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May 16, 2022 at 04:25 PM
What You Need to Know
- With strong consumer demand, a robust job market, higher wages and corporate earnings growth, the U.S. is unlikely to see a recession in 2022.
- Core inflation is projected to fall to 4.1% this year and 2.4% in 2023, despite less optimism about reaching those levels.
- Seek companies with strong earnings that are addressing inflation through increased efficiencies and pricing power.
Concern about soaring inflation, geopolitical tension and interest rate increases leading to a possible recession continue to roil equity markets globally. As a result, we’ve seen contraction in valuation multiples: Next-twelve-months (NTM) price-to-earnings (P/E) for the S&P 500 is now 17.1x, compared with 19.7x at the end of March and 21.5x at the start of the year.
The decline in the Nasdaq composite aggregate valuation is even more dramatic, down to 23.3x from 31.6x at the start of the year. Both indices are now valued below their five-year averages on an NTM P/E basis.
Despite the uncertainty, consumer demand is staying resilient, bolstered by elevated wages, plentiful jobs and higher-than-normal savings. The demand for goods and, increasingly, services is spurring business investment as companies take steps to add capacity and optimize their supply chains to meet demand.
Earnings continue to grow: With more than 90% of companies in the S&P 500 reporting first-quarter earnings, they are now tracking to 12.4% year-over-year earnings-per-share growth for the quarter. That increase is 36% higher than the 10-year quarterly average, which we view as a positive indicator for the U.S. economy.
Margins have held up better than expected, and are down just 2.9% year over year, with seven out of 11 sectors providing upside. Value and Growth styles have both posted similar revenue growth, 13.8% and 13.5% respectively, yet Value is outperforming earnings by 270 bps.
With fundamentals of strong consumer demand, a robust job market, higher wages and continued corporate earnings growth, we do not believe the U.S. will see a recession in 2022. Median projections anticipate that the Fed can engineer a soft landing, with core inflation falling to 4.1% at year-end and 2.4% in 2023, and the unemployment rate staying steady around 3.6%.
We are less optimistic about inflation coming down to those levels, with CPI and PPI remaining very hot and wages and rents continuing to be elevated; these are the stickier parts to inflation. As for the Fed’s success for a soft landing, that’s a hard call given its track record — since the 1930s, the Fed’s ability to produce a soft landing is just 10%. This means that in the past 11 rate increase cycles, eight ended in (at least a mild) recession, according to data from Merion Capital.
In my portfolio right now, I’m taking advantage of lower valuations to find quality companies on sale. This is not the time to take big sector bets; I’m being highly selective, seeking high-quality companies that hold top positions in their industries, have solid earnings, strong balance sheets, robust cash flow and the ability to pass on higher input costs. Share buybacks and dividends are also an important metric.
The Fed Is Data-Dependent, and So Are We
Consumer demand represents 70% of GDP, and a strong job market plays an important role in supporting consumers’ ability to spend. The U.S. has more job openings than unemployed people. Job openings hit 11.5 million on the last business day of March, the highest level since the Job Openings and Labor Turnover Survey (JOLTS) series began in December 2000.
We currently have 5.9 million unemployed, according to the latest nonfarm payroll report. Labor-force participation is still below pre-pandemic levels, with an unemployment rate at 3.6%. Last month, the U.S. saw notable job growth in leisure and hospitality, manufacturing, transportation and warehousing.
