Our second-quarter Asset Allocation and Equity Market Outlooks came out last week, and both shifted to a more cautious view on equity markets over the next 12 – 18 months. As Erik Knutzen has put it, an increasingly problematic mix of high inflation, rising interest rates and softening economic growth could persuade investors to go “from buying the dips to fading the rallies.”
Cautious, however, doesn’t mean bearish. Both sets of views are nuanced—noting, in particular, that the current economic robustness provides a meaningful buffer to absorb a slowdown in activity, high inflation and tighter monetary policy.
Those fundamental underpinnings are worth bearing in mind as we enter the first-quarter earnings season. While we think that elevated volatility is likely to persist, a substantial decline in equity markets remains unlikely as long as earnings hold up and recession is avoided.
Growth Versus Inflation
Current market consensus is for approximately 5% first-quarter earnings growth, year-over-year, for the S&P 500 Index.
Based on past patterns, reported earnings growth is likely to be modestly higher than that, which we would view as an important reminder that the economy is still recovering from the impact of the COVID-19 pandemic. For all of 2022, analysts’ S&P 500 earnings forecasts are still holding up in the high single digits.
Might inflation start to pressure margins and bite into those earnings? We are hearing more and more management teams talking about rising costs associated with tight labor markets and ongoing COVID-19 and supply-chain disruption but, so far, they have generally been able to increase prices to at last partially offset these higher costs.
We can see a similar balance of forces at the level of the broad economy: At 8.5%, the U.S. year-over-year inflation rate that came out last week was the highest since 1981; but initial jobless benefit claims have declined to levels unseen since the late 1960s. Consumers may be feeling the squeeze, but they continue to have job opportunities to choose from and confidence to spend.
How serious is the threat of recession?
In our view, at least on a 12-month horizon, we think the risk remains modest in the U.S., given the underlying robustness of the economy.
We think the biggest risk is from the impact of aggressive monetary policy response to contain inflation. A number of U.S. Federal Reserve policymakers have said that, to tame prices, rates need to be neutral or above by the end of this year.
In our Equity Market Outlook, Raheel Siddiqui notes that tighter monetary policy could bring global Purchasing Managers’ Indices (PMIs) back down to the level of a moderate industrial recession, but he does not anticipate negative U.S. economic growth. Brad Tank has also noted that the interest rate market appears to reflect reassurance about the central bank’s ability to manage inflation “without inflicting excessive collateral damage on the economy.”
The growth and inflation picture may be more challenging elsewhere.
Europe had looked to be at less risk of rising prices due to its looser labor market, but is now highly exposed through its Russian and Ukrainian fossil fuel and food imports. The current consensus expectation for the STOXX Europe 600 Index has earnings growth in 2022 at 10%, and 6.5% in 2023—however, as we are already seeing net-earnings revisions turn negative, we think those 2022 and 2023 forecasts are likely to be close to zero soon. China also looks more vulnerable than it did a few months ago, due to renewed COVID-19 disruption. This is one reason why we now favor U.S. equities.
Overall, we have little doubt that markets face a challenging period of stubborn inflation combined with slowing growth, likely leading to persistent volatility.
As we wrote in last week’s Outlooks, that makes a case for higher-quality, lower-beta, income-oriented equity exposures; for larger companies over smaller; and U.S. over non-U.S. markets.
But the economy is still growing, consumers are still spending, and many businesses are still making profits. Investors may want to position portfolios to mitigate the volatility—but we still believe equities have the potential to be positive this year.
In Case You Missed It
- U.S. Consumer Price Index: +1.2% in March month-over-month and +8.5% year-over-year (core CPI increased 0.3% month-over-month and 6.5% year-over-year)
- U.K. Consumer Price Index: +1.1% in March month-over-month and +7.0% year-over-year
- U.S. Producer Price Index: +1.4% in March month-over-month and +11.2% year-over-year
- European Central Bank Policy Meeting: The Governing Council made no changes to its policy stance
- U.S. Retail Sales: +0.5% in March
What to Watch For
- Monday, April 18:
- China 1Q 2022 GDP
- NAHB Housing Market Index
- Tuesday, April 19:
- U.S. Housing Starts and Building Permits
- Wednesday, April 20:
- U.S. Existing Home Sales
- Thursday April 21:
- Japan Consumer Price Index
- Japan Purchasing Managers’ Index
- Friday, April 22:
- Eurozone Purchasing Managers’ Index