James Ragan, CFA, Director of Wealth Management Research
2022 has been a difficult year for investors, especially in U.S. equity markets, as each of the indices shown above posted negative returns in the first half of 2022, including declines in both the first and second quarters (1Q22 and 2Q22). The large-company S&P 500, the large-company, technology-centric Nasdaq Composite, and the small-company Russell 2000 each at one point in the first half closed down more than 20% from prior highs, meeting that definition of a bear market. The widely-followed, large-company S&P 500 index was down 20.6% (price return, not including dividends) in the first half of 2022, and at its low point on 6/16/22 was down 23.6% from its closing high on 1/3/22. Following a 6.3% July rally through 7/27/22 (and up 9.7% from the 6/16 low), the S&P 500 was down “only” 15.6% year-to-date (YTD), as of 7/26/22. Many factors have contributed to eroding investor sentiment in 2022, but most can be connected to inflation, rising interest rates, and worries of a U.S. economic recession.
The Federal Reserve Bank Is Worried about Inflation
Inflation manifests in higher prices for goods and services, and will often erode consumer finances unless wages keep pace. If wages do keep pace, and workers demand higher wages, inflation pressures become entrenched, creating a long-term problems. While rising inflation itself can slow economic activity as consumers and businesses delay or cancel discretionary spending, the Federal Reserve Bank (Fed) is using its monetary policy tools (primarily raising short-term interest rates) to restrict the flow of credit, an attempt to constrain or reduce demand enough to relieve inflation pressure without restricting to the point of causing a recession. The Fed is able to affect short-term interest rates by setting a target range for its federal funds (fed funds) rate used among banks for overnight borrowing and lending. In November 2021, as inflation remained stubbornly high (the consumer price index - CPI - was 6.2% year-over-year in October 2021), the Fed disclosed that it would begin tapering its monthly purchases of Treasury and mortgage securities (which would begin to restrict liquidity), and in January 2022 said that it would soon be appropriate to begin raising its fed funds target. By January 2022, the CPI was reported at 7.5%, and by March when the Fed finally raised its fed funds target (low end of the range) to 0.25%, the CPI was 8.5%. Since March, the fed funds target has been raised by an additional 200 basis points (including 0.75% at both the June and July Fed meetings), taking the fed funds rate to 2.25% (officially the target is a range of 2.25% to 2.50%).
Growth Is Slowing
While headline inflation levels have continued to rise, there is mounting evidence that consumer spending has moderated, and the U.S. economy is slowing. U.S. first quarter (1Q) real gross domestic product (GDP, reported by the Bureau of Economic Analysis) declined 1.6%, but economic weakness was attributed to net trade (imports larger than exports), and a drop in government expenditures. U.S. second quarter (2Q) GDP declined 0.9% (reported on 7/28/22). Both consumer spending (personal consumer expenditures - PCE) and business investment (non-residential fixed investment) were weaker in 2Q vs. 1Q. The consumer (PCE) contribution was positive, but was at the lowest growth rate in the past eight quarters. This is an indication of slowing consumer trends but, at least through June, this has not shown up in the labor markets. The recession discussion continues; the debate on whether or not the U.S. economy is in a recession has driven increased market volatility and equity market weakness in 2022, in our opinion.
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Defining a Recession
A U.S. recession is loosely defined as a period of notable slippage in economic activity, which is generally measured using changes in gross domestic product (GDP). It is common practice to identify a recession with two consecutive quarters of negative GDP growth, but the federal government’s Bureau of Economic Analysis (BEA) maintains that is not an official definition. The BEA says that official recessions are designated by the National Bureau of Economic Research (NBER), a private, non-profit research organization based in Cambridge, Massachusetts. The NBER looks for “a significant decline in economic activity that is spread across the economy and lasts more than a few months;” and also looks at the depth, diffusion, and duration of the downturn. While most recessions last longer than two quarters, the NBER determined the 2020 COVID-19 recession lasted just two months. According to the NBER, in the ten U.S. recessions since 1957 (a period of 65 years), the duration of the economic downturn averaged 10 months, with the shortest just two months (2020) and the longest 18 months in 2008/2009 (Global Financial Crisis). The 10 recessions since 1957 are shown in the table below.
