News & Insights

These days being an investor takes fortitude. Since the start of 2022 stocks and bonds have each generated double-digit losses, upending the conventional wisdom that when stocks fall bonds rise, cushioning the blow to an overall portfolio. Further, elevated inflation levels not seen since the 1970s erode the value of holding cash and further exacerbate stock and bond market losses.

The economy continues to produce mixed signals regarding whether it will enter recession. Because the stock market looks ahead 6-9 months, its bear market performance has endorsed the recession argument. Further, after the Fourth of July the bond market joined the recession camp as the 2-year bond yield surpassed the 10-year rate to create an inverted yield curve. These stock and bond market signals haven’t always led to recession, but the odds now seem better than 50/50.

There are mixed signals as to whether or not the economy will soon enter recessionary territory, but the odds appear to be rising with every week that passes. The stock market seems to be screaming “yes,” but economic statistics are saying, “Whoa, not so fast.” The difference is that the stock market looks forward about six to nine months while economic stats reflect the past.

Retail sales increased for four straight months through April, though they took a step back in May. Likewise, industrial production has risen for four straight months. The Purchasing Managers Index reflects activity in the manufacturing and service sectors, and remains strong in both the U.S. and Europe, although it is down slightly from recent months. Yet, confidence surveys of consumers and small businesses are in the tank.

The S&P 500 barely avoided a 20% drawdown, the recognized threshold for entering into a bear market. After a recent bounce, it is currently down 15% on the year. The more volatile NASDAQ 100 is down 23%. Despite this year’s weakness, both indices remain well above their pre-pandemic highs, even in real terms adjusted for significant inflation. Bulls can take heart that the stock market has made good progress despite the unimaginable stress and uncertainty of the past three years, while bears may believe that stocks still have plenty of room to fall back to reality.

Who is right? Have we seen the bottom or not? The only reliable answer is maybe. FactSet’s John Butters notes that based on estimated forward earnings, the S&P’s P/E ratio is below 18 for the first time since the pandemic started. From a pure valuation perspective, we have come full circle. That said, stocks tend to carry lower P/E’s when interest rates are higher and also when economic conditions are softening, both of which are currently true relative to pre-pandemic levels. On the other hand, inflation tends to push stocks higher, and expectations for a new normal of somewhat higher inflation rates would support higher stock valuations.

After taking extraordinary measures to counter the impact of the pandemic, the Fed can reasonably claim “mission accomplished” as it relates to the full employment component of its dual mandate. The March report showed employers added 431,000 jobs while the unemployment rate dipped to 3.6% from 3.8% the prior month. This was only slightly higher than 3.5% registered in February 2020, representing a 50-year low. Job gains were also revised higher for the first two months of this year. Employment has rebounded sharply, with the economy now possessing just 1.2 million fewer jobs than in February 2020, a far cry from 21.6 million fewer jobs at the trough two years ago.

Labor force participation continues to run below pre-pandemic levels but is recovering. In March it inched up to 62.4% versus a recent low of 60.2% in April 2020. There are multiple drivers leading individuals to rejoin the workforce including declining household savings, as well as lower Covid cases, allowing workers who were home with children during school or caring for sick family members to return to the workforce. It would be helpful if this trend continues given there are currently more job openings than unemployed workers. Also reflective of the tight labor market, workers are quitting their jobs at near record rates, often for better opportunities. Fed Chair Powell has even expressed concern that the job market may be overheating, feeding higher inflation. Average hourly earnings grew 5.6% in March from the prior year, though this remains below most measures of inflation.

Vladimir Putin’s attack on Ukraine jarred global financial markets. Western democracies have responded with financial sanctions against Russia and its citizens, causing the ruble to suddenly lose roughly one-third of its value relative to major foreign currencies. Global investors are rushing to divest their Russian assets, but their efforts are frustrated by a lack of natural buyers and by the fact that the Russian stock market has been closed since February 25th. Nobody knows what Russian financial assets are currently worth.

Commodity prices and defense stocks jumped after the invasion. In the midst of a broad stock market selloff, Merrill Lynch sardonically proposed a new list of FAANG assets replacing the old investor favorites of Facebook, Amazon, Apple, Netflix, Google. The new FAANG according to Merrill? Fuels, Aerospace, Agriculture, Nuclear, Gold.

