The major variable across global economies is the path of inflation. In the U.S., inflation reached levels not seen in over 40 years. While originally driven by extraordinary demand and limited supply of goods, now, services and shelter are also exhibiting sustained price increases. Services and shelter prices each grew more than 5.0% year over year in May 2022, whereas overall prices excluding food and energy were up 6.0%. Services – which includes medical care, transportation, recreation, and education – are being pressured from both demand and supply. Services demand is accelerating, as the long-awaited switch back to services from goods has arrived due to lessened COVID complications. Indeed, since October, service expenditures have grown 4.8% while goods expenditures have grown 2.4%. This reshuffle is just beginning – as services are still less than 66% of personal consumption expenditures versus 69% pre-COVID – a difference amounting to $500 billion in annualized spending. On the supply side, labor is still very much a scarce resource with 1.9 jobs available for every unemployed person. Interesting to note – job openings appear to be losing some steam according to indeed.com though this data is not adjusted for seasonality.
Shelter is another troubling picture with rental vacancies at all-time lows. As noted by a recent article in the Wall Street Journal, bidding wars are breaking out for rental units in cities like New York, Chicago, and Atlanta. It appears that higher interest rates and rising home values are making a dent in the housing market, which will result in lower prices, or at least lower price growth. Redfin is reporting 6.5% of active listings have dropped their price during the past four weeks, which exceeds any level over the past three years (2019 inclusive).
A Brief Word on Recessions
How will we know if we are in a recession, when will we know and who determines that a recession has occurred?
There are two common ways to determine recession status. Financial journalists and market participants consider two quarters of negative GDP growth as a recession. Given recent data, it is possible the U.S. economy has already experienced two quarters of negative GDP growth in the first and second quarters this year. Current negative GDP reports have been driven by volatile and smaller components of the economy – inventories, exports, and imports, while trends in larger components, such as personal consumption expenditures have also been softening, but still growing. We will know whether we meet this definition of a recession when second quarter GDP data is released on July 28th.
The other and official determinant of recessions occurs months after the fact by the National Bureau of Economic Research (NBER). A committee at NBER considers many metrics including – real personal income, employment, consumption, wholesale and retail sales, and industrial production. Recessions need to exhibit persistent declines in economic activity across sectors to meet the committee’s definition.
Whether we are technically in a recession is more semantics than substance. The main points are future economic growth and inflation, and the influence they have on monetary policy and corporate profits. As noted in the Investment Outlook section below, whatever the recession status, a great deal of the slowdown/recession is already imbedded in current prices and risks are now more balanced.
Global central banks have continued to tighten monetary policy to fight global inflation with The Bank of Japan (BOJ) the big holdout. We expect the BOJ’s position to be temporary, as there is considerable tension building between a weakening Yen, higher inflation, and the BOJ’s 10-year yield cap. Market expectations of future rate increases have already tightened global financial conditions considerably – a prominent example being U.S. 30-Year mortgages with rates rising from the 3% area to over 5%. As tighter conditions work their way into slowing the economy, it is possible expected rate increases will decline.
Valuation & Sentiment
There have been substantial changes to equity market valuations this quarter. The forward price to earnings ratio for the S&P 500 currently stands at 16.4x next twelve-month earnings, which is below the 25-year average, and below the 21.0x seen at the start of the year. JP Morgan data also compares the forward earnings yield (E/P) of the market to corporate bonds, and on this metric, equities again appear quite reasonable, though dependent on the ‘E’ (earnings) being as forecasted. Despite economic data clearly slowing, next twelve months earnings estimates continue to expand, and are up 6.7% year-to-date. If earnings undershoot expectations, stocks may look less attractive.
Investor sentiment continues to be pessimistic, as the prevailing view can be summarized as “nothing can or will improve for the foreseeable future.” This view is held by both retail and institutional investors. While poor sentiment and undemanding valuations are good starting places for prospective equity returns, we remain concerned about earnings expectations. A more tempered outlook for future earnings would provide fertile ground for launching the next bull market.