Investors entered 2022 both hesitant and hopeful.
COVID-19, while not entirely gone, seemed to have transitioned into a more manageable endemic rather than pandemic. Supply chains were not back to normal, but the bottlenecks were showing improvement and suggesting the supply side of the inflation problem might soon meaningfully improve.
Demand and employment continued to show impressive strength, meaning the Federal Reserve may have room to tap the brakes and slow demand at the same time supply improves. Hope suggested the Fed may accomplish the storied economic soft landing while taming inflation. Financial markets were anticipating a steady stream of 0.25% Fed Funds interest rate increases at each Federal Open Market Committee Meeting during 2022, and potentially into 2023.
However, hesitation took over markets at the end of February when Russia made good on its threats to invade Ukraine.
Already elevated commodity prices quickly traded higher. Even though the economies of Russia and Ukraine are relatively small compared to world GDP, the region is a major exporter of energy, agricultural products, fertilizers, and some metals.2,3 Heavy economic sanctions and war itself immediately impacted these supplies for a still unknown time period.
Global and domestic stock market performance for the first quarter reflect our current dual worries of heightened inflation and slowing growth. Globally, Latin American markets returned over 28%. As commodity exporters themselves, these countries suddenly became alternative sources of valuable supply. The Asia Pacific region (-2.14%), U.S. large companies (-4.60%), and U.S. companies broadly (-4.64%) were negative for the quarter but, with relatively less exposure to Russian sanctions impacts, were not the worst performing areas. European markets (-6.08%) suffered the worst market performance during the first quarter. Russian energy exports, mostly in the form of natural gas, supply much of Europe’s energy needs.
Within the S&P 500, there were only two sectors with positive performance during the first quarter.
Energy stocks soared on higher prices for oil, coal, natural gas, and as an inflation hedge. Utility stocks represent more defensive holdings during times of uncertainty, and investors rewarded that stability. All other sectors within the S&P 500 Index were negative to start the year.1
The two worst performing sectors during the first quarter were consumer discretionary and technology. Many consumer stocks rebounded nicely from pandemic reopening activity. With that push now behind them, and economic growth expected to slow, the sector wasn’t in favor. Technology stocks still exhibit attractive longer-term growth rates relative to the overall market, but rising interest rates and higher inflation rates make investors question the higher valuations for many of these stocks.1
The same challenges remain for stock markets today as were in place when we entered 2022, only with a greater degree of complexity.
Geopolitical events have delayed the resolution of supply chain challenges, while inflation is likely to remain higher for longer. Higher commodity prices place pressure on global demand and accomplish some of the Fed’s demand-slowing work for it… although not the way that markets would prefer. After the Federal Reserve met on May 16, Chairman Powell’s press conference conveyed the Fed’s belief that it could slow the economy and inflation without too much of a negative impact on overall demand or employment. This is a tall order indeed, and many economists questioned the Fed’s assumptions behind these expectations. But a look at the data reveals that labor markets are unusually strong and excess demand versus supply is unusually elevated. In our efforts to avoid another protracted sub-economic potential growth decade like occurred after The Great Recession, our monetary and fiscal efforts may have been too much.
The March payrolls report and household employment survey released on April 1, showed yet another month of strong employment growth with the unemployment rate falling to 3.6%.1 The labor force participation (the number of people employed or seeking employment) rose for the 10 consecutive month.1 Participation hasn’t reached pre-pandemic levels yet, but it is headed in the right direction now. When you compare the number of job openings to the number of people searching for jobs, you discover there are now 1.8 open jobs for each job seeker.1 That is a new post-pandemic high. Wages reflect this labor market stress. Median wage growth is clocking a 6% average growth rate over the past three months.1 But with inflation even higher, workers aren’t gaining ground on real wage purchasing power. This isn’t sustainable.
Another way to judge the equilibrium of supply and demand is to observe the growth in demand post-pandemic to the growth in supply.
Yes, there are supply chain disruptions. We see them in business survey data and hear about them from our business owner clients. But the incredible growth in demand for consumer goods is the other side of the equation. In the chart below supply as represented by industrial production of consumer goods (red line) has recovered. But it is no match to the incredible growth in demand (blue line). The grey line is inflation as measured by the Consumer Price Index (CPI). It is clear which side of supply and demand is far above trend. Maybe the Fed is onto something. Maybe there is more economic room for demand to fall than economists realize.
Stock markets are forward looking and incredibly efficient in the long term.
In the short term there can be mis-pricings and dislocations. Even though stock markets around the globe are mostly down so far in 2022, they aren’t drastically down, and we’ve enjoyed several years of very nice investment returns.1 However, environments of rising interest rates, rising inflation, and slowing growth warrant more tepid expectations. This is no easy task the Fed and other global central banks are attempting, and rising interest rates are notorious for exposing those that are over-leveraged to risk.
Ultimately, the price of a stock or a stock index comes down to the earnings produced and how much investors are willing to pay for those earnings. Investors expect both slower growth and rising interest rates, meaning valuations are not likely to expand in the near term.
After a pandemic induced 2020 decline, and a vaccine and fiscal and monetary stimulus fueled economic recovery, we should be on our way back toward average trend growth for both real GDP and S&P 500 earnings per share growth. Current expectations are shown for both below.1 We’re about to hear from companies as first quarter earnings are reported. This will shed some light on actual results versus expectations currently priced into the market. This environment is nothing if not uncertain, so some surprises are not out of the question.
In an environment of rising labor and materials costs, still slower than normal deliveries, and slowing demand, the natural place to look for weakness in corporate earning reports will be profit margins.
Corporations are exceedingly good at creating efficiencies and expanding margins upon exiting a recession. This time is no different. Profit margins today for S&P 500 companies are quite healthy. The chart above shows how net profit margins reached new highs after The Great Recession of 2008/09 and have done the same post-pandemic. But this time is different when it comes to inflation and the speed of changes in supply and demand. It is a difficult environment for sure.
Earnings calls should be full of questions from research analysts about final demand, cost pressures, inventories, the ability to pass along price increases, and the ability to hire needed labor. Earnings guidance for future quarters is given by some companies to help investors gauge business strength throughout the remainder of the year. Earnings guidance has understandably been difficult to predict over the past two years, and that isn’t likely to change in this quarter. With or without guidance, research analysts will publish future earnings expectations as companies release first quarter results. These expectations have been steadily increasing as the pandemic lessened. We are now at the point where investors are concerned with downwards earnings revisions and what that could mean for market index levels. What do companies earn…
… and what are investors willing to pay for those earnings? Markets have so far remained quite resilient in the face of all this uncertainty. Valuations are always a question for investors. The S&P 500 reached a PE ratio high of 24 in August of 2020 on expectations for earnings over the next 12 months.1 Since that time, the PE ratio fell to a low of 18 in March during the early days of Russia’s invasion of Ukraine.1 It has now recovered to almost 19.5.1
As quarterly earnings reports are released, we will be watching for insight from company management and what happens to earnings revisions.
Our hope is to hear that companies are navigating these rapid changes well and anticipate improving cost pressures with stable demand. The reality is likely to prove much more uncertain.
Tracy Bell, CFA
Director of Equity Strategies
S&P 500 Index is regarded as a gauge of large cap U.S. equities. The index includes 500 leading companies and captures approximately 80% of the available market capitalization.
Presentation is prepared by First Horizon Advisors – April 5, 2022.
Sources:
1 FactSet
2 CIA World FactBook
3 CIA World FactBook