The evidence continues to grow that the Federal Reserve was caught wrong-footed by how rapidly the economy has recovered. Unemployment has fallen more quickly than expected and wages have moved higher. The healing of the labor market and emergence of higher inflation has resulted in a shift in the Fed’s focus towards tackling inflation, a dramatic change from recent years when it was more worried about inflation persistently running below its targeted 2% level. In less than a year, the Fed has transitioned from forecasting no rate increases before 2024 to now expecting as much as a half-point rate hike in the next month. To be fair this wasn’t easy terrain to navigate, as the Fed was reacting to a multitude of highly variable factors such as how quickly the virus receded and how quickly supply chains healed. Still, for an entity that claims to be “data dependent” the Fed seemingly disregarded earlier signs we were headed in this direction.

The January CPI showed inflation of 7.5%, a 40-year high that was ahead of already elevated expectations. Core prices, which strip out volatile food and energy, advanced 6.0%. Supply and demand imbalances related to the pandemic continue to contribute to higher levels of inflation; however, price pressures have broadened, and inflation tends to be sticky. A stronger economy is pushing up rents and wages, which appears likely to keep inflation elevated even after supply-chain disruptions ease. Despite downward pressure on inflation as supply chains normalize and base effects take hold, it seems rather presumptuous to believe inflation will cooperate by gently trending lower to the targeted 2%.

While Covid and politics still dominate the general news cycle, the financial news is focused on inflation concerns. Economic growth appears solid, but that is exactly when the Federal Reserve needs to act. In the words of former Chairman William McChesney Martin, the Fed’s job is “to take away the punch bowl just as the party gets going." The challenge is that the Fed failed to notice the party was in full swing for six months. Perhaps the reason it has fallen way behind is that it not only served as bartender but began imbibing its own concoction.

Inflation soared to 7% in 2021, a rate last reached 40 years ago. Even excluding the volatile food and energy sectors, so-called “core inflation” rose 5.5%, the highest in 31 years. Left unchecked, inflation can become imbedded in our cost structure through cost-of-living allowances in wages and Social Security. On top of that, flaws in the way housing is figured into the Consumer Price Index mean that recent increases in home prices and rents have yet to be fully reflected in inflation statistics.

The Federal Reserve operates under a dual mandate with the goal of fostering conditions that achieve both stable prices and maximum employment. Recent developments signal the Fed has pivoted from seemingly prioritizing maximum employment to combating inflationary pressures that could pose a threat to the recovery. The Fed’s move made in response to the pandemic more than a year ago towards easier monetary policy and significant stimulus has had the intended effect. Both U.S. and global GDP have recovered to the point that they have surpassed pre-pandemic levels. U.S. real GDP growth is expected to exceed 5% in 2021 with anticipated growth next year of approximately 4%. The pace of growth from here is contingent upon many factors, including the course of the virus and potential future variants. Early indications for the Omicron variant suggest it is more transmissible but has lower severity. While not exactly an ideal development there is some optimism that can be gleaned from that combination.

Democrats are making a late-year push on tax and spending increases but have struggled to find a strategy that unites the party. Some of the more ambitious revenue (tax) measures have been eliminated, which is probably good for American business. Ironically, government dysfunction usually is.

Pfizer had a good month. The FDA authorized the company’s Covid-19 vaccine for children as young as 5, while its oral antiviral for already-infected patients demonstrated excellent trial data, following on similarly strong results from a Merck antiviral last month. Meanwhile, the wave of infections associated with the Delta variant appears to have peaked across the nation, although trends vary by region. There appears to be a strong seasonal component underlying the infection statistics. Once we get past the winter cold and flu season it seems reasonable to expect that we will start to put Covid behind us.

Covid-19 statistics have improved recently for our country as a whole, although trends differ by region. About 65% of U.S. adults have been vaccinated according to the Mayo Clinic. For those over 50 years old the vaccination rate is higher than 80%. Covid-related fatalities are very rare for vaccinated people. Further good news comes in the form of a new antiviral pill from Merck which improved outcomes dramatically in a placebo-controlled trial, stoking hopes that future waves may be easier to treat. Life is gradually getting back to normal. International travel restrictions are loosening, and most schools have reopened for in-person instruction.

Life is also getting back to normal in Washington DC, where division typically rules. A spat over the debt ceiling looks like a small skirmish in the larger battle over ambitious spending and tax increases. Centrist Democrats hold a lot of power in the Senate and appear to be taking full advantage of their political leverage.

U.S. Covid statistics have lately shown a frustrating rebound. Total infections are running at about two-thirds the previous peak, with total deaths about half their previous peak. Overall, the curve appears to have leveled off since late August. Some public health officials have predicted that Covid will continue to recede, and climb, and recede in a series of progressively weaker echo waves. This could prove to be the crest of a significant wave.

