April 22, 2022
Dear Clients and Friends:
After the Ukrainian-Russian conflict served as an inflection point for markets in the first quarter, worries over the US economy have mounted. Historically, geopolitical events have typically dented market sentiment for a period, but stocks have shown a tendency to rebound rather quickly when initial pessimism subsides. The market rebound in March seemed to fit that historical precedent. However, investors have now shifted their focus to concerns surrounding the impact that inflation and the projected action by the Federal Reserve will have on the economy.
With the spike in oil prices related to the conflict, inflation reached its highest levels in over four decades, hitting 8.4% year-over-year in March. Inflation has been widespread across goods and services, but wage growth has been a significant factor. In March of 2022, the US reported 11.3 million job openings across the country, with only 6M unemployed workers – the largest gap in US history. Wages have been increasing as companies have been forced to expand benefits and compensation to attract talent. Wage growth reached 6.7% in March and does not show signs of slowing down in the short term. However, there are still long-term secular forces at play that tend to put downward pressure on inflation such as demographics, technology, and income disparity. These forces help make the current economic backdrop different from the 1970s. We expect inflation to fall to more reasonable levels as supply chains normalize and the Federal Reserve takes action to slow the economy, but it may remain stubbornly high for a time.
Ultimately, the Federal Reserve targets a stable 2% inflation rate, and recent commentary has shown their concern that inflation levels are not dropping as quickly as expected. The Fed raised overnight lending rates last month for the first time since December 2018, and investors expect eight further increases throughout the year. The inflation and interest rate backdrop has led to a difficult environment for bonds, whose prices fall when yields rise. However, as key inflationary pressures such as shipping logjams and car prices continue to resolve themselves in coming months, we may see a peak in CPI, thereby stabilizing interest rates and paving the way for improved bond performance.
It is important to note that the Federal Reserve raises interest rates when they are confident the economy can withstand them. The current economic data supports their theory. Consumers continue to display higher than normal cash reserves. Corporate America is in investment mode – as evidenced by an increase of 7.4% spending in fixed investment in 2021, the largest uptick since 2012. The largest area of increased spending occurred in software and information-processing, as many companies sought to “digitize” business operations and allow their employees to work from home. Spending on these categories alone rose 14% in 2021, and companies project increased spending of 7-10% in fixed investment in 2022.
Leading Economic Indicators demonstrate a picture of a healthy economy, with truck shipments, housing permits, retail sales, and corporate profit margins firmly in expansion territory. 2021 S&P 500 earnings reached $200/share, a 30% increase from pre-pandemic levels. Through March, corporate earnings have increased an additional 4.1% YTD. Though wage growth may begin to weigh on margins, analysts still estimate profits to increase by double digits this year.
Despite the relative health of the economy, the overwhelming barrage of negative headlines across financial media has weighed on consumer sentiment. The University of Michigan Consumer Sentiment Index recently dropped to 59.4 – a level last seen in the 2008 financial crisis. Going back to 1971, those who invested at the peak of consumer sentiment would have experienced a subsequent 12-month return of +4%. Conversely, for those that had invested at a trough in consumer sentiment, subsequent 12-month returns were +18%.
Ultimately, we believe the overwhelming negative sentiment coupled with the overall health of the US economy make for a compelling investment opportunity within US markets. While we maintain an eye on the pace of Federal Reserve rate hikes and inflation expectations, there continue to be pockets of opportunity across financial markets.
As always, please feel free to reach out should you have any questions regarding your accounts or allocations.
Gallacher Investment Committee