The U.S. economy has started to slow under the combined weight of soaring inflation and climbing interest rates—including the highest mortgage rates since 2008. Sharp declines in key sectors have raised the prospects of a stalled economic recovery and a recession.
The U.S. economy has displayed an unusual dynamic: one with weakening output but strong employment growth. U.S. Q1 GDP was a significant downside surprise, contracting at a 1.4% quarter-over-quarter annualized rate. Nonetheless, the absence of fiscal stimulus, along with high inflation would mean a slower growth trend going forward. GDP should remain unchanged at an annual rate over the second quarter. The U.S. GDP growth forecast for 2022 is 2.4%.
High inflation has eroded real income and purchasing power, which will weigh on consumer spending growth in the coming quarters. Consumers have financed solid rates of spending growth by bringing down their saving rates and running up credit card debt, but these measures are not sustainable.
Home construction across the U.S. fell sharply in May. In addition to the drop in housing starts, building permits decreased in May and existing-home sales—the bulk of the housing market - fell. Factories in the mid-Atlantic region reduced activity for the first time in two years this month. And Americans broadly cut spending at retailers in May, for the first time this year. An end to the war in Ukraine is not in sight. The price of oil should rise in the near term with summer demand.
Jobless claims—a proxy for layoffs and a key barometer of labor market tightness—fell to 229,000 in mid-June, a historically low level. The unemployment rate held at 3.6% in June, close to the half-century low level.
Other financial conditions have tightened significantly. Credit spreads have widened, most major stock market indices have slipped into bear market territory, and the dollar has strengthened, which will depress growth in American exports. Tighter financial conditions will also impart slowing effects on the economy. Headline rates of Personal Consumption Expenditure and Consumer Price Index inflation could both now peak in the third quarter of this year.
The Fed is expected to hike rates by an additional 275 bps between now and early 2023. Higher interest rates will weigh on interest rate-sensitive spending. Growth in business fixed investment spending should turn negative starting in the second quarter of next year, which coincides with a modest decline expected in payrolls.
Expectations have changed from an economic soft landing to a mild and relatively brief recession starting in mid-2023.
That said, many underlying fundamentals remain sound. Household and business balance sheets are in good shape, and the banking system is well-capitalized. The recession next year is not necessarily assured, nor is the magnitude and length anticipated, but it may well be like the downturn of 1990-1991. That recession lasted for two quarters with a peak-to-trough decline in real GDP of 1.4%.
U.S equities gave back some of the gains achieved in the past few years in the first half of 2022, with the S&P 500 declining roughly 20% and over 16% in the second quarter alone. The Russell 1000 Index declined 16.7% in Q2, while the Russell Mid Cap and the Russell 2000 declined 16.9% and 17.2% respectively. International equities were not immune from quarterly losses as the MSCI Europe fell 14.5%, the MSCI Japan fell 14.6%, and the MSCI Emerging Markets fell 11.5%. The MSCI China rose 3.4% as the country ended their COVID lockdowns and business activity began to pick up again. Chinese equities were up 6.6% in June at the same time U.S. equities were down well over 16%.
Stylistically, Value stocks outpaced Growth stocks in a continuation of a trend that began in 2021. The performance differential between these two investment styles was over 8% in 2Q22 for large companies, 5% for mid-sized companies and about 4% for smaller companies.
Bonds, usually the ballast for portfolios, were not immune from price declines as interest rates soared. The full range of credit qualities was hit in Q2 with prices declining the most, i.e., spreads widening in riskier bonds. The Bloomberg Aggregate, a proxy for the full bond market in the U.S. declined 1.6% in Q2, while government bonds retreated only by 0.87%.
Losses also spread to non-traditional asset classes. The Bloomberg Commodity Index was down 5.7%, the S&P North American Natural Resource Index was down 10.4%, while the FTSE NAREIT Equity Real Estate Index was down another 17% after a stellar year in 2021.
In the near term, the outlook for equities and bonds does not seem particularly bright with profit growth winding down, interest rates on the rise, and plenty of uncertainty to go around the major developed and emerging markets economies.
