After a summer respite, volatility has returned to the markets. Tuesday’s inflation report came in higher than expected, reinforcing expectations of continued, aggressive Federal Reserve rate hikes. Investors scaled back optimism on how quickly inflation will ease, and markets responded with a broad sell-off.
While the volatility year-to-date and this week is disconcerting to many investors and the world economy is facing real challenges, there are many reasons for maintaining a constructive long-term perspective on portfolios. The market has been experiencing a painful repricing process since the start of the year as investors balance the conflict between a strong economy and the Fed’s actions to slow it.
One important note about the battle between inflation and the Federal Reserve is that inflation is proving persistent in part because of the resilience of the U.S. economy. The Fed would like to see the economy slow to help tame inflation, but economic strength is a good thing for individuals and usually is for markets. The economy continues to show resiliency both from a consumer and corporate perspective.
Consumers, who comprise over 70% of the U.S. economy, continue to exhibit strength. Consumer spending remains robust. While savings rates and balances are trending down, they have merely returned to near pre-pandemic levels. Consumer debt levels as well debt service levels, how much of monthly income consumers spend on servicing debt, are below pre-pandemic levels and far below levels seen prior to the 2008 crisis. If there is a recession, consumers will not need to go through the massive deleveraging process that occurred in the ’08 financial crisis. Additionally, unemployment remains near historic lows, and the labor market is still presenting more job postings than job seekers.
Corporations are also healthier than many headlines would lead you to believe. While earnings estimates have appropriately come down, the current expectation for 2022 is a 7.9% earnings growth and 7.4% growth in 2023. Meanwhile, valuations have fallen but now are below long-run averages. The forward 12 months P/E ratio is now below the 5- and 10-year averages. The picture of the U.S. economy is far stronger than in other areas of the world. While the investing landscape is difficult today, we strongly believe that the U.S. represents the best economic environment globally.
Continued rising consumer spending, the tight job market, and the general strength of the economy present headwinds to taming inflation but also provide room for the Fed to take the action necessary to fight spiraling prices. All said the strength in the U.S. will help the economy and markets weather the current storm and return to long-term growth.
Turning to inflation directly, the recent CPI data is less dismal than the market reaction to them. CPI was higher than expected but still well below the peak in August. Oil prices have fallen significantly from their peak. Nearly half of all components of CPI have declined from their 18-month highs. The Producer’s Price Index (PPI), which tracks wholesale prices, was released this week and was down .1% month-over-month. Year-over-year, it was 8.7%, well below the 9.8% increase in July. Core PPI was 5.6%, its lowest level since June last year. A positive signal to give perspective to the previous day’s CPI data.
Additionally, higher frequency data continues to show modest price improvements. Housing, which is typically a lagging indicator of inflation, has started to show signs of price growth slowing with purchase mortgages, new home starts, and pricing all painting a picture of a slowing housing market.
Used cars recently posted a 4% decline in prices. Inflation is clearly exhibiting persistence, and remedies are not working as fast as everyone would like; signs are emerging that the tide is turning.
In response to both the persistent strength of the U.S. economy and inflation, the Federal Reserve will continue to tighten monetary policy, which runs the risk it may push the U.S. into a recession. The war in Ukraine does not have a clear end in sight, and potential conflicts in the Taiwan strait threaten geopolitical stability in the future. It is undeniably a difficult environment for investors today, and we expect more volatility in the near-term future than the generally steady market growth of the past decade. Despite the hurdles we face today, we believe the economy will overcome them and return to a steadier path of growth in the long run. Inflation is an issue, but the Federal Reserve is taking aggressive action to combat it, and the economy is resilient enough to withstand rising rates. Innovation, free markets, financial markets, natural resources, and Americans’ work ethic have prevailed over past periods of uncertainty and will again this time, rewarding those who maintain a long-term perspective.