|Great synopsis from David Kelly. I don’t believe inflation will subside as quickly as he believes. Pent up demand and labor shortages will conspire to drive inflation but at a somewhat lower rate in my opinion. Mr. Buffet says, “Be fearful when others are greedy and greedy when others are fearful.” I prefer “Be careful when others are greedy and fear not when others are fearful.”|
|Growth? Inflation? Recession? Principles!|
|David Kelly – Chief Global Strategist at J.P. Morgan Asset Management|
Published May 31, 2022
My father, otherwise a very accomplished man, never learnt how to type properly. However, he compensated for a lack of skill with an intensity of application. As children, we would hear him behind the door of his study, pecking away at his Remington typewriter using only his two index fingers. In the afternoons, it would be a gentle, relaxed clicking, interrupted every 20 seconds or so by the merry chime of the carriage return bell.
But when the Muse was with him or a deadline loomed, the clicking took on an urgent tone, accelerating to a frantic pace as his thoughts spilled out onto the paper. At such times, he would attack the typewriter with violence and I seem to remember the most commonly used letters, the “e” and the “a” and the “s” looking sadly faded on the keyboard. The “!” was also subject to abuse. But not the “?”. The “?” was pristine. My father was a man who expressed strong opinions and few doubts.
Such could not be said of market strategists today – or at least of the honest ones.
The economy still appears to be barreling past traditional estimates of full employment while inflation has risen to 40-year highs. However, at the same time, both growth and inflation should slow due to fiscal drag, a too-high dollar and slumping confidence. It is not clear how much growth will slow, how quickly inflation will fall, whether the economy could slip into recession or, for that matter, how bad a recession might be, were it to occur. This gathering of worries and uncertainties will take time to be resolved and could easily be blamed for the slide in financial markets this year which has seen 10-year Treasury yields double and the S&P500 make an inter-day visit to bear market territory before rallying last week.
However, investors should also remember that less uncertainty surrounds some fundamental principles of investing, namely:
Volatility is the price you pay for the better long-term returns on equities.
Diversification reduces risk – particularly when recession threatens.
Valuations are a bad guide to short-term returns but a better indicator of long-term gains, and,
good investment decisions are based on logic rather than emotion and the best decisions often take advantage of the emotions of others.
Economic data still generally point to a growing economy with a tightening labor market. While last week’s GDP report showed an even steeper-than-originally-reported 1.5% annualized decline in real first-quarter output, this was more than accounted for by lower inventory accumulation which should boost output in the current quarter. Other numbers, such as April data showing a sharp improvement in the goods trade deficit and strong momentum in consumer services spending, suggest real GDP could be growing at a 4%-5% annualized pace in the current quarter.
That being said, the economy is encountering strong headwinds:
Last week, the Congressional Budget Office projected a decline in the budget deficit from 12.4% of GDP in fiscal 2021 to just 4.2% of GDP in fiscal 2022, representing the sharpest fiscal drag seen since the demobilization following World War II.
A high dollar, combined with global weakness from the war in Ukraine and China’s attempts to battle Covid, should slow the growth in U.S. exports.
30-year fixed rate mortgage rates have risen from 3.11% at the end of last year to over 5%, contributing to a sharp decline in both new and existing home sales in April.
Consumer sentiment remains in the doldrums with the May reading of the University of Michigan Consumer Sentiment Index falling to its lowest level since 2011.
However, two factors act as strong counterweights to these recessionary impulses.
First, pent-up demand appears to be at levels unprecedented in the modern era. Chronic supply chain issues and labor shortages have suppressed production with very low inventories of vehicles, homes and consumer goods for sale. In top of this, there is a pent-up demand for travel and entertainment after the pandemic as well as all the spending involved in long-postponed family celebrations. This should help sustain overall consumer demand even as budgets tighten.
Second, while a lack of workers is constraining the long-term growth of the U.S. economy, it is also making it very difficult to forecast any increase in the unemployment rate. Indeed, in this week’s May jobs report, while we are forecasting the addition of less than 300,000 jobs, (which would be the smallest gain in over a year), we still expect the unemployment rate to fall from 3.6% to 3.5% which would be lower than in all but three months since 1969. This lack of workers should also spur stronger investment spending and productivity growth, helping sustain the economic expansion.
