Stocks remain volatile with concerns centered on inflation and how high the Federal Reserve (Fed) will have to raise interest rates to tame inflation. We remain positive on the economic outlook, continue to favor staying the course with long-term investment plans, and have the following observations.
While the stock market is forward looking and often discounts events before they happen, interest rates are still low and conducive for further economic growth. The Fed’s best estimate of neutral short-term interest rates (the rate that neither stimulates nor restricts economic activity) is about 2.4%. Given that the Fed is currently only targeting short-term interest rates between 0.25-0.5%, monetary policy remains conducive for further economic growth. Interest rates remain far from levels that would be consistent with a severe economic slowdown or recession and major bear market for stocks.
Monetary policy also acts with a lag of about a year. This implies that the major effect of this year’s rate hikes won’t be felt until 2023 and beyond. The Jay Powell led Fed also has a history of being data dependent as evidenced by the 2018 rate hike cycle. Today’s strong economic readings allow the Fed to pursue higher interest rates, but they will adjust their policy path based upon incoming inflation and economic data. While inflation is stubbornly high and its future path uncertain, most estimates show it falling by year-end as supply-chain bottlenecks get resolved. Lower future inflation readings would allow the Fed to be less aggressive with rate increases than the market is currently anticipating.
We would also note that the average year has about a 14% correction (usually caused by short-term fears about the economic outlook), while ultimately producing a positive 10% return. Outside of significant economic slowdowns, stocks typically rebound relatively quickly from corrections without much warning.
Meanwhile, incoming economic data remains healthy and is supporting solid corporate profit growth, which provides the fundamental support for stock prices.
The Conference Board’s Leading Economic Index (LEI) rose again in March. While off peak levels from earlier in the recovery, the pace of LEI growth and the breadth of its indicator improvement are still consistent with above- trend economic expansion. The Conference Board projects 3.0 percent year-over-year U.S. economic growth in 2022, which is slower than the 5.6 percent pace of 2021, but still well above pre-COVID trend.
The Philly Fed State Coincident Indexes increased in all 50 states in March, indicating sustained and broad- based growth across the country with minimal odds of recession at this time. The state coincident indexes are based on data from nonfarm payrolls, manufacturing hours worked, the unemployment rate, and wages and salaries. Their sustained gains in recent months show the resilience of the employment and income side of the economy in the face of rising inflation, Fed tightening, and adverse geopolitical events.
Jobless claims edged down last week to 184,000 with the trend in layoffs close to the lowest level on record. Continuing claims of 1.42 million is at the lowest level since 1970, while the insured jobless rate fell to 1.0%, a record low. Jobless claims are one of the timeliest economic indicators and continue to reflect strong labor market conditions.
Other positive indicators included March housing starts of 1.79 million (highest level since June 2006), building permits of 1.87 million (close to highest level since May 2006), and industrial production growth surpassing the previous high from August 2018. The preliminary Markit business surveys for April were also consistent with further growth.
These healthy economic readings are leading to better-than-expected profit growth. With about 25% of S&P 500 companies having reported first-quarter results, earnings are coming in much better than anticipated. At the current pace, first-quarter earnings would come in at about 12%, well above the 4.3% expected at the beginning of earnings season. We’ll soon learn a lot more from earnings with about 67% of S&P 500 companies scheduled to report in the next two weeks.
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