Life is getting back to normal across the pond. The United Kingdom has been a world leader in achieving vaccine access and popular acceptance. The data we have seen argues that serious outcomes are very rare for vaccinated persons, and the UK’s numbers agree. A recent resurgence in cases has been accompanied by a much lower fatality rate compared to the United States. The UK’s health minister recently proclaimed that no more lockdowns are expected for this wave or future waves.

The economy is at a stage when comparisons to year-ago quarters frequently produce ridiculously high numbers because last spring and early summer were depressed. The same observation applies when reviewing results for companies. Increasingly, we compare 2021 figures to 2019 on a two-year “stacked” basis. We found it more productive to bridge over 2020 as problems last year were widespread, not representative, and generally not a company’s fault.

Many economic figures are reported on a year-over-year basis and must be understood in the context of the “base year” (the prior year against which current figures are being reported). Inflation appears to be running hot at the moment, with the Consumer Price Index (CPI) rising 5.4% in both July and June compared to the previous year. However, inflation ran well below the Federal Reserve Board’s 2% target last summer. On a two-year stacked basis, the CPI was up 3.2% (annualized) in July and 3.0% in June. This suggests increasing price pressure.

The economic recovery continues, but the pace of the recovery is slowing. First quarter GDP was estimated at $22.1 trillion annualized, surpassing its pre-pandemic high of $21.7 trillion. Reclaiming our economy’s full potential might take a long time, however. GDP has rebounded sharply but remains approximately 2% below its pre-pandemic growth path. Gains have not been distributed equally, and inflation is squeezing the budgets of consumers left behind by the post-COVID recovery so far. Where we go from here is a bit of a mystery.

Employment statistics have recently plateaued at a level that would have been considered very unsatisfactory before the pandemic. June’s Bureau of Labor Statistics report showed the unemployment rate ticked slightly higher versus May at 5.9%, with labor force participation also about flat at 61.6%. Before the pandemic, unemployment averaged about 4% and participation about 63%. Wages were a bright spot in June, up 1%. Those who remain engaged in the workforce are being rewarded with paychecks growing faster than the cost of living, which is also increasing at a rate that would have caused major alarm before the pandemic.

The economy continues to improve, helped by the rollout of vaccines as well as fiscal and monetary support. Unlike typical recessions, this one was not born of financial factors but rather was the result of what was effectively a natural disaster. Economic activity was interrupted but much of the underlying demand for goods and services remained essentially intact. As highlighted in last month’s Investment Comments, the unique nature of this economic slowdown, and subsequent rebound, make parsing the data particularly difficult. When pandemic restrictions initially hit the economy, there were concerns it would take years for workers and businesses to heal. However, in the current quarter the size of the economy is now anticipated to surpass pre-pandemic levels and by year end GDP is expected to achieve its pre-pandemic path, if not exceed it.

According to the CDC, nearly 65% of U.S. adults have received at least one vaccination, and state and local governments continue to ease restrictions on businesses. Consumer balance sheets remain in good shape, aided by stimulus payments. Given a strong start to 2021, the National Retail Federation recently revised higher its expectation for retail sales this year, now anticipating an increase of 10.5%-13.5% versus its February forecast of 6.5%-8.2% growth. As consumers venture out categories such as beauty products have done well, as has spending on restaurants, lodging, and airlines. The Census Bureau announced May retail sales below expectations, down 1.3% from April, but up 24.4% versus a year ago.

President Biden is negotiating for a $2+ trillion spending bill centered around infrastructure. It is hard to argue with infrastructure, which explains why that word features so prominently in the bill’s marketing push. The positive economic value from infrastructure improvements may be diminished by the potential chilling effects of tax increases to pay for the bill. Investors should keep a close eye on the risk of higher corporate taxes. The market responded robustly to the tax cuts that were implemented four years ago, and from the market’s perspective it is very hard to find a silver lining in the prospect of a rollback.

Wouldn’t it be nice to get the benefits of more spending without the cost of higher taxes? The difference between outlays and tax collections is the deficit, and the government’s ability to run expanding deficits depends on its borrowing rate staying low. Bond owners have not been very demanding in recent years, but their continuing good nature is forever being tested. In early May Treasury Secretary Janet Yellen admitted that the improving economy, boosted further by a large infrastructure bill, could necessitate higher interest rates. This sounds to us like basic common sense, or maybe Macroeconomics 101, but it stirred up quite a controversy. Investors are very sensitive about interest rates, inflation, and asset prices, and the Secretary’s remarks touched off a modest stock market decline that was stemmed by Yellen quickly “clarifying” her comments, saying she was not predicting higher rates. She was only speaking hypothetically.

