2022 has been a difficult year for both bond and stock market investors. Year to date as of June 8th, the S&P 500 declined by 13.65%1 and the Aggregate Bond index was down 9.14%2. There are many factors that contribute to the direction of the stock market and the importance of various factors also can change with investor sentiment. We believe a few of the more important questions currently driving the stock and bond markets include:
- Inflation – can price growth begin to decline and when will this happen?
- Economic activity – will inflation, and the actions to control it, affect economic growth or possibly put the US into a recession?
- Corporate earnings – do estimates of growth need to come down as a result of inflation and potentially waning demand?
The level of inflation is at the highest level in 40 years and is the number one factor on the minds of investors. Today, June 10th, the Consumer Price Index (CPI), a measure of inflation, reported a new cycle high of 8.6%3, which can be seen in the chart below. Persistently high levels of inflation will cause the US Federal Reserve to continue to take actions to curb rising prices. Their main tool against inflation is raising the Fed Funds rate, but raising this rate aggressively also has a side effect of curbing economic growth. The big question is whether the Fed can be aggressive enough to curb high prices without sending us into an economic recession.
A way to measure economic activity is looking at Gross Domestic Product (GDP) growth. The chart below reflects GDP growth over the past 30 years. As can be seen, there are relatively few contracting GDP growth numbers, and the last two have coincided with very dramatic events like the US housing crisis and the COVID global pandemic. With the pandemic, GDP growth dropped into negative territory in 2020 contracting by 3.4% (red circle) but snapped back to growth mode in 2021 to finish up 5.7% (green circle). The forecasted annual GDP growth by Goldman Sachs4 in 2022 is 2.4%, which is in line with the 30-year historical average of 2.5% (blue line). Their forecast for 2023 is 1.6% which is below the 30-year average but still positive. We feel a GDP growth rate in the 1.5% to 3.0% provides a positive backdrop for stocks to grind higher.
Another factor to consider is corporate earnings. Analyzing a company’s earnings is a good way to judge the health of a company and how it is operating its business. The same analysis can be done to analyze the health of corporate America by looking at the earnings growth of the S&P 500 in aggregate. In general, a higher level of earnings growth is a positive tailwind for stocks. In the chart below, the compound annual growth rate (CAGR) has been 7.8% (blue arrow) for the last nine years for the S&P 500, and expectations for the next two years’ growth will accelerate to 9.8% (green arrow) 5. As companies continue to report their earnings, we will monitor trends to examine how these growth expectations change over time.
In closing, the current high level of inflation is a headwind for the market. As of now, economic health and corporate earnings have been able to grow despite higher prices, but we will monitor for changes as we move forward and as more actions are taken to curb inflation. As we progress through the 2nd half of 2022, we expect inflation to begin to decelerate and this could be a catalyst for a stock rebound in the future.
- Source: Goldman Sachs US Economics Analyst 5.15.2022