July Private Client Letter
/The S&P 500 suffered its worst half since 1970 after inflation and recession concerns sparked a 21% sell-off. This year’s first half performance was strikingly similar to that of 1970 (also down -21%) and in both periods, high inflation was the issue. It is interesting to note that the second half of 1970 saw the S&P up 27%. Of course, that does not mean that's how it will go for the back half of 2022; however, we believe it is likely the market will move higher if inflationary pressures subside.
The first half of 2022 has given us one of the trickiest economic backdrops any of us have ever experienced. Investors are faced with a barrage of confusing economic data and the highest rate of inflation in over 40 years. Inconsistent messaging and finger pointing relative to important policy decisions have helped drive consumer sentiment readings to their lowest on record.
This said, inflation sitting at multi-decade highs is the dominant challenge for this economic cycle. The question now is, can the Fed bring down inflation without tipping the economy into a recession?
It would appear that the U.S. economy is currently decelerating rapidly. The ISM Manufacturing Index fell below expectations to 53.0 in June, down from 56.1 in May. A reading above 50 still indicates expansion in manufacturing, however June’s activity was at its lowest level since June 2020. Looking more closely at the details, the ISM New Orders Index showed a contraction in new orders in June due to higher prices, longer lead times, and high inventory levels. The new orders index fell to 49.2 in June, sinking into contraction territory for the first time since the early days of the pandemic.
Consumer spending grew 0.2% in May, the lowest level of the year and a slowdown from April’s 0.6% month-over-month increase. Adjusted for inflation, however, consumer spending fell 0.4% in May, meaning consumers spent more to get less. Retail sales declined 0.3% in May and were revised lower for April, the first drop in five months. When adjusted for inflation, retail sales declined 1.3% in May.
The final revision for first quarter GDP showed a decline of 1.6% in the U.S. economy. As if the downward revision wasn’t bad enough, the latest update of the Atlanta Fed’s GDPNow model is now forecasting negative growth of 2.1% in Q2. Until we start to see a reversal of the trend of weaker than expected economic data as the Fed continues to pursue higher interest rates, investors are going to face headwinds with every attempt to have a sustained rally.
Federal Reserve Chairman Jerome Powell recently made it clear that the Fed would rather curb inflationary pressures than protect the economy against potential recession. This line of thinking harkens back to the era of Fed Chairman Paul Volcker, who tipped the U.S. into a recession in the early 1980s by raising rates into double-digit territory to tamp down 1970s inflation.
We believe inflation is largely a supply-driven issue, juxtaposed with extraordinary levels of liquidity. In other words, inflation can best be understood as too many dollars chasing too few goods. It is important to understand that the Fed only has monetary policy at its disposal and that tool is used to diminish demand. To effectively combat inflation there will need to be a fiscal policy response that promotes an increase in supply. These policies would be a combination of incentives to boost production and could involve reduced regulations, domestic energy policies, and potentially lower taxes.
We have been very focused on the unprecedented rise in M2 money supply following the COVID-19 pandemic. The M2 measure of money grew at an 18% annualized rate in 2020-21, or roughly three times the "normal" rate. In addition to a more robust fiscal policy response to the inflation problem, the economy will still have to absorb this massive increase in liquidity. This will take time and we are expecting higher than trend inflation for at least the next few years.
Countertrend stock market rallies are common in bear markets. There is a distinct possibility that later in the year we will see progress in supply issues and pandemic backlogs that would ease inflation pressure as the Fed is raising rates, giving the appearance that the Fed’s plan is working. This said, we would not be surprised to see the S&P 500 trade into the low-to-mid 4,000’s in the second half.
Monetary policy is regarded to be a “blunt instrument” when it comes to the economy and there is risk that the Fed will go too far and fast with interest rates. It will be critical for investors to closely monitor economic data and corporate earnings to adjust portfolio strategies for what comes next in 2023.
Our base case is that a recession remains unlikely in 2022, even as the risks have increased. Currently we see a 40% chance of recession in the next twelve months which would suggest it is more likely than not that pent-up demand, consumer spending, and business investment will be sufficiently robust to sustain the current economic expansion well into 2023.
We will continue to watch all developments and share our insights with you. Please do not hesitate to contact us should you have any questions or concerns. As always, thank you for your continued confidence and trust.
John E. Chapman
July 2022
