Market Update June 2022 – Stock Market Inflation?
Is the US economy in a slow patch, slowdown, or recession? The economic and capital markets evidence is mounting, and a temporary slow patch looks to be out of the picture. That leaves slowdown or recession and, while an economic slowdown may not be ideal, it would certainly be a welcome alternative to a recession.
An economic slowdown is an informal economic condition that recognizes continued growth, but at a slower rate than recent periods. Importantly, growth continues, but it’s common that the capital markets see a repricing of risk assets due to growth rates below that of previous periods. To date, these are the conditions most prevalent in the US economy.
For the authorities, managing the economy is more akin to navigating an aircraft carrier than a speedboat. Policy initiatives rarely have an immediate impact. But in a world with real-time data readily available and accessible to individuals and institutions alike, slow moving events such as economic cycles can be challenging for investors to digest. Generally, the initial response within the capital markets is immediate and typically exaggerated, rather than reflecting the necessary patience for these economic initiatives to have their impact. This often results in heightened volatility as investors are quick to respond to the latest data and, often times, overreact.
What is the message from the markets today? DataTrek Research LLC recently suggested that current market internals reflect the following baseline:
- Structural US inflation will not exceed 3 percent over the next 5 – 10 years
- Federal Reserve monetary policy is predictable
- Corporate earnings will remain robust and well above pre-pandemic highs
This implies that (1) current inflation levels are temporary and will gradually recede to an economically healthy level of 3 percent, (2) The Federal Reserve will continue to “telegraph” its future policy actions, and (3) earnings will remain healthy (notice that the implication is with regards to earning levels, not growth rates). These observations should not be viewed primarily as an outlook/expectation, but rather, a baseline that markets will adjust to (up or down) in response to outcomes that might differ from current expectations. Hence, they should be viewed not as a quantitative exercise, but rather through a qualitative lens. An example would be inflation, which will certainly not recede to 3 percent in the coming months but is expected to trend downward over the five-ten year period, eventually arriving at 3 percent. The direction of the trend is of most importance. (Certainly, the items mentioned are not an exhaustive list of what may move markets. But it does account for three important high-level items).
The current headline debate continues to focus on whether the US economy is experiencing an economic slowdown or is on the brink of a recession. Today’s issues at hand will not be solved by a single action or policy. Investors will not receive a notification on their phones with the answer but will be tested to react to the uncomfortably slow flow of mixed messages. Slowdown or Recession? The difference is significant as are the potential outcomes.
CHART OF INTEREST: Stock Market Inflation?
As financial markets further adjust to the current environment, the equity markets continue to search for proper levels in an environment with rising uncertainty regarding future earnings. But equally as important as earnings is the premium paid for expected earnings, often expressed as the price-to-earnings ratio (P/E). Often times confidence in earnings growth results in investors paying high multiples for stocks. But as uncertainty rises, premiums also decline.
Following the market lows in 2020, equity markets and multiples were off to the races. Now with more uncertainty, investor concern has jumped, and equity markets have dropped. But for the two factors of earnings uncertainty and declining multiples, the piece below from Bloomberg Intelligence suggests the risk of declining multiples has, in large part, returned to more common levels. If so, one contributor of the heightened volatility may have run its course.
Bloomberg Intelligence Equity Strategy (as of 5/26/22)
Stocks’ mini bubble may be just about busted, if the last one proves to be a guide. S&P 500 valuations have corrected in a fast and furious fashion in 2022, erasing excesses at three times the speed of the correction at the turn of the century. The trailing P/E multiple peaked at 31.6x a year ago and fell to 16.3x at the recent low. It took more than three years for market valuation to deflate a roughly equivalent amount when the tech bubble burst from a peak of 31.9x in July 1999 to just below 16x in October 2002.
The post-2002 backdrop may be an intriguing guide for what to expect next for stocks that are contending with higher inflation and higher interest rates. Though stock prices recovered with earnings, valuations remained suppressed.
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