Stocks faced another challenging month in April with the S&P 500 Index down 8.7% for the month and down 12.9% for the year. High inflation readings and the amount of Federal Reserve interest rate hikes needed to tame inflation-driving demand remain the major sources of market uncertainty. The Ukraine crisis and China’s COVID lockdowns are also adding to the uncertain outlook.

We are now close to the 14% correction that the average year has seen since 1980 with history showing that major bear markets are typically associated with economic recessions. However, the key economic indicators that we closely follow continue to suggest a low probability of a near-term recession. Stocks are also crucially supported by profit growth, and while corporate profit growth has slowed from the torrid pace early in the economic recovery, it remains positive (discussed below).

Given still healthy economic and profit underpinnings, we think reduced uncertainty around inflation and the interest rate outlook would be a key catalyst for a resumption of the bull market.

A significant portion of the recent high inflation has been caused by goods inflation as consumers opted for goods purchases over services (especially travel and leisure) during the pandemic while supply of goods was limited. We are now seeing a shift in spending from goods to services as the pandemic fades. Accompanying this are signs that overall inflation is peaking. Excluding autos, U.S. retail inventories are about 5% above their pre-pandemic trend which suggests that most goods demand has largely been met. This should ultimately result in lower prices. Indeed, core goods prices fell in March for the first time since February 2021.

We expect resolution of supply-chain issues as the year progresses, despite the near-term disruption from China’s current COVID lockdowns. Hopefully, a stabilization of the Ukraine crisis would also reduce current uncertainty. All of this could set the stage for lower inflation readings in the back half of the year which would help business and consumer confidence and an improving economic and market outlook.

Meanwhile, earnings growth remains respectable, despite decelerating from the rapid pace early in the recovery. With about 70% of the S&P 500’s market capitalization having reported, first-quarter earnings are beating estimates by 7.0%, with 78% of companies topping expectations. First-quarter expectations are for earnings growth of 7.9% with expectations at a much healthier 18% when Financials are excluded (Financials face a tough comparison from last year when they released pandemic-related reserves as earnings). Earnings should also come in better than the expected at 7.9%, given the current impressive 7.0% beat-rate. Earnings continue to be led by the strong rebound in cyclicals with Energy, Materials, and Industrials leading profit growth.

Given the high market volatility that exists, we continue to favor a “barbell” approach for portfolios. This involves favoring the relatively defensive Health Care sector with the more cyclically oriented Energy and Materials sectors.

Health Care earnings are relatively stable compared to sectors that are exposed to higher discretionary spending. This results in the sectors lower historical volatility relative to the market as evidenced by the sector’s 0.8 beta (a measure of the sector’s expected movement relative to the market with values less than 1.0 suggesting lower volatility). Health Care also has more favorable valuation than the overall market with a forward earnings multiple of about 16 compared to the market multiple of about 18. Favorable demographics are also a tailwind for the sector.

We also see favorable attributes for Energy and Materials. Both sectors have seen a lack of investment in recent years that suggests future supply growth will be muted. Demand for energy rebounded quickly with the reopening while supply has been slow to improve. This has resulted in higher energy prices that have been aggravated by the Ukrainian crisis where sanctions will likely impede future Russian production growth. The Ukrainian crisis also highlights the need to accelerate the transition to clean energy sources. Renewable energy requires significant base metals as inputs which benefits the Metals & Mining sector. Energy’s forward earnings multiple is 10.0 and Materials is 15.0, both favorably below the market’s 18.




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