Economic Letter

Economic Commentary October 2022

By Patrick Pascal

October, 2022

U.S. ECONOMY

The U.S. Bureau of Economic Analysis’s final estimate for Q2 GDP was unchanged from the previous estimate at negative 0.6%, the second straight quarter of decline, thereby meeting the commonly accepted definition of a recession. The Conference Board forecasts real U.S. GDP growth in 2022 will come in at 1.4% and that 2023 growth will slow to 0.3%. Economists recently surveyed by Bloomberg put the possibility of the US experiencing a recession in the next 12 months at 50%, up from about a 33% probability predicted in July.

In August, nonfarm payrolls surpassed their pre-pandemic peak. Jobless claims reflected a months-long string of stronger than predicted employment numbers. Layoffs and other involuntary discharges, at 1.4 million in July, were about 20% below their average monthly level when GDP was growing more quickly. Fed forecasts presently see the unemployment rate increasing to 4.4% by next year and effectively hovering there for several years. Over seven decades, both payrolls and economic output typically have fallen within two quarters of the start of a recession. However, during the inflationary recession that began in November 1973, employment first grew and then held steady before sharply declining after October 1974—one year later.

From 2008, central banks kept interest rates low and exchange rates moved in a tight range. Year-to-date 2022, the WSJ Dollar Index (against a basket of currencies) is up roughly 16%. In the third quarter alone, it gained more than 9% against the British pound. This year’s strong dollar has helped mitigate inflation by reducing the prices of goods and services imported into the U.S., however, it should be noted that 40% of S&P 500 revenues comes from outside the U.S.

Recently, S&P 500 earnings growth estimates have been trending lower. The +1.0% earnings growth expected for the S&P 500 index in 2022 Q3 is down from +7.2% expectations on June 30 and analysts have reduced S&P 500 2022 year-over-year earnings growth to 3.2%, down from 9.8%. Since mid-April, double-digit earnings percentage declines have emerged in Retail (down -14.9%), Construction (-15.8%), and Tech (-11.1%).

Robert Shiller’s data, since 1960, suggests the average peak-to-trough earnings drop in a recession is about 31%. Even a mild recession can produce a downward revision cycle in earnings estimates of 20%. Over the past few years, corporate profit margins have grown—last year’s average net margins reached 13%. A slowing economy with protracted inflation would certainly be expected to squeeze corporate margins.

INTEREST RATES / INFLATION

Federal Reserve Board Chairman Jerome Powell has been very vocal and clear over the past month. His statements warn that, “The chances of a soft landing are likely to diminish to the extent that policy needs to be more restrictive, or restrictive for longer” and “No one knows whether this process will lead to a recession or, if so, how significant that recession would be.” One assertion that is now missing from his recent public statements are hopes for a growth rate sufficient to reduce inflation without a recession.

He is not alone on his Board. On September 30, Vice Chairwoman Lael Brainard gave a speech saying that, “Monetary policy will need to be restrictive for some time to have confidence that inflation is moving back to target,” and “We are committed to avoiding pulling back prematurely.”

Markets now expect 125 basis points of tightening at the Fed’s next two meetings and a peak rate of 4.6% in 2023, compared to the 3.8% estimated in June. The Federal Open Market Committee projects rate cuts will now begin in 2024 rather than 2023.

With inflation far above target in almost every advanced economy, central banks are raising rates in response. According to the World Bank, more central banks raised borrowing costs in July than at any time since records began in the early 1970s.

To reduce inflation the Fed must typically push real interest rates into positive long-term territory. Since the beginning of August 2- and 10-year Treasury yields have risen 120 basis points to above 4.2% and 3.7% respectively, compared with a 1.9% yield on the S&P 500. The 30-year fixed mortgage rate averaged 6.29% last week, the highest since October 2008. As liquidity continues to contract, this volatility will likely persist into year-end.

The Federal Reserve’s recent statements suggest rates will peak during this period. We intend to use this volatility and higher rates to opportunistically extend average durations of our fixed income holdings.

EQUITIES

In July, markets rallied largely on speculation that a rate pivot (cuts) was at hand. But in August and September hawkish Federal Reserve statements, rising interest rates, reduced earnings estimates, and higher-than-expected inflation fueled renewed weakness.

In September alone, the Dow slipped 8.8%, while the S&P 500 dropped 9.3% and the Nasdaq lost 10.5%. In the third quarter, the Dow, the S&P 500 and Nasdaq all extended a three-quarter losing streak, falling 6.7%, 5.3% and 4.1%, respectively. These losses brought September 30, year-to-date returns to -19.7%, -21.5% and -32.0% respectively.

During the quarter, the aggregate price earnings ratio for the S&P 500 Index declined from 21.75 to 17.85 reflecting adjustments related to higher assumed rates of inflation. Going forward, corporate earnings will be watched closely as this same inflation may well result in lower earnings.

Yet, there are reasons for optimism. U.S. stocks have an eight-decade record of rising after each midterm election. On average, the S&P 500 has gained almost 15% over the following twelve months. Additionally, two market sentiment surveys showed the most negative readings since 2009. Such extreme pessimism often brings buying opportunities.

CONCLUSION

As extremely high liquidity is wrung out of the economy, markets have responded reasonably. Over this year, valuations of both equities and fixed income have markedly improved. We believe the worst of market conditions are largely past and look to use future market opportunities to selectively add prudent positions.

The opinions expressed are for general informational purposes only and are not intended to provide specific recommendations or advice on any specific security or investment product. It is only intended to provide education about investment issues.