Stephen M. Mills, CIMA® Partner
The U.S. equity markets have staged an impressive comeback since making lows in mid-June. The S&P 500 Index surged 14% since its June 17 low cutting the loss for the year to 13% which, at the low, the index was down almost 25%.1 The Dow Jones Industrial Average has also gained 11% since hitting its lows in June.1 In our view, the stock rally was fueled by investor optimism that the Federal Reserve (Fed), after hiking the Fed funds rate by 2.25% since March, is getting closer to the end of its rate hike cycle.2 This optimism was partially based on a better-than-expected Consumer Price Index (CPI) release for July. The Bureau of Labor Statistics reported that CPI increased by 8.5% on an annualized basis at end of July, lower than the 8.7% increase that a survey of economists were expecting.3 Although the rate of CPI increase was still high, it indicated that inflation may be peaking and heading lower over the next several months. This was welcome news to investors since the high inflation readings late last year and early this year prompted the Fed to embark on an aggressive monetary tightening strategy in order to bring the inflation rate back down toward its 2% target level. In addition to this optimism regarding future inflation and Fed policy, second quarter corporate earnings have so far been mostly positive indicating that the economy is still growing and a deep recession in the near term is less likely.
Recession talk has taken center stage over the last several weeks after the Department of Commerce Bureau of Economic Analysis (BEA) reported in early July that U.S. Gross Domestic Product (GDP) fell .9% after inflation which was the second quarter in a row that inflation adjusted GDP has declined.4 One common definition of a recession is two consecutive quarters of negative GDP, however, many economists disagree with that definition and prefer look to the National Bureau of Economic Research (NBER) to determine if the economy is in a recession.5 According to the NBER website, their broad definition of a recession is “a significant decline in economic activity that is spread across the economy and that lasts more than a few months.”6 The NBER examines the depth, diffusion, and duration of an economic downturn to determine if it qualifies as a recession.6 They look at a range of economic data including GDP, employment, household income, personal consumption expenditures, wholesale and retail sales, and industrial production.6 The NBER has identified 12 recessions dating back to 1948, or one approximately every six years.5
As of the date of this letter, the NBER has not announced that the U.S. economy is in a recession. Recent economic data has been mixed with areas like manufacturing, housing, business and consumer sentiment all indicating that the U.S. economy is deteriorating while areas like consumer spending, employment, and corporate profits indicate continued economic expansion, although, several of these areas are growing at a slower rate than last year. From our perspective, the jury is still out on whether we will fall into a recession this year. October’s third quarter GDP report will give us a good reading on how the Fed’s tightening policy is impacting economic growth. We think it is probable that based on continued high prices for food, energy and other goods, the increased cost of capital from the Fed’s rate hikes, and the possibility of an acceleration in job layoffs, the economy could fall into a mild to moderate recession by the end of the year or early 2023.
The global economy is showing weakness as well. It seems the global economy is in the midst of a perfect storm environment of high inflation, falling demand for goods and services, supply chain frictions, and rising interest rates. Europe faces a difficult winter with shortages of natural gas driving prices to extraordinary levels and China continues to show economic weakness from their Covid lockdown policy. Although the U.S. economy is somewhat immune to these forces, it will certainly be impacted by the economic weakness in these economies.
What does that potentially mean for the U.S. stock and bond markets? Given the uncertainty with the current economic and market environment, forecasting the short-term direction for stocks is particularly difficult. However, looking at it from the standpoint of risk/reward, we feel that at the current level for the S&P 500 Index at 4188, stocks are fairly valued based on earnings, interest rates and Fed policy.1 We see as much downside risk for stocks as we do upside reward in the short-term after the recent rally. Our base case is for the stock market to churn near current levels for the rest of year as the economy and corporate earnings continue to feel the pinch of Fed tightening. We believe the June low for the S&P 500 Index of 3637 will serve as the low of this bear market.1 However, we see the possibility that the index could test that low before the end of the year, perhaps before the November Congressional election.
As far as the bond market is concerned, we see interest rates on short to intermediate bonds like U.S. Treasury bonds, high grade corporate bonds, and municipal bonds remaining near current levels and possibly trending lower over the next few months. Recently, the 10-year U.S. Treasury note yield moved back above 3%, up from the 2.6% level reached at the end of July.1 Corporate and municipal bond yields have also moved higher. At this level, we believe high grade bonds are attractively priced, can add income to a portfolio, and provided some downside protection if the stock market tests the June lows. We don’t believe bond yields will go much higher over the next six months as the economy slows and perhaps falls into a mild recession.
Looking out twelve months, we are optimistic that the economy will be growing once again, corporate earnings will be reaccelerating, and stock prices will be trending higher. We believe there is a good possibility that the major stock market averages could recover most if not all of their losses from this year by next summer. However, in the interim, we see both stock and bond markets remaining volatile.
These volatile markets require patience and perseverance. They can certainly test one’s resolve to stick with portfolio allocations. In our view, this volatility can present an opportunity to adjust risk exposure and add to the growth areas of the portfolio. We are seeing value in several sectors of the stock market and where appropriate are adding to equities as the market presents good opportunities.
Lastly, we sincerely appreciate your trust and confidence in us. We are here to work with you on adjusting portfolio allocations if needed as well as achieving your long-term objectives. If you have any questions or concerns, please don’t hesitate to give us a call.
- Thompson Charts
See below for Disclosures
The indices presented in this material are to provide you with an understanding of their historic performance and are not presented to illustrate the performance of any security. Investors cannot directly purchase any index.
Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments. An investment in the stock market should be made with an understanding of the risks associated with common stocks, including market fluctuations
The opinions expressed in this report are those of the author(s) and are not necessarily those of Wells Fargo Advisors Financial Network or its affiliates. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy.
Past performance is no guarantee of future results
S&P 500 Index: The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market value weighted index with each stock's weight in the Index proportionate to its market value.
Dow Jones Industrial Average: The Dow Jones Industrial Average is a price-weighted index of 30 "blue-chip" industrial U.S. stocks.
Past performance is no guarantee of future results and there is no guarantee that any forward-looking statements made in this communication will be attained.
The Consumer Price Index (CPI) is a measure of the cost of goods purchased by average U.S. household. It is calculated by the U.S. government's Bureau of Labor Statistics.
Investment products and services are offered through Wells Fargo Advisors Financial Network, LLC (WFAFN), Member SIPC, a registered broker-dealer and separate non-bank affiliate of Wells Fargo and Company. Trinity Capital Management, LLC is separate entity from WFAFN.