May 2022 - AMI's Research Team discusses the recent market decline, what is driving it and where things go from here.
The stock market, as defined by the S&P 500, continued to decline in April falling 8.7% after posting a 4.60% decline in the first quarter. In Q1, the market focus was largely on the Russian invasion of Ukraine, with rising commodities a secondary worry. In April, the focus shifted to inflation and the Federal Reserve interest rate hike response that would likely slow the economy and increase recession risk.
Inflation remains elevated with April CPI at 8.1%, leading investors to forecast three 50 bps rate hikes this year with some speculating the Fed could raise rates 75 bps at the May 4th meeting. The fear of 75 bps didn’t materialize, as the Fed raised rates by 50 bps and signaled additional hikes of 50 bps at both the June and July meetings. While the market rallied on May 4th on the news that 75 bps hikes are not being considered at the moment, the market gave these gains back on the following day due to higher-than-expected labor cost data which quickly renewed fears of a 75 bps hike in June.
In our view, all eyes are on inflation. The Fed does not want inflation to get out of control, especially wage inflation, which can create a phenomenon known as a “wage price spiral”. This is particularly insidious as employees demand higher wages in order to offset higher prices of goods they buy. The employer then raises prices of its products to offset the higher wages and thus a vicious cycle begins. We believe the Fed will choose to sacrifice economic growth in the short term in order to control inflation. This has raised the risk of recession, mostly centered around 2023, which is currently weighing on the stock market. Fed Chairman Powell has stated that he thinks the Fed can engineer a “soft landing”, meaning slowing growth without causing a recession, but this may be somewhat difficult to achieve.
On a positive note, corporate earnings have generally been good during this reporting season and earnings estimates for the S&P 500 haven’t changed and continue to forecast growth. To date, we have mostly seen stocks decline on contracting P/E multiples to reflect increased recession risk in the future, as well as higher interest rates that are incorporated into valuations. Most of the multiple contraction has been focused on the higher valuation stocks, namely Technology, or those with little or no earnings. Some of this multiple contraction is justified in our view as stocks rose late in 2021 to unsustainable levels. However, we have not seen any significant earnings estimate cuts, reflecting the continued good earnings reports. Lastly, consumer spending remains strong, especially for travel as COVID has created pent up demand. While higher prices for items such as gas and food could begin to weigh on spending, the consumer remains in good shape with above normal savings.
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