Have we seen the worst – Market Update Q3 2022
Have we seen the worst?
I think this question is easy to answer, at least right now. There is undoubtedly more pain for investors as pandemic policies continue to be rolled back and central banks are implementing a coordinated hawkish policy.
I am certain that most everyone reading this has heard from either the news or other sources that the U.S. economy is currently in, or headed into, a recession. According to the University of Michigan consumer confidence survey, which hit an all-time low in June (worse than at the peak of COVID shutdowns or at the height of the financial crisis in 2008), it appears no one has any confidence that there will be any other outcome than a recession, and this has been reflected so in the capital markets, with stocks and bonds in bear territory, which is a fantastic leading indicator of economic health.
Even though we at ProCore Advisors believe more economic slowdown is ahead of us and a recession is the likely outcome, it is difficult to say we are currently in one. Reviewing some of the other leading economic indicators paints a different picture. In the first five months of the year, manufacturing production was up at a 6.6% annual rate, nonfarm payrolls were up at an average monthly pace of 488,000, the unemployment rate dropped to 3.6% from 3.9%, and the national home price index rose 7.4% to remain at an all-time high. Meanwhile, in April, both “real” (inflation-adjusted) consumer spending and real personal income were also at record highs.
We did have a decline in GDP for the first quarter, and the Fed is projecting zero growth in the second quarter, which will be reported on July 28th. However, we feel it is important to recognize that real gross domestic income, GDI, an alternative measure of economic output, rose at a 2.1% annual rate in the first quarter. The public pays very little attention to GDI because the government usually takes an additional month to report that data. after GDP is initially released. But, over time, GDI is just as accurate as GDP in describing the performance of the economy.
Of course, it is not all great news. The elephant in the room is inflation and increased interest rates, and it is starting to take a large toll on consumers as well as corporate margins and profits with little to no short-term relief in sight. Despite the high inflation, consumer cash flow and balance sheets remain healthy. Household net worth finished last year at more than eight times annual after-tax income, the highest ratio on record. Americans had $1.2 trillion in checkable deposits and currency before COVID. At year’s end in 2021, they had $4.1 trillion.
When is a recession likely to happen and how severe of a recession could we experience?
A recession is likely after monetary policy gets tight enough to wrestle inflation back down toward the 2.0% target. With the Federal Reserve looking to continue to increase the Fed funds rate 3 more times this year alone (July 26th, September 20th, and November 1st), we would expect a recession not to occur until probably mid to late 2023.
It will become more clear once we see some additional leading indicators worsen. Indicators such as rising unemployment or declining real estate prices. Real estate tends to lead the economy into recessions as most wealth is tied up in consumers’ homes, and as prices come down, consumers feel less wealthy and tend to spend less.
Some are concerned that we could be in for an extended or severe recession if home prices collapse or if we are in a new tech bubble. However, the notion that the U.S. is on the edge of a recession like the one in 2008-09 does not seem likely. Bank capital is well above regulatory requirements, and we don’t have a mark-to-market accounting rule that will generate a “fire sale” in bank assets. And as mentioned above, consumer balance sheets remain very strong, which would most likely fend off elevated default rates in the housing market. We would expect a recession more in line with the recessions of 1990-91 or 2001, when the unemployment rate went up about 2.5 percentage points, not like the soaring unemployment of the Great Recession or the 2020 Lockdown.
Have the current market levels adequately priced in the many risks investors face?
We expect that markets will continue to be tough to navigate over the next few months or until we see signs that inflation has peaked and that monetary policy is tight enough to bring inflation down to the Fed’s target of 2%. During this time, we could see short-term bull rallies followed by additional sell-offs that retest recent lows in the market. And until inflation is under control, we would not expect to see a new bull market head for new S&P highs until sometime during the beginning of the recession, once investors start to grow more confident about the recession ending soon. But is today the time to sell and sit on the sideline? We believe the market has priced in much of the negative news around inflation and recession fears, and we continue to believe there is a longer-term case for investors to roll with the punches here, now having officially weathered a bear market, and soon take advantage of this market volatility and negative sentiment. Our expectations are that by the second half of 2023, interest rates will have plateaued, inflation will be lower, a severe recession will probably not occur, and stocks will be higher, although it must be acknowledged that the current market is one that is testing our assumptions.
What could drive the markets higher this year?
A handful of wild cards could be flying under the radar and capable of upside surprises for the markets between now and year-end. These could include a resolution to the war in Ukraine, a definitive sign that inflation has peaked, a lack of downward revisions to corporate earnings, the upcoming November congressional elections, and the simple premise that most expected bad news might not turn out to be as bad as most fear.
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