After a year of robust economic expansion at home and abroad, signs of slower growth are emerging. Ongoing inflation and a hawkish Fed have broadly moderated growth expectations, and there are early signs the market may be responding in kind.
2021 Saw Explosive Growth
Last year’s record-breaking U.S. revenue and profit growth was fueled by a surge in consumer spending, a significant byproduct of 2020’s expansionary fiscal policy and shutdown-induced, pent-up demand.
According to the U.S. Bureau of Economic Analysis, Real Gross Domestic Product (Real GDP), the sum of all goods and services produced in the U.S. adjusted for inflation, rose by 5.7% in 2021, an explosive rebound from 2020’s coronavirus pandemic-induced 3.4% contraction.
Upstream inflation一including wage increases from a tight labor market and tangled supply chains一was also part of the story but was handily passed on to consumers to keep profit margins healthy. Pre-tax corporate profits topped $2.81 trillion in 2021一a 25% year-over-year increase.
2022 Headwinds Could Mean a Slowdown Ahead
More recently, the anticipated smoothing of supply chains, a formal end to the pandemic, and a reversion to “normal” have yet to appear. This is mainly due to another array of global challenges, including entrenched inflation, central bank tightening, the war in Ukraine, pandemic lockdowns in China, and skyrocketing energy prices. And though wages continue to increase, they’re not keeping pace with inflation elsewhere, resulting in falling real income and anticipated weaker demand for goods.
In addition, this season’s corporate earnings reports (thus far) suggest that profit weakness may already be here. While only 20% of companies have reported to date, 1Q 2022 earnings growth is clocking in at -2.6%, a significant slowdown from 4Q 2021’s pace of 32%. However, the full extent of this season’s earnings picture remains to be seen.
Still, these trends suggest we are likely transitioning to a period of slower economic expansion, and importantly, we’re starting to see evidence that the equity markets may agree.
The Impact of Fed Action
Thus far, inflation has proved to be tenacious一with the Consumer Price Index (CPI) reaching an annual rate of 8.5% in March. The Fed’s preferred measure of inflation, the Personal Consumption Expenditures Price Index (PCE), also grew by 6.4% for the same period, the fastest annual rate since 1982. This included price increases of 25.7% in energy and 8% in food. Excluding these components, the PCE still increased by 5.4% from a year ago.
While the Fed was slow to take measures to bring inflation under control (especially compared to its overseas counterparts), it’s now showing a willingness to focus on the task at hand. In mid-March, the Fed terminated its asset-purchase program and raised the benchmark Federal Funds Rate 0.25% to a range of 0.25% to 0.50%, its first increase since December 2018. The Fed also signaled six comparable hikes were likely to follow throughout 2022.
However, more recent comments from Fed Chairman Jerome Powell suggest faster rate increases with larger rate hikes are also still on the table. A flattening Treasury curve and increasing bond yields indicate rate hikes of 0.50% for May and June have since been priced into the market. This translates into higher corporate borrowing costs, fewer projects, less business expansion, and decelerating markets, especially in the rate-sensitive tech sector.
Still, how the Fed will proceed is not a given. Mitigating inflation without pushing the economy into recession will be challenging, and rate hikes that are too large or too frequent could extinguish growth altogether.
Equity Markets May Also Be Hinting at Slower Growth
Recent shifts in preference across equity style, sector, and beta risk also belie the possibility of slower growth ahead.
Value Is Outperforming Growth
Reduced growth and momentum expectations have resulted in growth stock valuation compression and a stepped-up hunt for greater upside elsewhere. This seems apparent in the shift in investor appetite from growth to value. According to data from index provider FTSE Russell, the Russell 1000 Value Index outperformed the Russell 1000 Growth Index for 1Q2022 by more than 13% and by 6.6% for the last 12 months. The story is much the same throughout the capitalization spectrum.
Staples & Defensive Are Outperforming Discretionaries & Cyclicals
While value outperformance can be seen in several areas, staples such as energy, real estate, and healthcare一those that can maintain their pricing power in periods of high inflation一have done particularly well recently.
Energy giant Occidental Petroleum Corporation (OXY) has doubled in price since January, for example, and the Halliburton Company (HAL), with an 80+% return over the period, isn’t far behind.
Utilities and other defensive sectors providing stable earnings and consistent dividends are also starting to outperform their cyclical counterparts, such as autos, airlines, and entertainment.
Lower Beta Shares Are Outperforming Higher Beta Shares
Investors are also rethinking their risk-reward preferences by opting for low beta stocks over higher beta shares. Beta is a measure of share price volatility relative to the broader market. A beta greater than 1.0 indicates greater price volatility than the market as a whole. Lower beta stocks have betas less than 1.0 and exhibit relatively lower price volatility, including lower downside risk.
High-tech semiconductor company Advanced Micro Devices (AMD) is considered a high-beta stock with a 5-yr monthly beta of 1.95. Its price has fallen over 37% YTD. On the other hand, Walmart has a 5-yr monthly beta of 0.53 and has increased by over 10% for the year.
While these stock performances are singular examples, the trend of low beta outperformance is apparent throughout the equity markets.
Our Current Thinking
Consistent with our close analysis of macroeconomic factors and market cycle activity, a gradual portfolio repositioning has been underway since January, when early signs of a possible shift in the economic cycle were becoming apparent.
Since then, we have reallocated capital away from risk-on assets (equity) to better balance the portfolio ahead of a possible market slowdown.
Within equities, we have rotated into more defensive sectors such as utilities, consumer staples, healthcare, and energy, away from more cyclical and high growth areas, such as technology.
Our outlook on fixed income (risk-off assets) remains guarded, with expectations of increased credit risk in the market. Thus, we have repositioned our fixed income allocations toward quality (U.S. Treasuries) and away from credit exposure. In addition, we’ve increased our average bond credit rating to AA and reduced average bond duration (a measure of sensitivity to interest rate change) to dampen overall portfolio volatility.
We believe these changes will potentially provide better opportunities for both return and protection against a slower growth environment. As always, we will revisit our thinking and portfolios as necessary as 2022 continues to unfold.
