Have We Hit Bottom, Yet?
10 Key Take-A-Ways From This Market Commentary
- Forecasting a recession is a fools game.
- In our judgment, stocks now present a very enticing level from a longer-term perspective.
- Employment growth has averaged more than 400,000 per month YTD. There has never been a recession without sizable job losses.
- Inflationary impetus is coming from imbalances between demand and supply, most critically in the labor market.
- We are still very early in the process of the Fed raising rates to contain inflation.
- It is doubtful inflation will moderate sufficiently to enable the Fed to stop raising rates in the near to intermediate term.
- Stocks have declined sharply, and are discounting at least a mild recession.
- 28% of the entire S&P now trades at P/E multiples of 12 or less.
- The are now good values in the equity market.
- Investors need to look beyond the short-term volatility and invest in the longer-term healthy prospects for the economy.
Investors are concerned that the Fed’s apparent strong commitment to calming inflation could trigger a recession. Economic growth must slow in order for the Fed to accomplish its goals, but investors also fret that the Fed could push rates up too much. Stocks and bonds sold off, but bonds have rallied more recently as the safe haven alternative to stocks. After retrenching by about 20% since the peak late last year, a large enough downdraft in line with past market declines during recessions, it seems reasonable to ask if we’re near the bottom. Such forecasts are a fool’s errand. A more useful question is whether stock valuations have fallen to attractive levels. In our judgment, stocks now present a very enticing level from a longer-term perspective.
Starting with the economy, which undergirds everything, GDP declined 1.5% in Q1 and the Atlanta Fed’s GDP Now estimate points to another small decline in Q2. These are anomalous results, since employment growth has averaged more than 400,000 per month so far this year. There has never been a recession without sizable job losses. Yet, our economy continues to produce job growth well above sustainable levels. Much of the decline in GDP is due to falling inventories, which reflect input shortages of all kinds that are hampering production. Since GDP is a measure of the economy’s output, it has declined slightly. However, demand is strong. Higher imports also drove GDP lower in the first quarter, and is another indicator of the strength of demand. Producers in the U.S. are simply unable to manufacture enough to satisfy demand and an inability to hire is a key part of the problem. So, shelves, car lots, and warehouses are being emptied, which is making for pent up demand that will serve as a tailwind to growth as new supply comes on line.
In the meantime, the imbalance between demand and supply is elevating inflation, which the Fed now considers its primary concern. Rate hikes started in earnest in Q2 and are likely to continue, raising concerns among stock and bond investors. Both markets are repricing, as are others, including cryptocurrencies, commodities, and currencies. The wishful thought of the day is that inflation has peaked and will moderate sufficiently that the Fed will not need to keep pushing rates higher. We do expect some moderation in inflation, because some of it is transitory. But much of the inflationary impetus comes from more fundamental imbalances between demand and supply, most critically in the labor market, where new supplies will not be forthcoming. So, it is doubtful inflation will moderate sufficiently to enable the Fed to stop raising rates in the near to intermediate term.
Market sentiment fluctuates wildly between the possibility that the Fed will hike rates too much, precipitating a recession, or rates won’t be increased enough, stoking even higher inflation. Such judgments are premature. We are still very early in the process of the Fed raising rates to contain inflation. Rates haven’t really moved that much, they remain negative adjusted for inflation, and it is too soon to see how strongly or weakly the economy will respond to rate hikes that haven’t occurred yet. Even so, we expect investors to make a major mistake by overreacting to a slower pace of job growth over the coming months. Job growth is unsustainably rapid and it must and will slow, if only because there aren’t enough unemployed to be hired. Chances are high this will be construed as a slowdown in growth due to higher interest rates. We do not see it that way. Hiring must slow due to the labor market running out of bodies to hire. Investors may think wage inflation will slow, but we expect labor scarcity to keep wage inflation higher than expected. Furthermore, fearmongering contributes to increased volatility in the market in both directions.
Even so, stocks have declined sharply, so they are already discounting at least a mild recession, in our judgment. This is fair. The Fed’s objective of raising rates to slow growth without causing a recession will not be easy to accomplish. Even so, it isn’t impossible. The outcome is far from clear, even if most such efforts historically have resulted in economic downturns. Either way, we find quite a few good values in the equity market, because we think the economy is fairly unlikely to suffer a deep recession when the banks are highly capitalized, shortages abound in major sectors like autos and housing, capital investment is likely to remain solid as firms bring more production back to the U.S., consumers remain in very good shape financially and defense spending needs to rise to replenish military needs drawn down by shipments to Ukraine. All of the traditional sources of strong downdrafts that cause recessions are lacking this time around.
Fears of recession will no doubt provide a full dose of volatility. Nonetheless, we find plenty of value in stocks, even as we expect continued upward pressure on interest rates. More than 20% of the entire S&P now trades at P/E multiples of 10 or less and 28% trades for 12 or less. From a longer-term perspective, there are quite a few very cheap stocks, including most banks, energy companies, and insurance companies, just to name whole industries when cheap stocks abound. That so many stocks are cheap is a clear indication that investors are worried that the economy will weaken, profits will decline, and they should wait to invest until they have greater clarity on the outlook. In fact, there is never real clarity, and it is when uncertainty is highest that stocks tend to be cheap from a longer-term perspective. Investors need to look beyond the short-term volatility and invest in the longer-term healthy prospects for the economy. It is hard, if not impossible, to catch the bottom. But there are lots of great investment opportunities already.
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