Investor concern remains focused on high inflation readings, the Federal Reserve’s pursuit of higher interest rates to slow the economy and combat inflationary pressures, and the risk that this could push the economy into recession. All of this is outweighing the surprising strength of first-quarter earnings results and still positive economic growth indicators. We have the following observations as we continue to stress the importance of sticking with long-term investment plans.
We expect the path of the stock market to follow the outcome of the Fed’s efforts to tame stubbornly high inflation. Investors are looking for signs that inflation is receding from pandemic-related highs, and while last week’s Consumer Price Index (CPI) posted the smallest increase in 8 months, it continues to come in higher than consensus expectations. High inflation is weighing on business and consumer sentiment, as evidenced by last week’s NFIB Small Business Optimism Index and Michigan Consumer Sentiment Index.
We expect inflationary pressures to recede in the coming months. A significant portion was caused by pandemic-related supply-chain issues that have been aggravated by the war in Ukraine and the current lockdowns in China. The pandemic (and related fiscal stimulus) also caused a spike in demand for goods over services. We are seeing these imbalances correct as evidenced by inventory levels (ex-autos) that are now above pre-pandemic levels while demand continues to shift back to services as the pandemic fades. The impact of last year’s massive stimulus is also fading.
Lower goods related prices should feed into lower inflation readings in the coming months, as early indicators are showing. April’s Producer Price Index was about a third of March’s increase, and the smallest gain in seven months, a sign of some notable deceleration in producer prices. Producer prices feed into consumer prices and this dip confirms the peak seen from April’s CPI noted above. Importantly, the speed at which inflationary pressures recede is critical for future Fed rate hikes and the impact on the economy.
Meanwhile, economic indicators remain consistent with further growth, which should support corporate profits and ultimately stock prices. Last week saw the OECD U.S. Composite Leading Indicator (CLI) increase in April, consistent with slightly-above-trend growth, albeit softer than earlier in this cycle. This suggests a positive outlook for growth in the near term, reducing the risk of an imminent recession.
Other important indicators we follow remain consistent with further growth. Initial jobless claims are a timely economic indicator, and while they have ticked up, continue to hover close to recent historic lows and suggest continued strong demand for labor. Business surveys and corporate bond yields are also consistent with further economic growth.
The 10-year Treasury – Fed Funds Rate (very short-term interest rates) yield curve is a critical recession indicator, and it remains consistent with further economic growth. Corporations, individuals, and state & local governments are all in healthy condition (unlike the situation prior to the 2008 recession) which provides support for economic growth. The stock market itself is now more reasonably priced with the consensus forward price-to-earnings (P/E) valuation multiple declining by 16% from 21x at the start of 2022 to 17x today, tracking closely the rise in interest rates. Meanwhile, with about 90% of S&P 500 companies having reported, 76% are beating first-quarter earnings. Since the beginning of the earnings season, first-quarter earnings have been revised up 7.2% and full year 2022 earnings have been revised up 0.5%.
With analyst earnings estimates moving higher, valuation compression has driven the YTD decline in the market. At a 17x forward P/E multiple, the market is trading close to its 25-year average valuation level of 16.9. Investor and consumer sentiment are also at negative extremes that history suggests is a good entry point for long-term investors, barring a recession.
All of this supports our recommendation that investors stay focused on their long-term plan.
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