The same forces slowing economic growth should alleviate some inflation pressures. April data showed some small signs of improvement with the core personal consumption deflator rising 4.9% year-over-year, its lowest reading since December. Food and energy prices are continuing to rise, partly due to the fallout from the war in Ukraine. However, barring further disruptions, these high prices should induce increases in production, paving the way for stabilization and declines in commodity prices later in the year. Overall, we expect inflation, as measured by the core consumption deflator, to fall to 4.0% year-over-year by the fourth quarter of this year and 3.2% by the fourth quarter of 2023.
The Federal Reserve would, undoubtedly, like to see a more rapid decline in inflation. However, one key assumption in our outlook is that later this year, as the Fed sees both growth and inflation slowing, it softens its recently hawkish tone, providing some relief to both the bond and stock markets. This doesn’t imply significantly easier policy this year – we still expect two more 50-basis point rate hikes followed by three 25-basis point increases, taking the federal funds rate to a range of 2.50%-2.75% by the end of the year. However, it should reduce fears of anything more aggressive this year or anything more than a slow further increase in short-term rates in 2023.
If this all transpires, the economy could well settle into a period of slow growth, declining inflation and relatively steady unemployment. That being said, there remains a significant risk of recession later in 2022 or in 2023, either because of aggressive policy tightening or some other issue.
If this occurs, however, investors would do well to recognize that such a recession is unlikely to be nearly as severe as the last two. The Pandemic Recession and the Great Financial Crisis were the two deepest recessions since World War II but they were both the result of unprecedented shocks to the global economy. If the U.S. were to slip into recession over the next year, it would likely be a more shallow recession, deep enough to mop up inflation pressures and curtail job openings but not bad enough to damage the long-term prospects of the economy overall or most companies operating within it. In time, growth would resume, margins would recover and markets would rebound.
All of this includes an uncomfortably high dose of speculation, mostly because of the very unusual nature of the current business cycle. However, investors should take some comfort in investment principles that have held true through numerous business cycles in the past. First, stock market volatility is normal and the price investors should expect to pay for better long-term returns on equities. Despite an average intra-year drop of 14%, the S&P500 has provided positive returns in 32 of the last 42 years.
Second, diversification reduces risk, particularly when volatility is high. Rising inflation has prevented bonds from offsetting stock market losses so far this year. However, if the economy were genuinely threatened by recession, Treasuries would likely rally helping provide stability to balanced portfolios. More generally, a broadly diversified portfolio containing stocks, bonds and alternatives both in the United States and overseas should provide protection against a wide set of unforeseen dangers.
Third, while markets have left investors bruised in the first five months of the year, they have also left valuations at better levels. In particular, even after a strong rally last week, the forward P/E ratio on the S&P500 is at 17.5 times – less than 4% above its 25-year average. 10-year TIP yields, which were at a bizarre -1.04% at the end of last year, are now 0.16% positive. In both cases, these cheaper valuations suggest significantly better long-term returns than were available at the start of the year.
Finally, investors should simultaneously resolve to shun investing based on emotions themselves and consider taking advantage of the emotional investing of others. On Friday, the University of Michigan reported that their index of consumer sentiment for May slumped to 58.4, its lowest level since 2011. The gloom is understandable given the world’s continued struggle with Covid, high inflation, the war in Ukraine and deep political divisions here in the United States. This negative attitude has also likely contributed to this year’s selloffs in the stock and bond markets.
However, history shows a remarkable inverse correlation between current consumer sentiment and future returns. On page 23 of our Guide to the Markets we identify eight distinct peaks and eight distinct troughs in consumer sentiment since 1972. On average, in the year following a confidence peak, the S&P500 has risen by 4.1%. However, in the year following a confidence trough, the S&P500 has, on average, risen by an astonishing 24.9%.
This is not to say that we know that we have reached the sentiment low for the current cycle or that, when we do so, we are guaranteed a double-digit return. What it does indicate, however, is that very often the best time to get invested is when people feel most scared and confused. In a world of “?”s, investing principles deserve an “!”.
For more of my insights, listen to my Insights Now podcast for a breakdown on big ideas, future trends and their investment implications.
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