With the S&P 500 down more than 21% year-to-date, investors are understandably concerned about current volatility, grim economic forecasts and an inflation rate that remains at 40-year highs. The Federal Reserve's 75-basis-point rate hike on June 15 confirmed that the central bank is now scrambling to play catchup in its efforts to curb inflation.
While watching the market turn bearish has been difficult for advisors and their clients, it's important to recognize that now is an opportunistic time to either invest or stay invested.
Staying calm, focusing on quality and being selective will help value-seeking investors make the most of this new, better risk-reward part of the market cycle. While the jury is still out as to whether the Fed can execute a soft landing, much uncertainty has been taken out of the equation now that the Fed has affirmed its aggressive rate-hike plan; higher rates and a slowing economy are now priced in.
For investors with excess cash, securities are on sale, and there are pockets of opportunity across multiple sectors. Valuations are now broadly below historic averages: Forward price-to-earnings for the S&P 500 is 15.5x, compared to 21.5x to start the year and well below the index's five-year average of 18.9x.
We're finding quality on sale and scrutinizing the economic data, particularly around consumer demand, to find areas of attractive growth in a slower economy.
Consumer Demand & the Macro Backdrop
While demand has shifted throughout the pandemic and into this year, so far it remains resilient. Second-quarter earnings will give us a bird's-eye view into how both consumers and businesses are reacting to inflation and higher rates.
We do expect second-half earnings estimates to be broadly revised lower from the current upward-trending S&P 500 FY22 consensus of 10.5% year-on-year growth in earnings per share (10.5% y/y is higher than the historical average).
While demand has been strong and supply issues are getting resolved, the economic slowdown and the Fed's tightening policy could lead to more revisions going forward. We also expect the strong dollar to be a headwind which has been confirmed from a few early earnings reports.
Despite 24 months of expansion in both services and manufacturing activity — as reported by the Institute for Supply Management (ISM), a leading indicator for the U.S. economy — the Fed projects the pace of U.S. economic growth to be below 2% through 2024.
While demand for goods accelerated during the pandemic, that demand has now shifted to services. Consumers are coming under pressure from both high inflation and rising rates, even as some supply-chain issues show signs of resolving.
We're closely watching consumer-demand data to see if spending stays resilient. We believe it can, based on healthy household balance sheets, the strong job market and rising wages. This sets the stage for a soft landing but ignores two significant challenges in bringing down price levels: supply-chain issues and the stickier components of inflation.
The Fed does not have control over shortages related to supply-chain problems. It will continue to struggle to rein in costs for energy, materials, food, shelter and labor. Food and energy combine for over one-fifth of the consumer's wallet share, while shelter costs represent roughly one-third. With widespread job availability and negative annualized productivity growth, wages are continuing to rise in tandem.
