The Quiet Machinery of Repair
Published on July 5, 2022
David Kelly
Chief Global Strategist at J.P. Morgan Asset Management
One minor side effect of this terrible pandemic is that we have all become more educated on our immune system. Looked at objectively, it is a masterpiece of evolutionary excellence.
The outward signs of infection are normally easy to see – coughing, sneezing and obvious fever warn other humans to keep away, while our own exhaustion makes us less mobile and thus less likely to infect. The extraordinary havoc wrought by Covid-19 is primarily due to the virus’s ability to make someone contagious even before these symptoms appear.
However, beneath the surface, at cellular level, a far more complex defense system is being mobilized with B-cells creating antibodies to latch onto viruses and specialized T-cells attacking both the virus itself and the cells it has hijacked for the purpose of reproduction. It is a silent battle in a war waged between viruses and cells for literally billions of years. In the vast majority of cases, humans win their personal battles as the immune system quietly responds to a virus attack, neutralizes it and repairs the damage done.
In a similar way, in 2022, even as financial markets have reeled from the effects of soaring inflation, labor shortages, supply chain issues, huge increases in home prices and rents, financial speculation and, most recently, much higher interest rates, economic forces have been mobilized to respond to imbalances and ultimately repair the damage done. While media reports will continue their frenzied jump from one economic crisis to another, it is important that investors understand that most of these problems look set to fade, setting the stage for better economic performance and financial markets in the months and years ahead.
The Reasons for the Market Selloff
The first half of 2022 saw miserable investment returns and for good reason - the economy is beset by the highest inflation in forty years and a growing threat of recession. However, beneath the surface, the quiet machinery of repair is at work, correcting the imbalances that brought us to this pass. Most importantly, valuations, which looked generally unattractive at the start of the year, appear much more rational today, opening up opportunities for those willing to seek them even in the midst of so much gloom.
In the first six months of 2022, as we show on page 61 of our new 3Q2022 Guide to the Markets, the S&P500 provided a total return of -20%, the Barclays Aggregate bond index lost more than 10%, and high-yield bonds, emerging market stocks, developed country international stocks and REITs all had negative returns of between -15% and -20%. The only two major asset classes to emerge unscathed were cash and commodities. If you’re feeling a bit poorer than on New Year’s Day, you are not alone.
The reasons for this negative performance are perhaps obvious but they should still be reviewed as they can cast some light on the path forward from here.
The central problem has been inflation that has remained hotter for longer than the Federal Reserve or markets expected. At the December 2021 meeting of the Federal Open Market Committee, the median expectation participants was that year-over-year headline consumption deflator inflation would fall from 5.3% in the fourth quarter of 2021 to 2.6% in the fourth quarter of 2022 and that core inflation would fall from 4.4% to 2.7% over the same period. The FOMC statement recognized “elevated levels of inflation” but expected “progress on vaccinations and an easing of supply constraints” to reduce inflation going forward.
Unfortunately, partly because of the Omicron variant and China’s zero-Covid policy and partly because of Russia’s brutal invasion of Ukraine and resulting sanctions, inflation rose early in the year and then moved sideways. By May, the year-over-year consumption deflator inflation rates were 6.3% and 4.7% respectively.
This caused the Fed to take a much more hawkish stance, raising federal funds rate by 0.25% in March, 0.50% in May and 0.75% in June. By June the median expectation of FOMC members was that the federal funds rate would be between 3.25% and 3.50% by the end of the year, up from an expectation of 0.75% to 1.00% just six months earlier.
This high inflation and aggressive Fed tightening led to a surge in long-term interest rates, hurting the bond market directly. Higher short-term rates and quantitative tightening also boosted both mortgage rates and the dollar, hurting prospects for housing and exports. This, combined with falling consumer confidence and massive fiscal drag, has applied huge braking power to the economy, raising the risk of a near-term recession. Indeed, following a 1.6% annualized decline in real GDP in the first quarter, the Atlanta Fed’s GDP tracking model is currently predicting a 2.1% decline in the second, meeting a frequently used back-of-the-envelope definition of recession.
The Quiet Machinery of Repair
All of this seems to justify both the selloff that we have seen in stock and bond markets and the current very negative mood of consumers. However, it should also be recognized that the economy and markets have begun to repair some important imbalances which should set the stage for better returns going forward.