In the first quarter the S&P 500 returned more than 6%, a respectable start building on last year’s impressive gains. All eyes remain focused on the vaccine rollout and how quickly the economy can reopen more fully. Uncertainty persists regarding the course of the pandemic given the emergence of more contagious strains of the virus, but happily trends are in the right direction. The U.S. is on track to vaccinate three-fourths of the population by late June, though achieving that number requires overcoming vaccine hesitancy. However, much of the world is further behind, with emerging-market countries on pace to have closer to 30% of their population vaccinated by year end. Regardless, vaccine progress continues and should serve as a strong tailwind through 2021.

Helped by vaccines and trillions of dollars in government support, expectations for growth have been improving. The International Monetary Fund (IMF) recently bumped its forecast for world economic growth this year to 6% from prior estimates of 5.5%. This would represent the fastest expansion in at least four decades. Closer to home, the IMF estimates U.S. growth at 6.4%, fully recovering last year’s 3.5% contraction and then some. Economists surveyed by The Wall Street Journal anticipate momentum will continue into 2022 but slow to just over 3% growth. This would mark the strongest two-year growth in the U.S. since 2005.

Government intervention has made it more difficult to read and predict economic tea leaves. Record low interest rates not only allowed homeowners to refinance their mortgages, but companies also refinanced their debt and increased their borrowings. This extended into “junk bonds” where yields edged below 4% before rising recently. Such a rate used to be reserved for only the most creditworthy companies, which were recently able to borrow for less than 1% on a short-term basis and less than 2% on a long-term basis.

Statistics for unemployment, retail sales, and personal income must now be interpreted in the context of stimulus payments and COVID-related restrictions on businesses. Retail sales fell a stunning 3% in the month of February compared to January. However, January was up 7.6% from December on a seasonally-adjusted basis that takes into account normal patterns like holiday spending. Government statisticians struggled to keep up, as the January surge was originally reported as a 5.3% gain.

It is quite clear that as COVID-19 goes, so goes economic activity, which leads political response and tests the remarkable ability of people to adapt.

The path of the virus over the past few months is evident when examining what is surprisingly fairly solid economic data. Fourth quarter GDP grew 4%, capping a year that saw GDP fall 3.5% as large sectors of the economy, particularly travel and hospitality, were off limits to consumers. After COVID-19 case counts declined during the summer, a resurgence of the virus in the late fall and through the holidays spurred the reimposition of stay-at-home orders and retail closures for restaurants, gyms, and other gathering places. With less opportunity to move about, consumers still boosted their spending a respectable 2.5%, but this was short of what economists expected during the critical holiday season.

In 2020 governments around the world responded to COVID-induced economic shock with fiscal rescue policies that injected trillions of dollars into their economies and added similar amounts to sovereign debts. The Department of the Treasury’s Data Lab (datalab.usaspending.gov) recently estimated the total bill for U.S. fiscal relief at $2.6 trillion of stimulus plus $900 billion of tax relief, for a total of $3.5 trillion. That total grows closer to $4 trillion including the stimulus that President Trump signed in December.

On January 5, a surprise result in the Georgia Senate runoff turned what initially looked like a mixed U.S. election result into a “blue wave.” With a willing Congress behind him, President-Elect Joe Biden has promised to make more fiscal stimulus his top priority, proposing a $3 trillion stimulus and infrastructure plan.

As we wrap up 2020 it is worth highlighting what a roller coaster year it was for the market. Midway through December the S&P 500 has advanced more than 13%, a result that ap­peared highly unlikely during late March when shares fell sharply on COVID-19 fears. However, the market is forward-looking and global support in the form of fiscal and monetary stimulus has helped drive markets higher since the spring. Currently, the prospect of further stimulus combined with the fastest development of a vaccine ever recorded has boosted investor optimism and provided hope that a return to a more normal environment is on the horizon.

While several vaccines are on the way, the U.K. was the first country to authorize the Pfizer-BioNTech COVID-19 vaccine, starting distribu­tion on December 8th. U.S. health regulators authorized use of the same drug on December 11th with the first vaccinations taking place December 14th. Initial supplies of the vaccine are limited, but production is expected to increase meaningfully over the next several weeks. Pfizer shipped out three million doses initially with an expectation of 25 million doses available in the U.S. by yearend. Health workers are first in line for vaccinations followed by other higher-risk populations. Americans are expected to broadly be able to get the vaccine by the end of March