Stocks rose again last week with the S&P 500 Index now up 8.1% over the past two weeks—its largest such rally since April 2020.

While we expect economic growth to continue slowing in 2022, this is from a very high level in 2021. While the Federal Reserve is expected to raise interest rates aggressively this year to combat high inflation, monetary policy acts with a lag and the major effect of 2022’s rate hikes will be felt in 2023 and beyond. Meanwhile, incoming economic data remains consistent with a healthy economic expansion. While recession talk has increased with portions of the yield curve inverting, we think it is too early to become pessimistic on the economy and stocks (discussed below).

A Range of Last Week’s Indicators Support the Healthy Growth Narrative

Contrary to expectations for a pullback in private sector activity in the immediate aftermath of Russia invading Ukraine, the U.S. Flash Composite PMI from S&P Global (a timely business survey) reached its highest level in eight months. Both manufacturing and services growth accelerated, supported by pent-up demand, further easing of Covid restrictions, some improvement in supply chains, and strong job creation that boosted production.

The Chicago Fed National Activity Index (CFNAI) was also consistent with the slower but still healthy economy narrative. Both the CFNAI and its trend suggest a modest deceleration in economic growth in February, but to a rate that is still robust and consistent with continued economic expansion.

While the Business Roundtable CEO Economic Outlook Index fell in the first quarter, as heightened geopolitical uncertainty and rising inflation weighed on sentiment, this was still the fourth highest reading in the near-two- decade history of the survey, indicating strong optimism about the near-term growth outlook. Expected sales growth eased modestly, as did capital expenditure and hiring plans. But all three metrics continue to indicate an ongoing economic expansion. CEOs project above-trend 3.9% economic growth for this year.

Initial claims for unemployment insurance dropped last week to 187,000, the lowest level since September 1969. It was the seventh decline in the past nine weeks, fully reversing the temporary upswing in claims due to Omicron. Continuing claims in the previous week fell 67,000 to 1.350 million, the lowest level since 1970, while the insured jobless rate was unchanged at 1.0%, matching a record low. The stellar decline in jobless claims shows that labor markets continue to tighten and suggest that a recession is not on the near-term horizon.

Thoughts on Yield Curve Inversion

A yield curve inversion occurs when short-term interest rates move higher than long-term rates. Yield curves invert close to the peak of an economic cycle, and after a peak there will be an inevitable slowdown or recession. Consequently, talk of recession intensifies when the yield curve inverts.

The yield curve between 2 and 10 years has recently flattened significantly while the 5- to 10-year portion has already inverted. However, not all of the curve has been flattening or inverting. The short end (using the 3- month to 2- or 10-year Treasury) has actually been steepening.

It’s important to note that an inverted curve, no matter the maturities involved, is not very good at predicting the timing of recessions. Historically, recessions follow inversions, with long and variable lags. In addition, stock prices tend to appreciate between curve inversions and recessions—suggesting that it doesn’t pay to be overly pessimistic as soon as the curve inverts.

The recent flattening has been caused by expectations that the Federal Reserve will raise interest rates too high in its inflation fight and that this will lead to a recession. Studies show that the 2-year to 3-month Treasury yield is statistically best at predicting recessions. Importantly, this part of the yield curve has actually steepened significantly. These conflicting yield-curve signals suggest to us that it is too early to make a recession call that would impact corporate profits and stock prices.

While further volatility, driven by uncertainty around the Ukrainian crisis, inflationary pressures, and higher interest rates can be expected, we continue to expect further economic growth to support corporate profits and stocks as we move through 2022.

 


 

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