Market and Economic Outlook - Released 9/30/22

Key takeaways

• Markets continue to be negatively affected by the latest inflation readings and investor sentiment is nearing levels seen during the 2008 Financial Crisis.
• The short-term forecast for stocks is uncertain, we feel the longer-term outlook is favorable due to current valuations pricing in some of the current risks.
• Investment grade bond yields are at their highest levels in over 10 years providing an attractive alternative to other asset classes.   
  

Long time investment manager Ralph Wanger once wrote, “the stock market is like a man walking his dog in New York City. The walk is always the same: start at Columbus Circle, stroll through Central Park, and end at the Metropolitan Museum of Art. If you’ve walked a dog, you know they never walk a straight line. They go forward then backward, stop to smell this thing and that thing, jump up randomly on park benches, bark at other furry and feathered creatures. There’s absolutely no predicting where they’re heading next.” 

“But if you know the owner is heading roughly northeast toward the museum, you know where the dog is heading too. What is astonishing is that almost all investors, big and small, seem to have their eye on the dog, and not the owner.” 

This clever analogy seems to describe the current investment climate. It seems good news is actually bad news. A stronger economy and labor market lead to concerns the Fed will raise interest rates higher and faster than expected. Weaker data suggests the Fed is having success tightening financial conditions. As a result, financial markets continue to be pulled violently in different directions by the latest inflation readings and their impact on the economy. Not surprisingly, investor sentiment is nearing levels seen during the 2008 Financial Crisis (Figure 1).   

Inflation and the Fed

The Federal Reserve’s goal is to bring inflation back to its 2% target even if they risk weakening the economy in the process. We believe this is a primary factor affecting market sentiment. After a summer of rising CPI (Consumer Price Index) and PCE (Personal Consumption Expenditures) data, the federal funds rate increased 0.75% in late September. Markets expect a 0.75% increase in November and 0.50% in December, bringing the year-end federal funds rate range to 4.25-4.50. The key question for financial markets is how high will the Fed go to control inflation?  

Despite the persistence of inflation, the U.S. economy continues to be in decent shape even though overall growth does appear to be slowing. Monetary policy tends to work with a lag. However, the longer inflation remains elevated the more aggressive the Fed will need to be. This opens the risk of making a policy mistake. Aggressive Fed tightening cycles tend to pressure companies with weak balance sheets. Some inflation data is showing signs of topping thanks to lower energy prices with a national gasoline average of $3.73 per gallon down from the record high of $5.02 reached in June earlier this year according to AAA (Figure 2). 

Energy prices are still a wild card making it hard to bring inflation down. There are only so much the Fed and global central banks can do to address energy prices. If gas were to go back to earlier highs, it could result in serious issues for inflation. It is still yet to be seen what will happen once the use of the Strategic Petroleum Reserve ends. The tenuous situation in Ukraine will continue to create concerns about an energy crunch in the Europe this winter. To be clear, inflation is high across the globe and not just contained to the U.S. as can be seen below (Figure 3).

Economic Data Influences Markets

Any recession is likely to be mild given the strength of the labor market. A soft landing for the economy could mean the unemployment rate will go up but not much more than a normalized level. The JOLTS (Job Openings and Labor Turnover Survey) report shows turnover and layoffs modest at best with plenty of job openings. The unemployment rate is still extremely low and jobless claims have been on a downtrend since mid-August. Participation rate increase was a positive which may aid supply constraints and wage pressures.  

The downside to a healthy labor market is upward pressure on wages (Figure 4).

Increases in wages can lead to more prolonged inflation as the cost of goods and services rises as companies pay their employees more. Wages tend to be more ingrained and are less likely to come down.  

The housing market has also been strong but is showing signs of slowing where higher mortgage rates are affecting sales with seven consecutive months of declines. Housing prices, which even after a couple of months of declines, are still about 7.7% higher than a year ago according to the National Association of Realtors. This is feeding into core inflation numbers through elevated owners’ equivalent rent, or how much money a property owner would pay in rent to live in their home.  

It is still imperative that supply and demand become balanced. Either the supply chains work more efficiently, and we see an increase in the labor participation rate which will moderate wage growth, or consumer demand will need to be reduced.  

The positive in all of this is that while GDP growth in the U.S. contracted in the first two quarters of this year down -1.6% and -0.6%, respectively, real growth is expected to be flat to marginally positive this year while rebounding to 1.2% next year and back towards long-term trends in 2024 according to the Fed. 

