Stress Factors: Economic and Stock Market Update

Stocks have had both back-to-back downturns and a relief rally so far in 2022. Investor sentiment has flip-flopped as a result. Where is it heading?

Federal Reserve tightening, inflation, and the war in Ukraine have been the dominant big-picture forces influencing the economy in 2022. This confluence of negative factors set U.S. stocks up for a difficult start to 2022; the S&P 500 recorded its worst January since 2009 and officially hit correction territory (a plus-10% decline) in February 2022.

However, after hitting respective troughs, the major indexes experienced sharp gains of between 8% and 13% in March before retracing some of their downward path in April.

Those moves are impressive when considering—on a year-to-date basis—that the indexes have undergone a traditional correction (i.e., a decline of at least 10%), and the Nasdaq and Russell 2000 experienced traditional bear markets (i.e., a decline of at least 20% from a high). Individual company performance within those benchmarks has been worse; the average member firm’s maximum drawdown from year-to-date highs ranged from minus-19% to minus-29%, and from 52-week highs ranged from minus-25% to minus-46%.

There are headwinds facing both the market and the economy: the destructive Russian invasion of Ukraine exacerbating commodity and energy crises; the Fed’s transition from accommodative to tighter monetary policy; worries over inflation; and increased chatter about a recession on the horizon, among others.

Collateral Damage from Ukraine

Beyond warfare’s death toll and destruction of property, the Russian invasion of Ukraine is causing concern for global growth. The conflict remains a source of volatility as the highly uncertain situation evolves.

Russia, a major exporter of oil and gas as well as some metals and agricultural commodities, faces a decrease in exports—or even removal from the global economic system through sanctions. Ukraine, a major exporter of wheat, faces curtailment as the country deals with the shattering effects of the invasion. The resulting supply shocks put upward pressure on prices and inflation.

However, the situation could favor U.S. stocks, as the America is more insulated than its European counterparts from energy price spikes and the direct impacts of the war’s economic ramifications.

It is worth noting that bonds, which typically gain an edge in times of risk aversion, are providing less portfolio stability today as correlations to equities have converged.

What Will the Fed Do?

The Federal Reserve is expected to deliver two back-to-back half-point interest rate hikes in May and June to tackle runaway inflation, according to economists polled by Reuters. Fed chair Jerome Powell indicated during a panel discussion presented by the International Monetary Fund on April 21 in Washington, D.C., that the May rate hike will happen. While the central bank is likely to gear down to quarter-point moves in the second half of this year, the federal funds rate is now expected to end 2022 at 2.25% to 2.50%, 50 basis points higher than the median forecast in a poll taken last month.

In the next month, the Fed will announce its plans to reduce the balance sheet, a process known as “quantitative tightening,” and that will be another form of monetary policy.

A notable risk in this cycle is associated with the Fed’s need to move further off the zero boundary on rates and start shrinking its balance sheet amid elevated inflation pressures. The Fed’s focus is now clearly on inflation, and no longer on supporting the economy as it emerges from the worst part of the pandemic.

In fact, the Fed is actively pursuing tighter financial conditions and a slowing in aggregate economic demand. It’s always difficult for the Fed to bring the economic plane in for a soft landing, and it’s perhaps even more difficult in this unique inflation environment with the added stress of the fighting in Ukraine.

Inflation: Going up?

The Russian invasion of Ukraine, surging oil prices, a new draconian pandemic lockdown in China, further disruptions to supply chains, and wage growth resulting in unfilled positions for lower-paying jobs all present a perfect storm for inflation.

The March 2022 numbers reflect an increase in inflation. Consumer prices rose 8.5% from March 2021. The invasion of Ukraine drove a surge in oil and gasoline prices. Energy prices shot up 11% from February 2022. Prices for groceries accelerated, rising 1.5% from February 2022, while the cost increases for dining out moderated. The core price index, which excludes the often-volatile categories of food and energy, increased 6.5% in March 2022 from a year earlier, accelerating slightly from February 2022’s 6.4% rise. While inflation showed few signs of peaking, the core index on a month-to-month basis slowed to a 0.3% rise in March. That followed five straight months of a half percent or more increase.

