- The S&P is down about 21% year-to-date, making it the worst half since 1970.
- The Dow Jones Industrial Average is down 15.3%, its worst half since 1962.
- The Nasdaq is down about 29%, the worst half since the dinosaurs roamed the earth.
While there are numerous reasons for these drops, by far the greatest cause is high inflation and fear of a deep recession.
Crosscurrent of Inflation Data
“Pennies aren’t lucky anymore. You have to find at least a nickel.”
In numerous polls of the American public during the second quarter, inflation and higher interest rates were identified as their greatest financial problem and worry. Of course, interest rates and inflation are on either side of the same coin. The Fed., which we believe has been behind the curve in fighting inflation, raised interest rates by 0.75% at its June meeting. They do not seem reluctant to raise interest rates to curb inflation. The era of limitless credit and low borrowing costs is coming to an end for the foreseeable future.
Inflation seems to wane, however, as economic data has slowed down, if not outright contracted. The Fed’s preferred measure of inflation was trending in the right direction in May with a dip of 4.7% in the core rate, down from 4.9% in April. However, the data picture is unfolding with crosscurrent signals.
Consumer confidence, for example, dropped to a monthly low in June, and expectation of continuing inflation rose to 8%, the highest in its 35-year history, thanks to rising gas and food prices. Consumer spending rose only .02%, much lower than expected. In contrast, the savings rate rose to 5.4% in May, up from a 14-year low in April. Shoppers didn’t have to reach into their wallets too much as personal income gained.
The Fed’s interest rate policy seems to be working in slowing the housing market. Homes aren’t humble anymore. They are expensive. The median price for a new home rose to $450,600 in April, up from $435,000 in March. Again, we see the cross current of inflation measures. The housing market has been skyrocketing for the past two years, but it may now be coming back to earth. The mortgage interest rate hit 5.81% in June, the highest level since November 2008. This may have prevented many first-time buyers from purchasing a new home. The 30-year mortgage rate was about 2% at the beginning of the year.
More opposing data can be seen in the various gauges of overall inflation. The overall price index for the Federal Reserve’s preferred gauge of inflation climbed to 6.3% in May, (a repeat of April’s 6.3% gain). Yet, Personal Consumption Expenditures (PCE) rose in May by 4.7%, which was down from April’s 4.8% increase. This was the second straight month of declines and suggests inflation may have peaked.
It’s no wonder economists are scratching their heads. The latest data point on the health of the manufacturing sector came in below expectation at 53 in June, down from a reading of 56.1 in May, but still residing at a level above average for the 30-year-plus history of the gauge, according to the Institute for Supply management. Historically, the past relationship between the Manufacturing PMI and the overall economy corresponds to a 1.5% increase in real gross domestic product. In contrast, the GDP prediction declined again last week. Q1 figures with a 1.6% contraction on an annualized basis, even as the current-dollar nominal GDP figure of $24.4 trillion soared by 10.6% on an annualized basis to an all-time high.
For the first time since 2002, the U.S. dollar and the euro may reach parity. The dollar and the euro generally move in an inverse relationship to one another. Given the current turbulent financial markets; inflation in Europe, which is about 8%; and the war in Ukraine, investors are starting to look at the dollar as a safe haven in stormy seas. The dollar index is up 9% this year.
A stronger dollar is a double-edged sword. Americans traveling abroad will benefit, but it may discourage tourists from coming to the United States. Goods produced abroad and raw materials should be cheaper, but sales of American goods to foreign countries may be negatively impacted. Foreign multinationals in the U.S. will benefit from revenues in dollars, while American multinationals abroad will suffer as the value of sales in local currency will diminish. Imported goods by foreign countries will become more expensive, which will add to a European inflation rate already as high as the U.S. rate.
One Stock at a Time
One of the most heated debates among experts is corporate earnings. Q1 earnings reporting was by most accounts good, even though stocks sold off sharply on the news. Analysts’ estimates are still calling for growth during the remainder of 2022, 2023, and 2024 to be above 2021 estimates. On the other hand, respected entities such as Goldman Sachs feel this optimism is too high. We are keeping a close eye on analyst revisions for stocks we own and stocks we want to buy looking at each companies’ individual metrics.
Focusing on profit margin indicators is an example of an indicator to which we are giving priority. The Conference Board’s CEO Confidence Index has fallen sharply this year. Such an accelerated drop typically leads to weaker profit growth in the next three-to-six months. Taking emotion out of the equation is our job, and we are very comfortable with the long-term prospects of our broadly diversified portfolios, despite the chance of a short-term profit crunch.
Another significant fact is that although the Fed is fighting inflation, interest rates are still historically low. We agree with Powell’s statement, “Overall, the U.S. economy is well-positioned to withstand tighter monetary policy.” We are certainly not suggesting the economy won’t weaken further, but we do not fear a prolonged recession at this time.
While demand is slowing, supply chains are also improving simultaneously, moderating some of the bad news that suggests the potential for a global recession. The weakness in Fed Manufacturing surveys is confirmed by the Friday releases of U.S. Manufacturing PMI reports from S&P Global and ISM, which both decelerated relative to May. While production and new orders have generally slowed, we do note that manufacturers are reporting both less extreme inflation pressure and supplier delivery times.
The recent baby formula shortage reminds us that, while improving, supply chains are still not at their pre-pandemic levels. The war in Ukraine and China’s Covid lockdown continues to pressure supply chains. Since the problem is worldwide and not just domestic, we do not anticipate a significant improvement in the near future. Shortages have especially negatively affected electronics, the automobile industry, and technology.
Secrets to Success
Focusing on profit margin indicators is an example of an indicator to which we are giving priority. The Conference Board’s CEO Confidence Index has fallen sharply this year. Such an accelerated drop typically leads to weaker profit growth in the next three-to-six months. Taking emotion out of the equation is our job, and we are very comfortable with the long-term prospects of our broadly diversified portfolios, despite the chance of a short-term profit crunch.
Another significant fact is that although the Fed is fighting inflation, interest rates are still historically low. We agree with Powell’s statement, “Overall, the U.S. economy is well-positioned to withstand tighter monetary policy.” We are certainly not suggesting the economy won’t weaken further, but we do not fear a prolonged recession at this time.
While demand is slowing, supply chains are also improving simultaneously, moderating some of the bad news that suggests the potential for a global recession. The weakness in Fed Manufacturing surveys is confirmed by the Friday releases of U.S. Manufacturing PMI reports from S&P Global and ISM, which both decelerated relative to May. While production and new orders have generally slowed, we do note that manufacturers are reporting both less extreme inflation pressure and supplier delivery times.
The recent baby formula shortage reminds us that, while improving, supply chains are still not at their pre-pandemic levels. The war in Ukraine and China’s Covid lockdown continues to pressure supply chains. Since the problem is worldwide and not just domestic, we do not anticipate a significant improvement in the near future. Shortages have especially negatively affected electronics, the automobile industry, and technology.
