- Volatility is back as war in Europe and inflation has rattled investors.
- We believe our ‘Four I’s’ – Inflation, Interest Rates, Innovation, and Intrinsic Value, will determine market direction from here.
- Our optimism is dependent on inflation cresting, interest rates remaining relatively low, innovation offsetting higher costs, and corporate earnings staying robust.
We are proud to release our April 2022 Chart Pack – our visual quarterly designed to walk investors through our views on what’s happening and why, predictions about what may come next, and positioning in our RiverFront portfolios. In today’s Weekly View, we created a concise synopsis of four selected visuals from the Chart Pack that encapsulate a number of key takeaways.
The ‘mechanical bull’ we cited back in December in our 2022 Outlook as an analogy for stock markets in 2022 has turned into a ‘bucking bronco’. Volatility is back in a big way as war in eastern Europe has investors rattled and commodity prices soaring. We believe the ‘Four I’s’ first mentioned in our Outlook - Inflation, Interest Rates, Innovation, and Intrinsic Value - are as relevant now as they were when we wrote the Outlook. We revisit these market drivers here through the lens of geopolitical uncertainty overseas.
Inflation: Faster, Higher; Europe Uniquely At Risk Due To Russian Gas
At the risk of stating the obvious, Russia’s invasion is wreaking havoc on global commodity prices. Russia is a major exporter of oil and gas, and Ukraine is a major supplier of grains. Invasion related disruptions in energy and agricultural supply chains, as well as the economic effect of sanctions, drove commodities to multi-year highs in the first quarter.
Europe Natural Gas Imports from Russia
In our opinion, this is having a particularly detrimental economic effect in Europe, a continent deeply reliant on Russia for natural gas (see bar chart, above) and struggling to deal with its uneven recovery from the pandemic. Energy inflation is currently over 40% year-over-year, sparking legitimate fears of European ‘stagflation’.
In the US, inflation concerns are also top of mind. Headline Consumer Price Index (CPI) is currently at 8.5%, its highest level since the early 1980’s. However, under the surface, core inflation appears tamer. In our view, the “stickiest” parts of the Consumer Price Index (CPI) basket, like household furnishings, medical care, eating out, and education, represent a tamer picture of inflation than food, energy and auto prices, which are more volatile.
Currently, core 'sticky' CPI is trending at ~4.6%. This is different than the 1970’s, when even sticky CPI items skyrocketed. However, we recognize that the trend is alarming.
Interest Rates: Yield Curve Still Positive
Whether a major stock market pullback is followed by a subsequent economic recession matters for future returns. A Ned Davis Research study shows that, over the past 50 years, cyclical bear markets in the Dow Jones Industrial Average (DJIA) that are not overlapped by recession have an average peak-to-trough loss of roughly 18% and last about 7 months. When overlapped by recession, bear markets are far worse: -33% loss and last about 17 months on average.
While a spike in commodity prices often precedes recession, two other well-established indicators of impending recession remain healthy:
- The US 3 month-to-10-year Treasury yield curve remains well above zero, a positive in our opinion (see chart, below)
US Yield Curve Slope and Recessions
- Leading economic surveys such as the Purchasing Managers’ Index remain in expansionary territory for the US (chart, below)
Purchasing Manager Index (PMI) Surveys
Innovation: An Important Offset To Inflation, Especially In The Developed World
Current readings well above 50 on the composite Purchasing Manager Index (PMI) surveys (see chart above, left) suggests to us that the US economy is in healthy shape as it heads into an uncertain time for Fed policy…a crucial positive, in our opinion. We attribute this to not only the US’s geographic and energy production advantages, but also the benefits of a more flexible, innovative, and productive economy versus international peers. While European PMIs also appear healthy, we expect European sentiment to suffer going forward due to the economic impact of higher inflation and Russian sanctions. China and Japan have been at or under 50 for most of the year, reflecting muted business sentiment.
Intrinsic Value: Market Valuation Lower Than In ’21; As Long As Earnings Stay Robust, US Large-Cap Valuations Look Attractive To Us
To start the year, one of the least attractive aspects of the stock market, to us, was its high valuation.
At the time, the S&P 500 level was around 4750 and was trading for roughly 21 times 2022 estimated earnings. Today, the market multiple is about 2 multiple points cheaper (19x) on 12-month forward earnings, making US stocks more attractive to us.
The stock market's lower valuation is a mirage if earnings subsequently collapse, and thus we are watching analysts’ earnings revisions closely. Thus far, earnings forecasts have stayed robust. Currently, analysts estimate the S&P 500 12-month forward earnings at close to $230 per share, an increase of about 20% over the last year, and up over $12 from the estimate at the beginning of the year (see chart, left).
S&P 500 12-Month Forward Earnings-per-Share Estimate
Bottom Line: We Remain Constructive…Watching ‘Four I’s’ Closely
With the first quarter behind us and much bad news already reflected in global stock prices, we believe equity returns can improve throughout the rest of the year. Our optimistic outlook is dependent on inflation cresting, interest rates remaining relatively low, innovation offsetting higher costs and corporate earnings staying robust.