The Great Reset
The first half of 2022 marked a resetting of expectations for the economy, inflation, interest rates, and corporate earnings. As the year began, it was clear the Federal Reserve was on a path to reduce economic stimulus, leading to higher interest rates, slower economic growth, and a resetting of market prices to reflect these realities.
As part of this tightening, the Fed embarked on a series of measured interest-rate hikes aimed at bringing inflation under control without tilting the economy into recession. However, in early June, a white-hot inflation reading forced the Fed to abandon this more gradual approach and become far more aggressive in its pace. This caused a chain reaction that increased the odds of recession, shifted the outlook towards declining corporate profits, and ignited new levels of market volatility.
Halfway through the year, stocks as measured by the S&P 500 were down nearly 20% year-to-date, while bonds, as measured by the Bloomberg Aggregate Index, had dropped more than 10%. Fortunately, our portfolios were generally able to avoid much of this volatility thanks to their dynamic nature and the strength of our investment choices.
Looking back, we correctly anticipated the surge in commodity prices through our significant allocation to energy stocks. We continued to avoid interest-rate risk by keeping duration low. We also shunned the valuation risk of high-multiple equities by focusing on value and quality. And we maintained ample reserves that served both as a buffer against market declines and a fresh source of resources to take advantage of new opportunities that inevitably surface.
Eye on the Consumer
As we look forward, we believe the health of the consumer will be a critical component of what comes next. Consumption represents nearly 70% of the U.S. economy, and early evidence suggests there may be many challenges ahead. Higher costs are straining budgets, and even with strong wage gains, incomes are not keeping pace with the cost of living. Discretionary spending is drying up and savings are quickly dwindling.
All of this seems to be reflected in the Michigan Consumer Expectations Index. It can often provide a gauge of the health of the consumer and a glimpse into where consumption and ultimately corporate earnings may be headed. Its latest reading hasn’t been this low since the 1970s, and the last time it was near this level was just before the worst part of the financial crisis.
While consumption has remained steady thus far, the change in expectations has not been lost on investors. The chart above compares year-over-year changes in expectations with a similar price measure for the S&P 500. While the recent change in consumer sentiment is somewhat reflected in current stock prices, where prices end up will likely be strongly influenced by how actual consumption impacts future corporate profits.
With this in mind, we’re also keeping a close eye on corporate earnings and where they may be heading. Current analyst estimates have not adjusted for a more challenging economic environment and, in our view, are too optimistic. This is making current valuation estimates (e.g., price/earnings ratio) for many stocks appear fundamentally more attractive than they would otherwise be if estimates were more realistic.
Increased labor and overhead costs are almost certain to cut into profit margins while at the same time a more recessionary environment could shrink top-line revenues (see the chart below). The key question on both fronts is: By how much? We are spending endless hours continually evaluating and updating a variety of scenarios doing our very best to get this right. Every portfolio holding is being evaluated through these multiple lenses.
While recent volatility can be disconcerting, our dynamic investment process tends to stand apart in times like this. We believe we are well positioned to anticipate shifting conditions and their potential outcomes. This means reducing risk for now while being ready to jump on the next great opportunity. Both are top of mind.
As markets continue to change, we will keep you informed on our decision making and, as always, your advisor is just a phone call away and well equipped to provide clarity as we continue along this journey.