Recessions Are Usually Not Good for Earnings
It is important for investors to know during recessions that economic downturns create challenges for corporate profits, and S&P 500 earnings growth turned negative in each of the past ten recessions. S&P 500 earnings per share (EPS) declines, from peak to trough, ranged from -4.6% in the 1980 recession, to -91.9% during the Global Financial Crisis (GFC) from 2007 to 2009. The average earnings decline across all ten recessions was -29.5%. That included two unusual events, as the GFC caused a collapse in the financial system and bank earnings, and the earnings decline in 2001 followed the bursting of the technology bubble, causing a massive earnings decline in that sector. Excluding those two periods, the average earnings decline during the other eight recessions was -18.7%. In 2022, as economic growth has slowed, S&P 500 earnings growth rate expectations have remained positive. 1Q22 (mostly reflecting the March quarter) S&P 500 EPS increased 9.8%, exceeding estimates, and 2Q22 S&P 500 EPS, with earnings season underway as of this report, are expected to increase 6.1% Y/Y (according to FactSet consensus estimates). For the full-year 2022, the FactSet consensus estimate is for S&P 500 EPS to grow 9.7%. If the U.S. does enter a recession in 2022, earnings results are likely to fall short of estimates, but the fact that earnings have exceeded expectations in early 2022 suggests to us that a recession is not yet a certainty.
U.S. Recessions (as defined by the NBER) 1957-2020
Recession Investment Strategies
In a recession environment, earnings for most companies are at risk, but we expect better relative earnings results from companies in sectors that are historically less immune to economic cycles. Companies in these “defensive” sectors often see demand for their products and services hold up better during periods of economic volatility than companies in more economically sensitive industries. The classic defensive sectors are Consumer Staples, Utilities, and Health Care. These sectors have significantly outperformed (down much less than the broader market) in 2022, an indication that investors have anticipated the slowing economy and perhaps expect some earnings challenges in other sectors. There are also several sub-industry groups in other sectors that we believe could hold up well in a recession. This includes companies in industries that receive government contracts, including defense contractors, engineering and construction firms, and other companies that can participate in infrastructure investment. In the Financials sectors, insurance companies offer some defensive protection, and in Real Estate, some real estate investment trusts (REITs) can outperform if they serve industries that are more recession-resistant. This includes REITs that own properties occupied by grocery stores, convenience stores, and pharmacies, or REITs that own property serving the healthcare and telecommunications markets. Similarly, within the Consumer Discretionary sector, grocery and convenience stores often are less affected by a slowdown in consumer spending in a recession. Finally, telecommunications service providers benefit from monthly subscription revenue that historically has held up well during recessions.
We also can identify potential in a couple traditionally cyclical sectors in the current environment; Energy and Information Technology. During a recession, oil demand typically falls, creating lower oil and gas prices that negatively impacts the Energy sector. In the current environment, however, oil supply, which was already constrained as production shut down during the global pandemic, has been further disrupted by international sanctions on Russia. This could create a supply imbalance even during a recession, keeping oil prices high. Finally, many of the large-capitalization, technology-centric growth stocks have established, highly profitable business models with strong cash generation and pristine balance sheets. Some of these companies could gain market share as the economy slows and also have the ability to use cash for capital expenditures, research and development, and acquisitions, creating possible long-term opportunity for investors.
Are We in a Recession?
Although the U.S. has posted two consecutive quarters of negative GDP growth (1Q22 and 2Q22), we have not seen the erosion in corporate profits or increase in unemployment that we typically see in recession periods. We are watching that data closely, but according to the Bureau of Labor Statistics (BLS), the U.S. economy created 372 thousand (K) net new jobs in the month of June and 1.1 million in the second quarter (April, May, and June), bringing the unemployment rate down to 3.6%, matching the lowest rate since the onset of the pandemic in 2020. In addition, 2Q22 S&P 500 earnings growth has exceeded estimates in the current reporting cycle. Through mid-day 7/28/22, approximately 49% of S&P 500 companies (according to FactSet) had reported quarterly results for the quarter ended June 30th, and estimates have moved to expected growth of 6.1% from a consensus estimate of 4.3% at the end of June. Consumer spending has shifted to services (travel, entertainment, medical services) away from goods, but has remained positive. At the same time, housing data (housing starts and new home sales) has weakened, several leading general merchandise retailers recently reduced their business outlooks as customers pare spending on discretionary items, and a major consumer confidence survey from the University of Michigan has plunged to multi-decade lows.