Election Anxiety

November brings the midterm elections in the U.S. which can add to investor apprehension. As we have said in the past, we recommend making portfolio management decisions based on your personal circumstances and not political headlines. A divided House and Senate could keep controversial legislation from being passed. However, we would only be guessing on the outcome and any long-term ramifications for financial markets.  

Adjustments based on elections and politics can be a losing proposition. There have been many regimes shifts over the last century and policy announcements can cause short term volatility. However, over time, markets have shown resilience to navigate these policy shifts, and the impact on individual sectors is not always negative, which helps balance out the political risk through diversification.  

Volatility Continues yet Valuations Improve

Stocks began the third quarter with a strong rally through mid-August on speculation of a “Fed pivot” away from recent policy in raising the Federal Funds Rate in as aggressive of a manner. Continued strong inflation readings and dire earnings guidance from companies, such as FedEx, put that belief to rest. This led to mid-quarter volatility and the S&P 500 declining for the quarter. We believe earnings and economic data going into year-end will prove to be a “show me” story. This may lead to a range bound market with continued volatility, both on the upside and downside, until the data sends a clearer picture of what the sustained direction of the economy looks like.  

To expand on our analysis from last quarter, in a normalized earnings environment, valuations on the S&P 500 are in line with their 25-year averages (Figure 5).  

For added context, we compare current valuations with longer term average yields for the 10-year US Treasury bond, which also hovers near 25-year averages. To us, this suggests that stocks appear fairly valued at current earnings levels and may suggest the selloff in 2022 is driven by higher interest rates causing valuation multiples to fall. Stock valuations can be influenced by interest rates for several reasons.  

We believe earnings estimates for the S&P 500 companies are likely to be revised lower which could lead to more pressure on stocks, but how much lower is still unknown. While the short-term forecast for stocks is uncertain, we feel over longer time periods the outlook is much more favorable due to current valuations pricing in some of the current risks. We also project an eventual cooling of the high inflationary environment. Because of this we do not believe that short-term factors should be a reason to make dramatic portfolio shifts in effort to time peaks and valleys of the stock market.  

Due to the short-term uncertainty, we believe it is prudent to adjust portfolios when necessary while still being appropriately aligned to client’s investment goals. In the current high inflationary environment, we have made a small shift towards quality companies, and as a result have reduced some exposure in small cap companies in favor of large caps. We continue to remain neutral on international stocks as the strong U.S. dollar continues to affect returns for U.S. investors overseas.

Pay Attention to Those Yields

Like stocks, bond market returns have been impacted by elevated inflation readings and concerns of more interest rate increases by global central banks. Rising interest rates continue to produce negative returns for bond investors, making 2022 one of the most challenging fixed income markets in history. Bond values usually move in the opposite direction of interest rates. So, when interest rates rise, existing bonds become less attractive in the marketplace and their prices decline.  

Not only has the general level of interest rates risen to compensate for inflation, the credit spread, or the difference in the yield of two bonds with the same maturity, but different credit quality, has risen due to investors apprehension for risk. This difference in interest rates for A rated and BBB rated U.S. corporate bonds, compared to an equivalent Treasury, has risen this year (Figure 6).

Due to this credit spread widening and move higher in the general level of interest rates, investment grade rated corporate bond yields are at their highest levels in over 10 years (Figure 7). Higher yields now provide an attractive alternative to other asset classes. 

Today’s bond yields also position bonds to have greater downside protection against additional increases in interest rates. For example, a 1% rise in the general level of interest rates over a 1-year period could cause the Bloomberg Aggregate Bond Index value to decline about 6%. However, the average yield to worst on the index has risen to 4.75% as of September 30 of this year. This higher income paid by the bonds helps offset the decline in bond values if interest rates continue to rise.  

We continue to believe owning longer duration bonds may prove valuable if fears of a recession develop. Due to uncertainty surrounding the economic outlook over the next year, our targeted duration for fixed income portfolios is slightly shorter than our benchmark. In our view, U.S. investment grade bond valuations are very compelling for investors with a longer-term time horizon.

The Bottom Line

Inflation and its economic impacts have proven difficult to forecast, making it challenging for anyone to speculate where stock and bond markets are headed in the short term. Like the dog in Wanger’s analogy, the day-to-day news items can be unpredictable and exhausting at every turn. While we continue to pay close attention to the most recent economic data, we are laser focused on the path towards long-term success for our clients.

COUNTRY Trust Bank® Wealth Management Team

• Chelsie Moore, CFA, CFP® - Director, Wealth Management & Financial Planning
• Kent Anderson, CFA - Portfolio Manager
• Jonathan Strok, CFA - Portfolio Manager
• Samantha Reichert - Investment Analyst
• Cody Behrens - Investment Analyst