May 16, 2022
Darrell Cronk, CFA
President, Wells Fargo Investment Institute
Chief Investment Officer, Wealth & Investment Management
Darrell L. Cronk is the president of Wells Fargo Investment Institute, which is focused on delivering the highest quality investment expertise and advice to help investors manage risk and succeed financially. Mr. Cronk leads global investment strategy and research including equity, fixed income, real assets, and alternative investments. He also serves as chief investment officer for Wealth & Investment Management, a division of Wells Fargo & Company that includes Wells Fargo Private Bank, and Wells Fargo Advisors.
The math is easy, the decisions are hard
-- William Arthur Ward, American author end call out
Let me open with a combined math and history lesson. First, the hard numbers. Last Wednesday’s headline consumer price index (CPI) inflation reading for April 2022 came in at a stubbornly high 8.3%, a clear indication that while inflation pressures may be stabilizing, they are not yet reversing. In fact, core inflation — which calculates inflation minus food and energy — rose 0.6% in April, double the monthly increase from March. No surprise to those who have shopped for a car lately, tried to rent an apartment or buy a home, frequented the grocery store, or bought an airline ticket. Inflation is not just a problem for the consumer, however. If you are in business making virtually anything, and your transportation costs have spiked, your labor costs are soaring, and the cost of your raw materials have gone up 20% to 30% in the past year, you may be wondering how fast you can increase prices of your goods to simply maintain the same margins and earnings power.
Some take solace in speculation that inflation may have peaked in March, but I am not sure that is the right question to ask. A far better question, in my opinion, is this: Can the Federal Reserve (Fed) slow inflation faster than it slows the economy and without triggering a contraction in growth and the next recession? Even Fed Chair Jerome Powell, along with many of his fellow Fed committee members, have acknowledged that they are not convinced they can slow inflation to levels acceptable to them without derailing economic growth.
That is the math. Now for our history lesson. We went all the way back to the 1930s and found that the Fed has never been able to reduce inflation by greater than 2.50% in any cycle without ultimately causing a recession. Therefore, the Fed’s cure — aggressively hiking interest rates — may very well be the medicine that kills the patient — the economic growth that has enabled the S&P 500 Index to register annual returns of 28.9% in 2019, 16.3% in 2020, and 26.9% in 2021. The Fed, after initiating a standard-issue 25-basis-point (0.25%) hike in March, raised the federal funds rate by 50 basis points (0.50%) in May, and markets expect more of this medicine when the Federal Open Market Committee meets again in June and July. The recent tightening in financial conditions may already be weighing on the economy. The housing market historically has been particularly sensitive to changes in interest rates, and various housing indicators have weakened throughout the year. Consumer sentiment dropped in early May to the lowest levels since 2011, and recent Chief Executive Officer (CEO) and Chief Financial Officer (CFO) comments from first-quarter earnings reports are flashing signs of caution that growth ahead may slow.
To be clear, every economic cycle is different, but the economy has always operated in cycles. From 2008 to 2020, we enjoyed the longest economic expansion in the past 70 years, but the U.S. economy also registered one of its slowest average growth rates of any expansionary cycle. As we stare hard at the data from this current expansion cycle — only two years old beginning in second quarter of 2020 — we have strong reason to believe it is likely going to be one of the shortest and most volatile expansion cycles over that same 70-year horizon. We see clear late-cycle indicators, and while the risk of economic growth contraction or recession has risen steadily through the first four-and-a-half months of this year, we are now beginning to cross over a probability level that makes recession a base case for the end of this year and beginning of next. The good news is that, at this point, the data tell us it should be a relatively mild economic growth contraction and a short-lived one.
Investment markets have been grappling with a slowing growth condition all year, as 2022 has proven to be the worst combined start for financial markets since the 1930s. During the second half of 2021 and the first several months of 2022, markets were pricing in two simultaneous shocks: the first was rising and broadening inflation, and the second was a return to rising interest rates for the first time in years. With inflation now at its highest level in 40 years, the 2-year U.S. Treasury yield has tripled since the start of the year, and the 10-year Treasury yield has almost doubled. It is only recently that the markets began to discount a third shock — the possibility of recession late this year or next. This latest shock has caused the S&P 500 Index to once again approach bear market territory — defined by a 20% drop from prior peak levels. Investors will recall the last bear market experience, prompted by the coronavirus pandemic in March 2020, had a peak-to-trough decline of 34%. In fact, the long-term average of the last 12 bear markets over the preceding 70-plus years has been 33% peak to trough.
Typically, in volatile times like these, investors ask us either “What buying opportunities do you see in this market?” or “Should I move from risk assets to cash?” Both are wise questions, each taking an opposite end of the risk spectrum. To be clear, markets have risen every time they have fallen in the past, and we unequivocally believe they will rise again. The question really comes down to this — over what time horizon? When we look back historically, any bear market or recession has proven to be an excellent opportunity for savvy investors willing to check their emotions at the door and buy into good, quality investments at discounted levels. We expect this one to be no different. In the very near term, however, there is compelling evidence to suggest that markets may have not yet fully discounted the impending contraction in both economic and earnings growth. If your time horizon is shorter term, be patient as these challenges continue. Valuations are resetting to the new reality of tighter policy, higher consumer prices, and pressure on company margins and earnings. Turning points will come and a market bottom will emerge, but we do not believe we are there quite yet; however, we remain watchful and vigilant.
Wall Street investors are a funny crowd as they assess their forward outlook. Often, when something such as the next contraction in economic growth or recession is debated, it is commonly ridiculed. From ridicule, it then moves to being staunchly opposed and dismissed. Finally, after the data confirms, often after the fact, it is generally and quite astonishingly accepted as self-evident. As I have said many times in these pieces and everywhere I travel, I do not have the luxury of being an optimist nor a pessimist. My sole focus is to be a realist and attempt to provide clarity and transparency to smart readers such as yourselves about what I see in the math and the data, and what we’ve learned from the annals of history. Markets are efficient, forward-looking, discounting machines that clearly see the slowing growth and tighter policy on the horizon. They respond by correcting, selling off, and ultimately convulsing to a bottom. This has been a natural part of any and every economic and market cycle. The key is to not fear it, but to position for it and have portfolios ready for the eventual recovery that has historically come on the other side of the re-pricing. I will end where I began. The pessimist complains about the wind; the optimist waits for it to change; but the realist adjusts the sails. Be wise, speak with your advisor, and make sure you are adjusting accordingly.
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