June Private Client Letter - Soft Landings and Hurricanes

The global capital markets have been besieged this year by an unusual and disturbing mix of headlines.  Over these same months key economic measures have demonstrated resiliency, even as consumer confidence has collapsed. 

Jamie Dimon, the respected Chief Executive Officer of JPMorgan Chase, recently warned investors to brace for an economic “hurricane” that’s “coming our way.”  Only one-week earlier, Mr. Dimon’s position had been one of cautious optimism wherein “the U.S. economy remains strong, and potential obstacles to growth are not set in stone.”

Bank of America Chief Executive Officer, Brian Moynihan, downplayed dire forecasts about the U.S. economy this week with his support for the Fed’s expected move to hike interest rates by a larger-than-normal half-percentage point at meetings in June and July.  He went on to observe that U.S.  “consumers are in good shape and not overleveraged.  What’s going to slow them down? Nothing right now.”   Mr. Moynihan’s comments appear to support a soft-landing scenario.

We acknowledge that this is a frustrating time to be an American investor.  High growth of jobs, wages, and consumer spending are offset by soaring inflation driven mostly by volatile commodity markets and supply chain disruptions, just as ever-higher earnings estimates are being offset by falling valuation multiples.  Traditional market axioms are not currently working as expected and nearly every asset class has lost value in 2022. 

Our view is that such mixed messages only underscore how complex the economic dynamic has become over a remarkably short period of time.  A deadly global pandemic, record inflation, war in Europe, supply chain disruptions, and a looming international food crisis have created an extraordinarily difficult environment.  This said, we believe the weight of the available data supports our view that the U.S. is still on track to avoid a recession.

Early signs that the U.S. economy is slowing have emerged and the Fed’s tightening cycle may not have to go as far as has been feared.  Inflation may be peaking at these record levels, and we believe it will fall to 4% - 5% by year end.  These levels would still be too high, but any moderation in the pace of inflation would likely produce a boost in consumer confidence.

The key takeaway from the May jobs report is that labor markets remain strong while possibly easing from extremely tight conditions.  The labor participation rate for people aged 16 to 64 rose to 74.4% last month, matching its pre-pandemic peak.  Job openings and “quits” were still elevated in April and continuing unemployment claims stand at 50-year lows.

A key gauge of manufacturing was strong last month, and retail sales grew at a solid pace in April.  Consumer cash flow and balance sheets remain healthy.  The share of consumers' after-tax incomes needed to service debt obligations and recurring payments is now at its lowest level since 1980.  Household net worth finished last year at more than eight times annual after-tax income, the highest ratio on record. 

Even as U.S. equity prices have dropped considerably from their 52-week highs, analysts remain optimistic with aggregate forward earnings per share estimates for the S&P 500 continuing to rise.  Equity valuations are getting downright reasonable for many quality stocks.  While the economic backdrop may be “slowing”, it’s definitely not weak.

All eyes are now on the next FOMC meeting on June 15th, when the Fed is expected to raise rates another 50 basis points.  While the markets entered 2022 unprepared for the Fed tightening cycle, those tightening pressures are now properly calibrated.  The markets now widely expect the Fed will complete back-to-back 50 basis point hikes at the June and July meetings.

What investors really want to know is what is the outlook for September's meeting? Last week Fed Vice Chair, Lael Brainard, said she doesn't see the Fed pausing their rate hikes, but she hinted at the idea that they could switch back to the more traditional 25 basis point hike vs. 50 basis points after July.  The only thing that can be said about the September decision is that it will be data dependent. 

As for the markets, U.S. equities managed to bounce in late May and we are gaining confidence that the bulk of the market’s recent downside is behind us.  Seven-week losing streaks, like the one we just came through where the S&P 500 declined by 18.7%, are historically quite rare.  Before this year, the index had only posted losses in that many consecutive weeks three times - in 1970, 1980, and 2001.  Within a year of those first two downturns, the S&P 500 was up by over a third - rising 33.5% in 1970 and 33.4% in 1980.

Large corrections historically lead to long-term rallies.  Previous corrections between 10% and 20% showed average gains of nearly 25% a year later and 40% two years later.  Of course, this historical perspective does not guarantee we will see gains going forward, however our base case remains constructive and we expect to see better times ahead.

Thank you for your continued confidence.  Please do not hesitate to contact us should you have any questions or concerns.

John E. Chapman

June 2022