A U.S. economy that has contracted for two straight quarters to start the year has more recently appeared to be growing slowly. U.S. consumer sentiment ticked up in early September from historically low levels as Americans felt slightly better about the economy, while equally expressing uncertainty about the future. The consumer sentiment index, a reflection of consumer attitudes on the state of the economy, rose slightly in early September but down from a year earlier. While consumers were more optimistic about the near-term economic outlook than earlier this summer, when inflation touched a four-decade high, they expressed more pessimism about long-run economic prospects.
Since June, inflation has proven to be persistent, while the labor market has remained strong despite signs of a slowdown in some parts of the economy. While falling gasoline costs held down overall inflation in July and August, climbing housing costs and prices for services have kept inflation elevated.
Other economic data in August and September showed the U.S. economy appeared to be running lukewarm. Retail sales rose in August, largely due to increased spending at auto dealerships. Excluding motor vehicles and parts, sales were down 0.3%. Separately, industrial production declined a seasonally adjusted 0.2% in August, due to a sharp drop in utility output, reflecting weather conditions. A continued bright spot was the labor market. Jobless claims, a proxy for layoffs, fell in August and September. Continued strong job growth - employers added 1.1 million jobs in the past three months - and rising wages have given consumers a tailwind, even as they have grappled with rapidly rising prices for everyday goods.
All of these developments have kept the Federal Reserve on track to raise its benchmark interest rate to slow demand and inflation.
Since June, the U.S. economy has been forecast to slip into recession in 2023, and the Fed's firmly stated resolve to bring inflation to heel reinforces the conviction that the U.S. economy is set to contract modestly in coming quarters. The FOMC has raised the target range for the federal funds rate by 225 bps since March, and another 175 bps of tightening is expected by the time the committee finishes its tightening cycle early next year. The combination of continued Fed tightening and elevated inflation, which has caused real personal income to contract in recent quarters, will likely lead to retrenchment in real consumer spending beginning in Q1-2023. Weakness in consumer spending and the continued squeeze on profit margins will then likely lead businesses to cut business investment spending, both fixed investment and inventories, and reduce payrolls. The slowdowns, if not outright economic contractions, forecast in some key U.S. trading partners should also weigh on growth in American exports. U.S. real GDP should contract for three consecutive quarters beginning in Q1-2023.
But this downturn is not likely to be especially deep or prolonged. The underlying fundamentals of the economy, especially the relative strength of balance sheets and the labor market, are reasonably sound at present. Moreover, the Federal Reserve may indeed be able to pull off a "soft landing." However, the Fed's hawkish view and the demonstrated difficulty of actually engineering a "soft landing" make recession next year more likely than not.
Many of the major factors that negatively impacted capital markets in the second quarter, continued to play a dominant role in roiling markets in the third quarter. Soaring inflation, rising interest rates, a strong U.S. dollar, declining consumer sentiment, a tight labor market, a pullback in the U.S. housing market, the war in Ukraine, and supply chain issues continued to headline economic news. News out of China, the world’s second largest economy suggests their economic growth is slowing rapidly and materially as well. And developments in Europe and the U.K. also signaled economic decline and potentially a recession on the near-term horizon. Analysts forecasts for corporate profits in the U.S. continued to decline during the quarter as the U.S economy slows. And as stock valuations have fallen, like last quarter, securities prices slipped into a sea of first half 2022 red ink.
U.S. equities continued to give back some of the liquidity-driven easy gains achieved in the past few years when interest rates were near zero. The declines were less extreme in the third quarter than earlier in the year, perhaps due to greater clarity on the end of the Fed hiking cycle, more attractive relative equity valuations (with the S&P 500 price/earnings ratio lower than the past five and ten-year averages at less than 16 times earnings), and the strength of the U.S. dollar. The S&P 500 was down 4.3% while the broader measure of U.S. capitalizations, the Russell 3000, was down 4.5%. International equities struggled even more with the MSCI All Country World ex-U.S. down 9.9% in the quarter, Emerging Markets equities were down 11.6%, Europe was down 10.2%, Japan declined 7.7%, while China was down 22.5%. The MSCI Emerging Markets Latin America was up 3.6% in the third quarter.
