a P/E ratio which is much lower-than-normal relative to growth stocks which could point to better returns for value going forward, particularly in a rising rate environment.

Third, international equities also look very cheap relative to U.S. stocks and could fare better if the Ukraine conflict is resolved and, as seems likely, U.S. economic growth slows relative to the rest of the world.

Finally, with traditional asset classes challenged, investors may want to pay greater attention to alternatives such as real estate and infrastructure for diversification and income and clean energy for a new source of growth.

For more of my insights, tune in to my latest episode of Insights Now.

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