When we break down major components of the quarterly GDP report (consumer spending, business investment, government expenditures, trade balance, and inventory adjustments), we see that most of the 1Q22 weakness was attributed to international trade as exports softened and imports spiked (imports subtract from GDP as it represents goods not produced in the U.S.). This was at least partially attributed to supply chain disruptions and Russia’s invasion of Ukraine, and in 2Q22 the trade imbalance partially reversed. When stripping out the trade impact, the core drivers of consumer, business, and government were all weaker in 2Q vs. 1Q, and suggest to us that GDP weakness could continue. Therefore, in our view, the odds of an official recession being declared in the third quarter have increased in recent weeks. But at this point, due to jobs and earnings strength, the recession is shaping up to be relatively mild, which could be bullish for equity investors, as investors position for an economic rebound. However, we continue to see volatility ahead as economic data remains uncertain and visibility is limited.
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Market Indices: The information on indices is presented for illustrative purposes only and is not intended to imply the potential performance of any fund or investment. Indices provide a general source of information on how various market segments and types of investments have performed in the past. Index performance assumes the reinvestment of all distributions, but does not assume any transaction costs, taxes, management fees, or other expenses. You may not invest directly in an index. Past performance is not an indicator of future results. The Russell 2000® Index is a market cap weighted index that measures the performance of the 2,000 smallest companies in the Russell 3000® Index. The S&P 400 Index is a market cap weighted index comprised of U.S. stocks in the middle capitalization range, generally considered to be between $200 million and $5 billion in market value. The S&P 500 Index is a market cap weighted index that is designed to measure the US large-cap equity performance. The index is composed of the 500 leading publically traded US companies based on size, liquidity, industry, and profitability criteria. The Dow Jones Industrial Average is a price weighted index that tracks 30 large, publicly-owned companies trading on the New York Stock Exchange (NYSE) and the NASDAQ.
The Federal Reserve Bank’s Open Market Committee (FOMC) consists of twelve members--the seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis. The FOMC holds eight regularly scheduled meetings per year. At these meetings, the Committee reviews economic and financial conditions, determines the appropriate stance of monetary policy, and assesses the risks to its long-run goals of price stability and sustainable economic growth.
The term "monetary policy" refers to the actions undertaken by a central bank, such as the Federal Reserve, to influence the availability and cost of money and credit to help promote national economic goals. The Board of Governors of the Federal Reserve System is responsible for the discount rate and reserve requirements, and the Federal Open Market Committee is responsible for open market operations. The Federal Reserve influences the demand for, and supply of, balances that depository institutions hold at Federal Reserve Banks and in this way alters the federal funds rate. The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.
The National Bureau of Economic Research (NBER) is a private non-profit research organization. The NBER is widely used as an organization that analyzes U.S. economic data and the business cycle and determines the start dates and end dates of economic recessions.
The forward S&P 500 price-to-earnings ratio (P/E) is a valuation measure, calculated by dividing the price of the S&P 500 index over the weighted average earnings per share (EPS) estimate of each company in the index. Earnings are based on “forward” consensus estimates expected over the next 12 months (NTM), using quarterly analyst estimates as provided by FactSet. These estimates are also used to determine earnings growth rates of one period compared to another.
Gross domestic product (GDP) refers to the monetary measure of the market value of all final goods and services produced within a country’s borders within a specific time period.
FactSet is a data aggregation software utilized by D.A. Davidson’s Wealth Management Research. The FactSet Consensus refers to the aggregate of all analyst estimates from firms that submit estimates to FactSet for a given financial metric.
U.S. Personal Consumption Expenditures (PCE) is an indicator of the growth in consumer spending and measures the value of goods and services purchased by persons who reside in the U.S. It is reported monthly by the Bureau of Economic Analysis. Retail Sales, reported monthly by the U.S. Census Bureau, reflects a monthly survey of sales by retail and food service firms in the U.S.
The consumer price index (CPI) is a measure of average change over time in the prices paid by urban consumers for a market basket of goods and services. It is reported monthly by the U.S. Bureau of Labor Statistics.
We define “Defensive Sector” as sectors whose constituents are companies that are generally less exposed to changes in the business cycle, and thus have less volatility in revenue and earnings. Traditionally we view Consumer Staples, Utilities, and Health Care as defensive sectors, although some companies in these sectors are less defensive than others, and some companies in other sectors have defensive qualities as well.
The Global Industry Classification Standard (GICS) is a four-tiered, hierarchical industry classification system. Companies are classified quantitatively and qualitatively. Each company is assigned a single GICS classification at the Sub-Industry level according to its principal business activity. MSCI and S&P Dow Jones Indices use revenues as a key factor in determining a firm’s principal business activity.
The Bureau of Labor Statistics (a division of the U.S. Department of Labor) publish a monthly employment report, The Employment Situation. It presents statistics from two monthly surveys to report labor force status, including unemployment and demographics. The unemployment rate is the number of unemployed as a percent of the labor force.