Headwinds to Tailwinds
Continuing uncertainty about the path of the economy has created significantly bearish investor sentiment and positioning. Investors are unclear about the stickiness of inflation and how extreme the Federal Reserve will have to be to bring it under control, as well as the necessary timeframe. Recent problems resulting in the failures of some regional banks adds another layer of unpredictability and even caused economists at the Fed to predict a mild recession later this year. These are a few of the significant headwinds investors face today. Despite the perception of heightened risk, this may be a better time to own stocks than many would realize.
Inflation remains a problem, but to a much lesser extent than in the recent past. Having peaked in June of last year above 9%, consumer prices were up 5% in March from a year earlier. Over the past three months, prices have risen at the annual equivalent of 3.8%. The Fed’s goal is to return inflation to the neighborhood of 2%. Even though pricing pressure has steadily declined, more work remains to be done, with no timeframe yet determined.
The Fed began raising interest rates more than a year ago to battle inflation. The effect of those increases is increasingly showing up in many parts of the economy. (It is challenging for the Fed to continuously make decisions regarding rate increases when many of the consequences can occur a year or so in the future—tighten monetary conditions too much or for too long and cause a recession, or do the opposite and watch inflation flourish.) However, the Fed raised rates more quickly and dramatically this time around than in past cycles. Now that those increases are beginning to be felt more widely, the Fed is generally expected to pause its rate hike cycle in the coming months to avoid overtightening.
While the job market continues to remain very strong with the unemployment rate at 3.5% in March (compared to the long-term average of 5.7%), it is expected to soften some. There have been numerous announcements regarding mass layoffs, especially among technology firms. Historically, tech companies have been managed to emphasize rapid growth of revenues and therefore staffed up accordingly. In today’s economic environment, the focus has changed to include, or even prioritize, profitability. In other words, many of the companies are maturing. The result will be higher profit margins, cash flows and earnings. Those are attributes of strength and longevity, and highly regarded by investors.
Corporate earnings are expected to decline 6.2% in the just-ended first quarter versus last year. Analysts are projecting a smaller decline in the second quarter followed by an uptick in the second half of the year, resulting in slight growth for the year as a whole. Companies have been suffering from operating margin compression brought on by escalating costs, supply-chain snarls and inventory overhangs. There are signs that margins appear to have troughed in the first quarter. Additionally, the strength in the dollar versus other currencies has also hurt margins, as 40% of S&P 500 revenues derive from abroad (59% for tech companies!). Interestingly, following a swift
16- month increase of 29%, the dollar’s value peaked shortly before the stock market bottomed in mid-October of last year and has declined 11% since then. Taking this
all into account, current projections are for earnings growth of 11.9% next year.
With the economy stalling by design to beat back inflation and tighter lending conditions from regional banks, many economists foresee a mild recession beginning as early as later this year. Looking at various bond futures and the Treasury yield curve, the markets also expect interest rates to peak soon and then begin to gradually decline. A potential economic slowdown, therefore, is already reflected in today’s security prices.
While many of us naturally focus on current events happening around us and the headlines of the day, the markets look ahead. The S&P 500 bottomed in October of last year. The index is up 14.9% since then through the end of March. The market sees inflation continuing to moderate, interest rates peaking and profit margins rebounding. As the current year progresses, investors will increasingly give more weight to analysts’ stronger earnings expectations for next year. That helps explain why increasing talk of an impending mild recession has not sent stocks headed south. Watching numerous current headwinds for stocks, bonds and the economy morph into tailwinds may not be that far off and the markets will recognize it before it becomes clear to many investors.
Holger Berndt, CFA
Director of Research
hberndt@rssic.com
