Welcome to the second part of our 2022 Halftime Report! The goal of this 4-part report is to help you better understand what happened in the markets in the first half of 2022 and what may unfold in the months ahead. In our last post, we covered a review of the first half of the year. For the next two posts, we’ll take a closer look at what drove U.S. equity market performance. In our final post, we’ll have an outlook for the second half of 2022.
Let’s look at some economic and financial indicators to help understand how we got here.
The 2012 Economy
To put today’s economy in perspective, let’s look back to January 2012 when the U.S. economy was in a fragile recovery. Though the U.S. economy was officially out of recession, growth was slow as we continued to feel the effects of the 2008 credit crisis.
Here, you see 20 speedometers representing 20 indicators. You can see that there are an equal number of green indicators as there are of the cautionary yellow indicators. Four red indicators show that there still remained a fair amount of uncertainty over our economic health.
Let’s fast-forward to January 2022. It’s a different picture, with 17 of 20 indicators reported strengthening or positive numbers and no negative indicators. Perhaps the most notable of the three neutral indicators is the equity market valuation dial.
Nevertheless, the year began with an optimistic outlook for the economy and capital markets.
By June 2022, however, there was a more mixed outlook.
While there is only one red indicator – geopolitical risk, there are fewer green indicators than just six months ago. In fact, eight inputs moved from green in January to yellow in June, including monetary policy, yield curve, housing/mortgages, interest rates, fiscal policy, international economic outlook, inflation, and energy costs.
The indicators reflect a shift in the Fed’s monetary policy, the continuing overhang from the pandemic, such as supply chain disruptions that have elevated inflationary pressures. Also, the war in Ukraine has unsettled overseas economies and driven energy prices higher, while China’s zero-COVID-19 policy has hurt its economic growth and exacerbated global supply chain issues.
This chart shows the relationship between changes in S&P 500 performance and the 12-month forward earnings per share (EPS).
As you can see, the two lines have generally moved in the same direction over the past decade. During 2020, the volatility in stock prices and earnings was the result of COVID-19.
As markets rebounded on the expectation of economic recovery, earnings rose but not at the same rate as stock prices, creating a wider gap between prices and earnings. As you can see, this gap closed in 2022 as stock prices have come down, and corporate earnings have grown.
Here are a couple of reminders.
First, past performance does not guarantee future results. Over the next 10 years, the correlation between stock prices and corporate profits may look different.
Second, individuals cannot invest directly in an index.
And third, the return and principal value of stock prices will fluctuate as market conditions change. Shares, when sold, may be worth more or less than their original cost.
At the highest level, the Federal Reserve has three functions: to provide an effective payment system for the U.S., to regulate banking operations, and to set monetary policy.
When determining monetary policy, the Fed is tasked with supporting “maximum employment, stable prices, and moderate long-term interest rates.”
As it works to uphold its monetary policy goal, one of the indicators monitored by the Fed is the overall level of consumer prices, which helps it determine whether to adjust interest rates. The Fed has stated that it’s comfortable with inflation in the 2% range.
This line graph shows the Consumer Price Index (CPI) and Core CPI (which excludes food and energy prices) over the past 50 years. The chart is through May. On July 13, the June CPI was released and it showed an increase 9.1%. Core CPI, which excludes food and energy, rose 5.9%.
Inflation became a principal worry for investors in 2022 since rising prices may hurt corporate profits, reduce the business investment necessary for future growth, and influence the spending capacity of consumers. As inflation has become more persistent than originally anticipated by the Fed, there is a growing anxiety that inflation could play a role in moving the economy toward a recession.
The pace of inflation will also dictate Fed policy. Notice the PCE (Personal Consumption Expenditure) numbers at the bottom of the box. This is the measure of inflation that the Fed watches most closely for making decisions on interest rates. Right now it is above the Fed’s 2% target, and though the Fed has said it’s comfortable with overshooting its target for a brief period, this elevated PCE may keep pressure on the Fed to raise rates in the months ahead.
Components of Inflation
Everyone in this audience may have felt the impact of inflation. For some, it can be especially difficult to adjust to rising prices. This chart is instructive for a couple of reasons. First, it shows that various contributors to each month’s year-over-year inflation rate. As that bar charts suggest, inflation has hit consumer wallets on nearly every level, from food and energy to eating out and new and used cars.
The overhang for markets in 2022 has become whether inflation continues to rise or plateaus and comes down from here. Economists have pointed to a number of reasons for the emergence of inflation, including monetary policy, strong consumer demand during a period of supply chain problems, and fiscal stimulus that helped create greater consumer demand.
We’ve gone through a lot of information in our Halftime Report, and you might have lingering questions. So, let us know how we can help!