Stylistically there was a reversal of fortune as Growth stocks modestly outpaced Value stocks though both retreated in the quarter. While U.S. stocks overwhelmingly turned in negative quarterly performances, small cap growth stocks posted an anomalous 0.24% positive gain for the quarter.
Bond values continued to retreat as interest rates rose in the quarter. The degree of the decline was driven by credit quality and maturity with lower quality holdings (e.g., high yield bonds) and longer dated maturities taking a larger hit to prices.
In a repeat of last quarter’s comments, the (near-term) outlook for equities does not seems particularly bright confronted with rising interest rates, declining profit growth, and ample uncertainty especially in Europe which still could be further hurt with soaring energy prices and the spread of war. Recessions around the world are definitely in the cards in the near term.
Competing factors are likely to play an important role in market behavior, especially of stocks in the months ahead. Near-term downside risks include what may well be a robust tax selling season as the year ends, souring investor sentiment, declining corporate profits, and what has become the ever present geo-political risk surrounding the war in Europe.
Near-term positives include still solid business and consumer balance sheets, relatively lean corporate inventories that will need re-building when the economy turns up, and trillions in cash waiting to be invested. Additionally, a provision of the recently passed Inflation Reduction Act (IRA) was a 1% “buyback tax” levied on corporate stock buybacks. Companies planning such stock purchases may well choose to move those purchases into 2022 before the new tax goes into effect in 2023.
A longer-term view of markets suggests the tailwinds stock and bond investors enjoyed for the past decade including massive fiscal stimulus as well as declining and ultra-low interest rates will not likely come to the rescue of the markets. Market volatility could well remain elevated in comparison to recent years which could also help create new opportunities for investors. With this in mind, and as rates continue to rise, short- to medium-duration investment grade bonds and cash are reasonable places for fixed income allocations. Equity values are more likely to be driven by the organic operational successes of businesses and not because “there is no alternative” to owning stocks, making the case for ‘know what you own’.
When we talk to our clients about their own portfolios in unsettling markets like the ones we find ourselves in now, we tend to focus on the benefits of not making reactionary decisions. It’s virtually impossible to time the tops and bottoms of the markets and we don’t even attempt it. Rather, in an effort to be prepared for the inevitable periods of volatility and downturn, we construct portfolios for our clients that take their risk tolerance, lifestyle and goals into account, and which seek to weather entire market cycles. Then, where appropriate, we look for opportunities to buy, sell and take advantage of tax efficiencies.
If you have any questions, please do not hesitate to contact your Counselor or you can reach us at info@gwwade.com.
Based on the S&P 500 trailing twelve-month Price-to-Earnings ratio, our gauge of U.S. equity valuation registers a current reading at the 23rd percentile from January 1957 to September 2022.
Based on the Federal Reserve Bank of Philadelphia’s U.S. Coincident Index, our gauge of U.S. economic activity registers an August 2022 reading in the 63rd percentile (Weakening from 87th last month) from 134.94 to 135.16.
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.
The information provided above is general in nature and is not intended to represent specific investment or professional advice. No client or prospective client should assume that the above information serves as the receipt of, or a substitute for, personalized individual advice from GW & Wade, LLC, which can only be provided through a formal advisory relationship.
This outlook contains forward-looking statements, predictions, and forecasts (“forward-looking statements”) concerning our beliefs and opinions in respect of the future. Forward-looking statements necessarily involve risks and uncertainties, and undue reliance should not be placed on them. There can be no assurance that forward-looking statements will prove to be accurate, and actual results and future events could differ materially from those anticipated in such statements.
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About the indices presented above:
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