First, economic growth has slowed to a sustainable pace. In the year that ended in the fourth quarter of 2021, real GDP grew by 5.5%. Our current estimate of second-quarter real GDP growth at +1.4% is higher than the Atlanta Fed’s. However, even at this pace, year-over-year growth would have fallen to 2.2% in the second quarter and will likely fall further over the rest of the year. This decline is, in some ways, very necessary, since we believe the potential long-run growth rate of the U.S. economy is well below 2.0% and we entered the year at very close to full employment. If growth had not slowed, inflation could only have spiraled higher.
Second, the Federal Budget deficit has fallen very sharply to now manageable levels. We will get Treasury estimates on the June budget deficit next week. However, based on the numbers through the end of May, we now expect a deficit of $825 billion or 3.3% of GDP this fiscal year, (which ends on September 30th) and $780 billion or 3.0% of GDP next year (in the absence of major policy changes). At these levels, the federal debt will not approach the debt ceiling until 2024 and, importantly, federal debt as a share of GDP is now declining, reducing the risk of a federal fiscal crisis.
Third, falling business confidence and higher wages should begin to eat away at the enormous excess demand for labor. The number of job openings in the United States fell from a record 11.855 million at the end of March to 11.400 million at the end of April. We forecast that the end of May report, due out on Wednesday, should see a further decline to 10.710 million. Openings should continue to decline over the rest of the year as businesses reassess their plans, bringing balance back to the labor market without causing a notable increase in the unemployment rate.
Fourth, high prices are having their usual, albeit somewhat delayed, impact on supply and demand. The Bloomberg Commodity Index, having hit an all-time peak of 292.5 on June 9th, has now fallen back to 251.0, a fall of 14.8% in less than a month, reflecting declines in crude oil, gasoline, natural gas, copper and corn prices. This, in turn, reflects the impact of higher prices in both increasing production and cutting demand. Airfares, which soared 37.8% year-over-year in May and which are now well above pre-pandemic levels, appear to have fallen sharply in recent weeks according to on-line price tracker, hopper.com. Fewer manufacturers are complaining about slower deliveries, according to the Institute of Supply Management, and the prices paid index fell to its lowest level in four months in June.
Even with this, prices remain high which should continue to increase supply and constrain demand in the months ahead. While we believe overall CPI could have increased by a strong 0.7% in June, we expect much milder readings of 0.1% or 0.2% in July and August.
The Valuation Opportunity
Finally, valuations have mostly returned to more reasonable levels.
The S&P500, which was selling at 21x earnings at the start of this year is now selling at 16x forward earnings – below its 25-year average of 16.9x
The yield on a 10-year TIP has risen from -1.04% at the end of last year to 0.54% positive today.
And the P/E spread between the 20th percentile and 80th percentile stock in the S&P500 has fallen from 21.7 P/E points on December 31st to a much more reasonable 14.8 P/E points today.
It’s also notable that the valuations that seemed most out of whack at the start of the year have generally fallen the most year-to-date.
Bitcoin has fallen by 58% year-to-date.
Mega-Cap stocks, as represented by the 10 stocks with the largest market cap in the S&P500, have fallen by roughly 26% year-to-date compared to a decline of 19% for the rest of the index.
The year-to-date total return on growth stocks has been -28% compared to -13% for value, and,
International Stocks have seen a total return of -12% in local currency terms and -18% measured in U.S. dollars compared to a -20% return on the S&P500.
All of this is moving in a somewhat logical direction. Still, there seems further room to go with the dollar still looking fundamentally too high, value still looking cheap relative to growth, international still looking cheap relative to US equities and Bitcoin still priced far above its negligible fundamental value.
This should present opportunities for those are willing and able to invest today. There are, of course, many things that could still go wrong, including U.S. economy stumbling into recession. But there are also things that could go right, such as a ceasefire in Ukraine or a decision by the Federal Reserve to tack to a less hawkish path.
Even when suffering from a pretty nasty virus, a rational person should be able to look forward to when they will feel better and plan accordingly. And even after a very difficult first half of 2022, rational investors may want to take advantage of better valuations to position themselves for better economic and market days ahead.
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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Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. The views and strategies described may not be suitable for all investors. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.
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