Positivity has been scarce in the economic commentaries of 2022.
Our news feeds have been filled with talks of market downturns, bubbles bursting, geopolitical tensions tightening, and pandemics dragging on. The negative coverage isn’t misplaced, as we’re likely in a recession (whether the NBER has officially declared it or not). But as with most things, there’s more to the story, and it’s worthwhile to balance our views with the positives—even if the headlines are less attention grabbing.
While there are certainly headwinds in the economy today, there are also a few positive developments that we, and the investors we serve, can consider to create a more comprehensive picture of where we stand today.
Let’s dive in.
The Market Has Become Much More Affordable
This factor might blur the lines between economy and market, but it’s greatly important (especially in our fundamentally-rooted mind).
Ahead of the Q1 market correction, the forward P/E ratio of the S&P 500 floated around a frothy 19 to 23. In early August, the forward P/E of the S&P stands at a more reasonable 17.5.
S&P 500 Forward P/E ratio
Where will the market go from here? No one can answer that for certain (and if they say they can, they’re not being truthful). The direction of the market will depend on a number of factors—inflation, interest rates, corporate earnings, etc. But what we can say is that the market is less vulnerable to negative shock than it was in the beginning of the year.
Our general thoughts? Consumer spending likely won’t remain as strong as it has, and corporate earnings are likely to shrink in the future. However, a modest earnings decline of 5% to 10% is likely baked into prices today.
If we do see a decline, we do not expect it to be catastrophic.
Earnings Slow, But Remain Positive
Corporate earnings have been strong, but are beginning to show some weakness. S&P 500 earnings-per-share (EPS) rose steadily through June of 2022, supported by elevated profit margins over the last two years. We’ve seen similarly elevated profit margins in the past, but they are not typically sustained.
As mentioned before, we don’t expect consumer spending to remain as strong as it has been, which would lead to lower corporate earnings. However, while we expect further declines in earnings estimates through 2022 and 2023, we do believe growth rates will remain positive. Topline growth is still tracking at a positive 14% year-over-year for the S&P 5001, which should provide some support to more moderate stock price levels.
Employment Continues To Be Strong
The pandemic and our aging demographic clearly forced some workers out of the labor market that might have otherwise remained. Also, we know that a weaker economy usually leads to weaker employment. However, current unemployment has been falling and remains steady at 3.5%, which would mark the lowest level ever during a recession.
Another positive for workers is wage growth. In July, wages increased by 6% year-over-year2. And while this is a double-edged sword because it contributes to and perpetuates inflationary trends, growing wages have offset some of the negative impacts of inflation—which will help sustain consumption figures moving forward. The bottom line here is the labor market remains positive, at least for now.
Consumption Has Not wavered
Consumer spending, which the economy revolves around, rose by 1.1% in June3. Consumption has historically been the largest contributor to GDP – when consumption is strong, the economy is generally strong.
However, it is important to note that while consumption is growing, so is consumer credit. As such, we might see future consumption moderate, as well as a shift toward staples, rents, and energy (energy and gas were the largest contributors to consumption growth in the goods category).
In the markets, we would expect strength in segments with pricing power and inelastic demand. Healthcare is a prime example (the largest contributor to consumption growth in the services category).
There Are Signs That Inflation Is Beginning To Moderate (Slightly)
Headline inflation fell from a 40-year high of 9.1% to a still-high-but-lower 8.5% in July of 20223.
Rampant inflation has been everywhere, and it certainly won’t normalize in the near future. But we are seeing positive trends, which can be seen in commodity prices.
During and after the pandemic, lumber prices skyrocketed to a high of more than $1480 (up from a pre-pandemic price of around $400). Currently, Lumber sits around $600, a 59% decrease from the pandemic high and 55% decrease from recent 2022 highs4.
Why is Lumber important? Because it is a key component of construction costs, which filters through to housing prices and availability. This in turn affects rents. Housing costs represent a relatively sticky 33% of the consumer price index. In short, the level of lumber prices is relevant to virtually everyone.
Oil prices are also beginning to retreat from their highs. We’ve all seen higher prices at the pumps in 2022, with the average price per gallon reaching a historic high of more than $5 per gallon in June of 2022. Since then, the average price per gallon has fallen significantly, down to just over $4.00 per gallon in early August—still high, but trending in the right direction5.
Without a change in domestic energy policy, we’re unlikely to see a reversion to pre-pandemic prices. However, cooling oil prices will carry a positive effect not just to your investors, but to most retailers as well. Higher oil costs equate to higher freight costs, something major retailers have consistently referenced as a constraint to profitability in their earnings calls.
Things Could Be Better, But They Could Be A Lot Worse As Well
Investors’ news feeds are likely creating more questions than answers, and more fear than anything else. The reality is that the technicality of a recession is irrelevant.
What we should focus on are the actual implications of the downturn. And as we’ve seen, the market, while still vulnerable, is much less so than it was before the Q1 decline. Inflation, while elevated, is beginning to show signs of moderation. The consumer remains relatively strong, with high rates of employment, wage growth, and strong consumption trends. And it’s worth noting that the United States remains the largest economy in the world, with relatively stable long-term GDP growth6.
The main takeaway is this. In times of uncertainty, fundamental investing stands as a steadfast tool for evaluating opportunity in the market. We’re living in a new normal, and predicting the future is impossible. By looking at the fundamentals of market pricing and sector valuation, investors and advisors can seek more attractive segments of the market while limiting exposure to riskier segments, something we think is wise in times of uncertainty.
1Morgan Stanley Research
3Federal Reserve Bank of St. Louis
5U.S. Energy Information Association
6Research FDI, International Monetary Fund
The information and opinions in this report have been prepared by the investment staff of Advanced Asset Management Advisors (AAMA). This report is based upon information available to the public. The information herein is believed to be reliable and has been obtained from sources believed to be reliable, but AAMA makes no representation as to the accuracy or completeness of such information. Opinions, estimates and projections in this report constitute AAMA’s judgment and are subject to change without notice. This report is provided for informational purposes only. It is not to be construed as a recommendation to buy or sell or a solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy in any jurisdiction in which such an offer or solicitation would violate applicable laws or regulations.
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