High levels of inflation can negatively impact both spending, which accounts for about two-thirds of gross domestic product (GDP), and consumer sentiment. For instance, on an adjusted basis, retail sales for March 2022 fell by 0.7%, according to the Federal Reserve Bank of St. Louis. Consumers have moved away from some pandemic-era spending habits; they have shifted more spending to services and away from physical goods. The Fed lowered expectations for GDP growth this year at their March 2022 meeting.

When the Fed raises rates to stem rising inflation, it is not an immediate reaction. Higher rates make money costlier and borrowing less appealing. That, in turn, slows demand to catch up with supply, which has lagged badly throughout the pandemic. Less demand means merchants will be under pressure to cut prices to lure people to buy their products.

Yield Curves, Recession Fears

Going forward, stock market participants may be laser-focused on economic reports, seeking clarity. Investors were concerned about a possible recession even before the key yield curve inverted, particularly because continued high inflation could weigh on consumer spending. The pace of growth for the GDP for the first quarter will be released on April 28. Economists’ estimates are between 1.5% to 2.0%.

Rising costs, especially for gasoline, are likely leading to changes in consumers’ behavior to cushion the impact on their budgets. High gasoline prices accounted for a big share of a March 2022 increase in U.S. retail sales as inflation took up a larger part of consumer spending.

In a move away from pandemic-era spending habits, consumers have shifted more spending to services instead of physical goods. Higher prices have also decreased demand for some discretionary purchases, such as furniture, which saw a modest rise in sales in March 2022. Households are spending more on staples such as food, gasoline, and utilities. They are also returning to shop in physical brick-and-mortar stores rather than online; sales at virtual retailers declined for three of the four months before April 2022.

Earnings season in coming weeks will be top of mind for many investors searching for signs of how businesses are coping with higher costs for everything from energy to labor.

Companies are still expected to report growth in profits, but not at the levels seen in 2021 when results were being measured against the knocked-down earnings of the early pandemic. Analysts currently believe companies in the S&P 500 will report earnings growth of 4.8% in the first quarter of 2022, which would be the lowest rate since late 2020, according to data compiled by FactSet. The net profit margin for the S&P 500, FactSet data indicates, is projected to come in at 12.1% for the first quarter, above the five-year average of 11.2%, but down from the record 13.1% in the second quarter of 2021. The lower earnings growth rate for Q1 2022 relative to recent quarters can be attributed to both a difficult comparison to unusually high earnings growth in Q1 2021 and continuing headwinds.

The projected growth isn’t evenly distributed among industries. Companies in the energy sector are expected to more than triple their earnings, and the industrials and materials groups are projected to report increases of more than 30%. By contrast, analysts are projecting lower profits from the financial, consumer-discretionary, and communication-services segments.

Yield Curve Questions

The yield curve, where rates for two-year Treasuries briefly rose above those for 10-year Treasuries in April 2022, has been a source of contention among investors. Normally, interest rates tend to increase as the maturity of U.S. Treasury bonds lengthens. Such an inversion is concerning because it has preceded six of the seven recessions since 1978. Some investors, however, have given a broad range of reasons why the yield curve’s predictive power may not apply this time, including the potentially distortive effects of the Fed’s massive pandemic stimulus on rates markets. In any case, recessions have followed past inversions with an average lag of 16 months, and the S&P 500 has averaged an 11% gain in the 12 months following inversions.

Two other metrics have historically been important for yield curve inversion. First, many experts think the best indicator to watch is the three-month yield relative to the 10-year yield. That pair of rates has not inverted, though other parts of the curve have inverted, if temporarily. Second, the depth of inversion may matter too. So far, the inversion has been shallow, which may be a positive sign.

Conclusion: Fasten Your Seatbelts

The correction earlier this year was largely about higher inflation and rate hikes. More recently, the inversion in the yield spread between 10-year and two-year Treasuries has heightened the recession risk. The fighting in Ukraine, which has sent commodity and energy prices soaring, is also making it harder to predict when inflation will eventually come down.

However, going forward, we believe inflation should moderate, if only because some of the biggest increases are behind us. But there is a difference between decelerating and low inflation.

The state of the consumer within the U.S. is robust. Balance sheets are robust. Unemployment is at an all-time low. Wage progress is going on. The recession risks have grown, especially because of the supply shocks from Ukraine and Fed tightening; we’re diligently monitoring both situations. We expect the market to stay volatile.