It has been a nasty start for U.S. stocks in 2022. The S&P 500 Index fell 20.0% over the six months ended June 30, 2022, and was down 16.1% in the latest three-month period alone. The weakness in stocks has been driven by concerns about a 50-year high in inflation and the U.S. Federal Reserve’s (Fed) singular focus on bringing inflation down by raising short-term interest rates and reducing the size of its balance sheet. With investors understandably anxious, we recently sat with Brad Willock, Vice President & Senior Portfolio Manager, North American Equities, to hear his perspective on where things stand in the U.S. market.
What are you following most closely as you evaluate the potential paths stocks might take?
The Fed and its fight against inflation is, and has been, the single most important driver of markets. The Fed is tasked with a dual-mandate of achieving full employment and controlling inflation to 2%. It succeeded at its first objective. Unemployment sits near a 50-year low. But the Fed has failed to control inflation. The Fed has promised to raise short-term rates “expeditiously” to slow economic growth such that the price level decelerates from multi-decade highs toward the central bank’s long-run target of 2%.
To curb inflation, the Fed needs to bring demand more in-line with supply by tightening financial conditions. By raising interest rates, the Fed raises the cost of borrowing money which reduces spending and puts pressure on asset prices. When people feel less wealthy, they tend to spend less. As the largest source of leverage and wealth for most individuals, the housing market is target number one. In the U.S., the 30-year mortgage rate has surged to nearly 6% in response to the Fed’s activity. At this level, no existing mortgages are able to refinance at a lower rate. Though home prices have been resilient so far, sales activity has slowed and we expect price appreciation to slow going forward.
The Fed has also said that it believes it can bring inflation under control without causing a recession. However, the weakness in stock prices, particularly of cyclical companies, and the inversion of the yield curve suggests many investors are skeptical.
When might the Fed stop hiking rates?
Where the U.S. Fed Funds rate will peak is a moving target. The Fed itself isn’t sure yet, as it continues to gauge the reaction of inflation to its policy actions. As of writing, the bond market is pricing in a peak Fed Funds Rate of roughly 3.55% in February 2023. It seems likely that there will be no pause in hikes until the Fed sees clear signs that inflation is slowing toward its target of 2%.
While the Fed has acted with vigor thus far, rate hikes have a lagging impact on inflation. Short-term inflation is likely to remain elevated as a result. But looking at the 5-year forward inflation rate reflected in the market, expectations have moderated back to towards the Fed’s 2% target after peaking earlier in the second quarter. This signals a vote of confidence in the Fed’s actions thus far and its commitment to bringing inflation in check.
What does this all mean for the U.S. economy and stock market?
Despite its aspirations for a soft landing, the Fed’s aggressive tightening does put the economy at a heightened risk of a recession. That doesn’t mean, however, that the Fed is acting in error. While economic weakness isn’t desirable, systemic inflation would likely be far more problematic.
In the U.S. stock market, we’ve seen a rapid downward adjustment so far this year as investors have priced in the heightened risk of a negative economic scenario. This has so far been concentrated in the price-earnings (P/E) ratio, which conveys how much investors are willing to pay per share for $1 of earnings. Since January, the forward P/E multiple of the S&P 500 has decreased by roughly five times, from 21 down to a more reasonable 16 times P/E. This multiple contraction represents around a 20 to 25% decline in stock prices – about what we’ve experienced.
The risk now lies in large part with earnings. Despite recession concerns, expectations for earnings have continued to rise to record levels. This, to some extent, can be attributed to recent high inflation. All else equal, as prices rise so too do business revenues. However, in a recession scenario, corporate earnings could come under pressure. Investors will be paying close attention to upcoming earnings results to try to gauge the path forward.
How are you positioning your U.S. equity strategies?
We’ve been overweight the defensive sectors, which have all outperformed relative to the broader S&P 500 since the start of the year. With the exception of perhaps Health Care, the relative performance of the defensive sectors could soften quickly when the market believes the Fed is close to the end of its hiking cycle. The timing of that is something we’re watching closely and we remain defensively positioned as we balance the rising economic risks.
Cyclicals have performed poorly on the back of recession fears. The exception here being Energy, an area we’ve been overweight. Energy producers, which are clear beneficiaries of higher oil prices, are generating significant free cash flow, which is being used to reduce debt, and boost dividends and share buybacks. Overall, on the supply side, underinvestment in crude production will support higher prices for longer. In the short-term, we may see some reduction in demand given the sharp increase in the price of gasoline, but over the long-term we expect the demand for oil to continue to increase for many years. We’ve used the recent pullback in the Energy sector from its March peak as an opportunity to add to our exposure.