Equities that are bolstered by strong corporate balance sheets, a surer and more stable profit outlook, and can pay and even raise their dividends despite a slowing economy would appear to be in the driver’s seat in terms of market leadership. This should continue the Value-over-Growth style trend that has been apparent for some time. While stock valuations have “come back down to earth” to a large degree, it is not entirely clear that the equity market has bottomed. Further consolidation is possible in the months ahead as rising rates take a bite of the economy.
While short-term interest rates are sure to rise in the coming quarters, it is not as certain that long-term interest rates will follow suit. Long-term interest rates on the liquid 10-year U.S. Treasury have been hovering around 3% for some time despite the forecast of higher short-term interest rates. This would seem to suggest that the broad bond market believes that inflation will decline significantly as the economy slows in the coming quarters. As often happens when short-term rates are higher than long-term rates, a so-called inverted yield curve, presages a recession. So, in some respects, a picture is emerging of a slowing economy, stocks searching for a bottom but still not there, and a bond market that appears to be anticipating a lot slower growth and perhaps even a recession in the quarters ahead.
While we know that this assessment doesn’t provide a lot of near-term comfort, history tells us that these economic conditions and markets do happen, and with some variety in duration.
Source: Calamos Advisors LLC
We have tried to consistently remind our clients that there is no use in trying to time the market. Rather, we continue to believe that, for long-term investors, sticking to a well-conceived investment plan is the best course. These charts illustrate this concept.
Source: Calamos Advisors LLC
Source: Calamos Advisors LLC. Similarly, investment returns are improved when investors are uninvested during the market’s worst days.
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Based on the S&P 500 trailing twelve-month Price-to-Earnings ratio, our gauge of U.S. equity valuation registers a June reading at the 16th percentile from January 1871 to June 2022.
Based on the Federal Reserve Bank of Philadelphia’s U.S. Coincident Index, our gauge of U.S. economic activity in June registers at the 94th percentile from April 1979 to June 2022.
The equity valuation and economic activity gauges have been reviewed by GW & Wade and are consistent with the firm’s near-term outlook.
This economic and market commentary was prepared by Capital Market Consultants, Inc. (CMC), an independent investment management consulting firm, and has been approved for distribution by GW & Wade, LLC. Data used to prepare this report by CMC are derived from a variety of sources believed to be reliable including well-established information and data software providers and governmental sources. CMC is not affiliated with any of these sources.
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About the indices presented above:
- Standard & Poor's 500 (S&P 500®) Index is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.
The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange (NYSE) and the Nasdaq.
- The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership.
- The MSCI ACWI (All Country World Index) is a market capitalization-weighted index designed to provide a broad measure of equity-market performance throughout the world.
- The MSCI EAFE Index is an equity index that captures large and mid-cap representation across Developed Markets countries around the world, excluding the US and Canada.
- The MSCI Emerging Markets Index (EM) captures large and mid-cap representation across 24 Emerging Markets (EM) countries.
- The Bloomberg Barclays Global Aggregate Bond Index measures global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers.
- The Bloomberg Barclays US Aggregate Bond Index measures the performance of the U.S. investment-grade bond market. The index invests in a wide spectrum of public, investment-grade, taxable, fixed-income securities in the United States – including government, corporate, and international dollar-denominated bonds, as well as mortgage-backed and asset-backed securities, all with maturities of more than 1 year.
- The Bloomberg Barclays US Credit Index measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate and government-related bond markets. It is composed of the US Corporate Index and a non-corporate component that includes foreign agencies, sovereigns, supranationals and local authorities.
- The Bloomberg Barclays US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody's, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded.
The charts are for illustrative purposes and are not indicative of any actual investment. Investments cannot be made directly in an index. The index returns represented in the article above are provided gross of fees. Advisory fees, compounded over a period of years, will reduce the total value of a client’s portfolio. For most clients, GW & Wade assesses advisory fees on a quarterly basis in arrears and deducts the fees directly from a client’s account. To the extent that such fees are deducted on a quarterly basis, the compounding effect will increase the impact of such fees by an amount related to the account’s performance.
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