By Chris Konstantinos, CFA, Director of Investments, Chief Investment Committee
- Volatility is back as war in Europe and inflation has rattled investors.
- We believe our ‘Four I’s’ – Inflation, Interest Rates, Innovation, and Intrinsic Value, will determine market direction from here.
- Our optimism is dependent on inflation cresting, interest rates remaining relatively low, innovation offsetting higher costs, and corporate earnings staying robust.
Update On The “Four I’s”: Inflation, Interest Rates, Innovation, & Intrinsic Value Still As Relevant As Last Year
We are proud to release our April 2022 Chart Pack – our visual quarterly designed to walk investors through our views on what’s happening and why, predictions about what may come next, and positioning in our RiverFront portfolios. In today’s Weekly View, we created a concise synopsis of four selected visuals from the Chart Pack that encapsulate a number of key takeaways.
The ‘mechanical bull’ we cited back in December in our 2022 Outlook as an analogy for stock markets in 2022 has turned into a ‘bucking bronco’. Volatility is back in a big way as war in eastern Europe has investors rattled and commodity prices soaring. We believe the ‘Four I’s’ first mentioned in our Outlook – Inflation, Interest Rates, Innovation, and Intrinsic Value – are as relevant now as they were when we wrote the Outlook. We revisit these market drivers here through the lens of geopolitical uncertainty overseas.
Inflation: Faster, Higher; Europe Uniquely At Risk Due To Russian Gas
At the risk of stating the obvious, Russia’s invasion is wreaking havoc on global commodity prices. Russia is a major exporter of oil and gas, and Ukraine is a major supplier of grains. Invasion related disruptions in energy and agricultural supply chains, as well as the economic effect of sanctions, drove commodities to multi-year highs in the first quarter.
In our opinion, this is having a particularly detrimental economic effect in Europe, a continent deeply reliant on Russia for natural gas (see bar chart, above) and struggling to deal with its uneven recovery from the pandemic. Energy inflation is currently over 40% year-over-year, sparking legitimate fears of European ‘stagflation’.
In the US, inflation concerns are also top of mind. Headline Consumer Price Index (CPI) is currently at 8.5%, its highest level since the early 1980’s. However, under the surface, core inflation appears tamer. In our view, the “stickiest” parts of the Consumer Price Index (CPI) basket, like household furnishings, medical care, eating out, and education, represent a tamer picture of inflation than food, energy and auto prices, which are more volatile.
Currently, core ‘sticky’ CPI is trending at ~4.6%. This is different than the 1970’s, when even sticky CPI items skyrocketed. However, we recognize that the trend is alarming.
Interest Rates: Yield Curve Still Positive
Whether a major stock market pullback is followed by a subsequent economic recession matters for future
returns. A Ned Davis Research study shows that, over the past 50 years, cyclical bear markets in the Dow Jones Industrial Average (DJIA) that are not overlapped by recession have an average peak-to-trough loss of roughly 18% and last about 7 months.
When overlapped by recession, bear markets are far worse: -33% loss and last about 17 months on average.
While a spike in commodity prices often precedes recession, two other well-established indicators of impending recession remain healthy:
- The US 3 month-to-10-year Treasury yield curve remains well above zero, a positive in our opinion (see chart, right)
- Leading economic surveys such as the Purchasing Managers’ Index remain in expansionary territory for the US (chart, below)
Innovation: An Important Offset To Inflation, Especially In The Developed World
Current readings well above 50 on the composite Purchasing Manager Index (PMI) surveys (see chart, left) suggests to us that the US economy is in healthy shape as it heads into an uncertain time for Fed policy…a crucial positive, in our opinion. We attribute this to not only the US’s geographic and energy production advantages, but also the benefits of a more flexible, innovative, and productive economy versus international peers. While European PMIs also appear healthy, we expect European sentiment to suffer going forward due to the economic impact of higher inflation and Russian sanctions. China and Japan have been at or under 50 for most of the year, reflecting muted business sentiment.
Intrinsic Value: Market Valuation Lower Than In ’21; As Long As Earnings Stay Robust, US Large-Cap Valuations Look Attractive To Us
To start the year, one of the least attractive aspects of the stock market, to us, was its high valuation.
At the time, the S&P 500 level was around 4750 and was trading for roughly 21 times 2022 estimated earnings. Today, the market multiple is about 2 multiple points cheaper (19x) on 12-month forward earnings, making US stocks more attractive to us.
The stock market’s lower valuation is a mirage if earnings subsequently collapse, and thus we are watching analysts’ earnings revisions closely. Thus far, earnings forecasts have stayed robust. Currently, analysts estimate the S&P 500 12-month forward earnings at close to $230 per share, an increase of about 20% over the last year, and up over $12 from the estimate at the beginning of the year (see chart, left).
Bottom Line: We Remain Constructive…Watching ‘Four I’s’ Closely
With the first quarter behind us and much bad news already reflected in global stock prices, we believe equity returns can improve throughout the rest of the year. Our optimistic outlook is dependent on inflation cresting, interest rates remaining relatively low, innovation offsetting higher costs and corporate earnings staying robust.
Important Disclosure Information:
The comments above refer generally to financial markets and not RiverFront portfolios or any related performance. Opinions expressed are current as of the date shown and are subject to change. Past performance is not indicative of future results and diversification does not ensure a profit or protect against loss. All investments carry some level of risk, including loss of principal. An investment cannot be made directly in an index.
Chartered Financial Analyst is a professional designation given by the CFA Institute (formerly AIMR) that measures the competence and integrity of financial analysts. Candidates are required to pass three levels of exams covering areas such as accounting, economics, ethics, money management and security analysis. Four years of investment/financial career experience are required before one can become a CFA charterholder. Enrollees in the program must hold a bachelor’s degree.
All charts shown for illustrative purposes only. Information or data shown or used in this material was received from sources believed to be reliable, but accuracy is not guaranteed.
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