Since 2022 began, stocks and bonds have generated double-digit losses, upending conventional wisdom that when stocks fall bonds rise.

These days, investing in stocks requires a healthy dose of foritude. Elevated inflation levels not seen since the 1970s have further eroded the value of holding cash and further exacerbate stock and bond market losses for many investors.

The economy continues to produce mixed signals regarding whether it will enter recession. Because the stock market looks ahead 6-9 months, its bear market performance has endorsed the recession argument. Further, after the Fourth of July the bond market joined the recession camp as the 2-year bond yield surpassed the 10-year rate to create an inverted yield curve. These stock and bond market signals haven’t always led to recession, but the odds now seem better than 50/50.

With all this doom and gloom, the easy decision for the investor would seem to be to get out of the market and stay on the sidelines. However, atypical conditions in the housing and auto markets, sensible monetary policy, and the employment market provide signals that things can work out fine, even if we experience an environment that meets the definition of recession.

The Federal Reserve, albeit late, appears serious about tackling inflation by raising its benchmark lending rate and beginning the process of shrinking its substantial holdings of Treasuries and mortgage-backed securities purchased during the pandemic. The conventional wisdom of any Fed tightening cycle is that higher interest rates slow the demand for long-lived assets purchased on credit, particularly the large housing and auto sectors. A slowdown or contraction in these two sectors has a substantial spillover effect for economy-wide employment given the vast network of suppliers providing them goods and services. The Fed’s tough anti-inflation talk, more than the relatively modest increases in rates it has already undertaken, has substantially increased market rates for mortgages and auto loans, impacting affordability.

However, demographic trends and unusual pandemic-related conditions are likely to blunt the typical response of housing and autos to rising borrowing costs. According to a Freddie Mac study the nation faced a shortage of 3.8 million homes at the end of 2020 due to more than a decade of underbuilding caused by lack of construction labor, land use restrictions, and lack of land to develop in populated areas. The existing shortage is being exacerbated by housing demand from the Millennial generation, the largest demographic in the U.S. at 72 million. A higher percentage of Millennials are now entering their peak first-time homebuying age of 25-34, an elevated source of demand that will last through the end of the decade. Further, according to the U.S. Census Bureau the number of renters 25-44 years old with $75,000 or more of income is about 3.5 million, double what it was 10 years ago. With easing supply chain disruptions and remote work supporting the building of homes in less expensive real estate markets the demand for housing should resist the full impact of interest rate increases.

We follow the employment market closely, as growth of jobs and wages provides the cash flow consumers need to fuel the economy. On this front the news is supportive of growth as June saw 372,000 new jobs, better than expected, leaving the unemployment rate unchanged at 3.6%, near a 50-year low. While the number of employed is still about 500,000 jobs short of its pre-pandemic peak, the demand for workers remains robust as there were 11.3 million job openings at the end of May compared with seven million prior to the pandemic. In the face of this labor imbalance, it is likely that employers will respond to any reduction in demand by reducing new hiring versus widespread layoffs.

Even with these counterforces, the Fed can do significant damage by overtightening credit conditions. However, this doesn’t mean a resulting recession has to be severe, in fact it is possible the U.S. is already meeting the conventional definition of recession: two straight quarters of negative real GDP growth. The most recent revision of first quarter 2022 real GDP was a decline of 1.6%, largely caused by inventory reduction as businesses lost production from supply chain disruptions, including Covid lockdowns in China. Second quarter data looks weak as consumers cut back on spending for household goods and clothing in response to elevated energy and food prices. We suspect that the Fed is aware of its role in causing the stagflation of the 1970s when it raised rates to fight inflation only to cut them too quickly when the employment market began to buckle, convincing consumers that inflation was a permanent fixture of the economy. We expect the Federal Funds rate will rise to 3%-3.5% by the end of 2022, up from 1.5% today, and that the central bank will pause to assess inflation expectations before proceeding further.

In this environment companies are doing a reasonable job coping with four factors they site as concerns: the war in Ukraine, Covid lockdowns in China, supply chain costs, and the strong U.S. dollar. According to FactSet, analysts expect S&P 500 consensus second quarter 2022 earnings to grow 4.3%. Such short-term forecasts are notoriously understated, as FactSet notes that earnings growth could be as high as 9%-12% if it adds the margin that actual historical earnings have exceeded consensus over the past five- and ten-year periods. However, investors won’t give companies much credit for strong second quarter results if their guidance for the third quarter and full year is cut. This is quite likely as consensus expectations for earnings growth in the third and fourth quarters are 9.4% and 10.0%, respectively, quite high compared with the robust profit growth of the second half 2021.

With the stock market’s decline, the forward P/E ratio of the S&P 500 is 16.3, below the 5-year average of 18.6 and 10-year average of 17.0. As noted, consensus earnings growth estimates look optimistic, but several high-quality growth stocks, particularly in the technology and consumer discretionary sectors, have fallen by 40% or more.

As always, investors who focus on a firm’s long-term fundamentals will be rewarded when the doom and gloom likely turns out to be overblown. In our August issue of the Investor Advisory Service, we recommend three companies for subscribers with high-quality fundamentals and reasonable current valuations. Any of these three stocks could be strong additions to an investor's portfolio at present prices.

Reprinted from the August 2022 issue of the Investor Advisory Service stock newsletter, rated #1 for performance in 2021 by Hulbert Ratings.

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