With tighter financial condition, it is expected to slow down economic growth in US. Many banks have revised year end target for the S&P500 lower, and me too (link to my revision here). But recovery and growth will eventually materialise once inflation is contained (expecting some time after 2Q 2023). But what’s the risk versus reward at today’s market level? Will US enter a recession with the FED tightening? What does history taught us pertaining current economic condition?
Market Reaction to CPI Numbers
Last week, US released its CPI numbers which came in above estimates which sent the major US indexes spiraling downwards with the S&P500 falling 178 points, a total of 4.3%. The 10-year treasury moved higher to 3.42% on the same day. Investors who were expecting inflation numbers to taper off started to get jittery after the released of the CPI numbers. Most of them are now expecting the FED to continue its rate hikes trajectory, even contemplating a jumbo 100bps increase at their next meeting. As such, the drop in all major indexes was a result of market participants trying to price the jumbo hike expectation, which might caused the US economy to experience a hard landing as higher rates will slow the economy down. Many are also wondering if the FED might be behind the curve this time round too; raising rates too fast and too furious while the economy is in the process of adjusting itself after prior hikes.
Inflation to Stay Longer as Economies Re-calibrate
I believe that the recent strength in cyclical and wage-sensitive services has kept the inflation to stay near its all-time highs. As price pressures remaining sticky, the pace of rate hikes will stay elevated for a longer period of time causing financial conditions to be tighter too. Valuation compression for risk assets has started to reflect such a condition since March 2022. S&P500 has traded sideways, between the range of 3,650 to 4,200 since the turn of June.
FED Prioritising Taming Inflation ahead of the Labour Market
The slowdown in the US labour market is underway as companies start re-evaluating hiring in view of the macro-environment. Additional reduction in hiring is required to balance market participation to contain wage growth going forward. US initial jobless claims fell for a fifth-straight week to 213k for
the week ended September 10; signifying a strong labour market, giving the FED more room to orchestrate monetary policies to curtail inflation. Unemployment rate remains within FED target of below 4% for August 2022 and personal income growth is showing signs of slowing (refer to table below).
Looking at the other data points, US consumers remained strong and healthy. US retail sales rose 0.3% month-over-month in August, higher than consensus expectations. Though gasoline prices have declined, inflation has likely limited additional spend. US Consumer spending remained elevated since the beginning of 2022 (refer to table below).
Household debt to GDP continues to decline.
Falling gasoline prices allowed consumers to buy other items, with spending rising for motor vehicles (2.8%); miscellaneous stores (1.6%); food services and drinking places (1.1%); building materials and garden equipment (1.1%); sporting goods, hobby, musical instruments and books (0.5%); general merchandise stores (0.5%); food and beverages (0.5%); and clothes (0.4%). On the other hand, sales at gasoline stations were down 4.2%, and decreases were also seen in sales at furniture stores (-1.3%); non-store retailers (-0.7%); health (-0.6%); and electronics (-0.1%). Excluding gasoline stations, sales rose 0.8%. Core retail sales which exclude automobiles, gasoline, building materials and food services, were unchanged.
Recession Possible but not Probable
In my opinion, the probability of a recession though has increased, remains highly unlikely as US consumers remain healthy. The tighter financial condition will definitely slow down the economic growth in US. But once inflation is more well controlled, central bank will then refocus back on growth. With ALL the asset managers that I had spoken to, we agreed that a US recession remained a worst-case scenario and not the base-case.
Consumer sentiment has been improving in the last few months too as observed on the chart above. I believe most market participants are expecting the FED to eventually steady inflation numbers and economy will resume its recovery as the other global economies open up and supply chain returning back to normalcy as well.
As the market is always forward looking, moving ahead of the real economy, I think that the ongoing valuation reset offers medium to long term investors interesting opportunities. Market will have more clarity towards the end of the year as mid-term election’s results will be out by then and FED’s earlier tightening will have worked through the economy, slowing inflation. US economy is still expected to grow in 2022, though downward revision has been made. Currently, the IMF has a US GDP growth YOY target of 2.3% for 2022 and 1.0% for 2023. Earlier in April 2022, IMF targets for the US GDP growth was 3.7% in 2022 and 2.3% for 2023. We saw some downward revision since then.
Downside Risks to Global Economy
- The war in Ukraine further raises energy prices.
- Inflation remains stubbornly high.
- Tighter financial conditions trigger debt distress in emerging market and developing economies.
- China’s slowdown persists; causing spillover effects to other economies including US. For example, further tightening of supply bottlenecks could cause higher consumer goods prices worldwide, but lower demand might ease commodity pressures and intermediate goods inflation.
Opportunity in the US Market
The current valuation reset in the US market presents medium to long term investors to position into the market. Selection however is key. Investors will need to look out for companies with good earnings visibility and strong balance sheet. Of course, if you think this is too much work and you don’t know which instrument to employ, you can always seek advice from your investment advisor and buy into unit trusts or ETFs to get that exposure. A good technical level as of now is 3,800-3,880. Investors should look to position themselves into the US market at or below these levels. At 3,800 level, the S&P500 is trading at 16.6x FPE (based on analysts ‘consensus EPS forecast for year 2022 of US$228.86), which is below the ten-year average of 16.9x. However, it is still above the next three most recent historical averages: 15-year (15.5x), 20-year (15.5x), and 25-year (16.5x).
Historically, the US experienced a similar economic situation back in the late 70s to early 80s. In 1981, FED chair Paul Volcker engineered two massive but brief recessions to force inflation down. By the end of the 1980s, inflation was ebbing and the economy was booming. The US economy is in a better position today then what they had in the 1980s as job market then was weak with unemployment above 7 percent.
From the table below, the S&P500 had a negative return of 4.91% and a peak to bottom correction of 9.73% in 1981 as a result of hiking interest rates. But from 1982 to 1989, the index rallied 116.06%.
Demographics continue to drive the Corporate America story. Population growth in the US will fuel consumption in the next 20 years as shown below, driven by a high level of immigration. The latest data from the Census Bureau shows that US population growth is running at between 0.7% and 0.9% per year. A 2015 Census Bureau Report suggests that growth will slow somewhat, and projects a 2060 population of 417 million, with the country crossing the 400 million threshold in 2051. The United Nations projects a lower total, estimating a population of just over 400 million in 2060.
The US market continues to be one of the core allocation that investors should have in their portfolio. With the current valuation reset, I see it more of an opportunity for positioning. Of course this remains my own personal research/opinion and I can be wrong. But the long term narrative of US growth is too compelling, and statistically, it remains the best performing market in the long term. Is the cup half empty or half full? I invite you to draw your own conclusion.
Have a great week ahead!