By Tim Courtney, Chief Investment Officer
Following another high inflation reading, and the market’s poor reaction to it in September, we enter the last quarter of the year and look at market and economic fundamentals that will be driving market behavior. Things look much different than they did at the start of the year. We ended 2021 with annual earnings for the S&P 500 up 32% higher than 2019 and 70% higher than 2020.1 Real gross domestic product (GDP) increased nearly 6% last year. We knew 2022 would be a more challenging year with the end of 0% rates and stimulus spending fading. But we still have not been able to overcome the problems we started the year with: inflation, labor shortages, malfunctioning supply chains, an ongoing war, etc. We will be looking at the below fundamentals to give us an idea of how 2023 may start.
- Inflation: The market has focused like a laser on inflation and interest rates, and this has been, by far, the main driver of volatility. Markets didn’t price in the 8% inflation and are still priced for inflation to begin to decline.2 However the market’s wishful thinking that inflation would plummet immediately ended in September. We believe inflation will begin to decline, but at a slow pace. There is still pressure from wage inflation, supply chain challenges and increased housing prices that have not yet made their way into the consumer price index (CPI) yet. Additionally, food prices have been surging. The next several CPI readings will be critical.
- Earnings: We started 2022 with reasonable expectations. We were coming off huge growth numbers in 2021, which we were almost certainly not going to repeat this year. Analysts predicted some cooling in 2022, but earnings were still expected to increase another 10-12%.3
However, the realities of 2022 hit quickly and earnings from some bellwether companies, like FedEx, began slipping.4 We will be closely monitoring Q3 earnings reports to assess how the challenges are affecting company health. Overall, we now expect to end the year flat, which is not the worst-case scenario when you consider last year’s surge and the fact that equity valuations are now lower and are already pricing in some weakness.
- Gross Domestic Product and a Recession: The Federal Reserve, in recognition of the role it played in inflation, is rapidly raising interest rates, with three-consecutive hikes of 75 basis points.5 At some point the rates will have a negative impact on economic activity, with fewer loans for houses and cars and, in turn, a decrease in demand. Some decrease is necessary, but too much causes a recession.
While we’ve already seen two consecutive quarters of real GDP decline, other numbers such as employment are quite healthy for what you might expect in a recession.6 The Q3 GDP data will give us an idea of how quickly the growth is slowing.
We entered this year with market prices that assumed low inflation and continued growth. We are in a much different environment now as valuations look reasonable to us – not necessarily cheap if we end up going into a recession but also not priced for perfection either. Many of the most speculative and expensive areas of the market have, to a large degree, already been washed out. If you have questions about your portfolio as we approach the end of the year, please contact your Exencial Advisor.
- SPGlobal.com (1/13/22) — S&P 500 Earnings and estimate report
- CNBC.com (9/13/22) — Inflation rose 0.1% in August even with sharp drop in gas prices
- Forbes Advisor (1/3/22) — 2021 Stock market year in review
- Yahoo! Finance (9/26/22) — Nike is the next bellwether in focus after FedEx earnings whiff
- The Associated Press (9/26/22) — Fed officials call for more rate hikes to fight inflation
- Forbes (9/26/22) — Will the U.S. see a recession?
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