The Independent Market Observer

2022 Midyear Outlook: Slow Growth Ahead?

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Jul 6, 2022 11:39:48 AM

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IMO Blog Post 1 – 1As we move into the second half of 2022, there are lots of things to worry about. Covid-19 is still spreading, here in the U.S. and worldwide. Inflation is close to 40-year highs, with the Fed tightening monetary policy to fight it. The war in Ukraine continues, threatening to turn into a long-term frozen conflict. And here in the U.S., the midterm elections loom. Looking at the headlines, you might expect the economy to be in rough shape.

But when you look at the economic data? The news is largely good. Job growth continues to be strong, and the labor market remains very tight. Despite an erosion of confidence driven by high inflation and gas prices, consumers are still shopping. Businesses, driven by consumer demand and the labor shortage, continue to hire as much as they can (and to invest when they can’t). In other words, the economy remains not only healthy but strong—despite what the headlines might say.

Still, markets are reflecting the headlines more than the economy, as they tend to do in the short term. They’re down substantially from the start of the year but showing signs of stabilization. A growing economy tends to support markets, and that may be finally kicking in.

With so much in flux, what’s the outlook for the rest of the year? To help answer that question, we need to start with the fundamentals.

The Economy

Growth drivers. Given its current momentum, the economy should keep growing through the rest of the year. Job growth has been strong. And with the high number of vacancies, that will continue through year-end. At the current job growth rate of about 400,000 per month, and with 11.5 million jobs unfilled, we can keep growing at current rates and still end the year with more open jobs than at any point before the pandemic. This is the key to the rest of the year.

When jobs grow, confidence and spending stay high. Confidence is down from the peak, but it is still above the levels of the mid-2010s and above the levels of 2007. With people working and feeling good, the consumer will keep the economy moving through 2022. For businesses to keep serving those customers, they need to hire (which they are having a tough time doing) and invest in new equipment. This is the second driver that will keep us growing through the rest of the year.

The risks. There are two areas of concern here: the end of federal stimulus programs and the tightening of monetary policy. Federal spending has been a tailwind for the past couple of years, but it is now a headwind. This will slow growth, but most of that stimulus has been replaced by wage income, so the damage will be limited. For monetary policy, future damage is also likely to be limited as most rate increases have already been fully priced in. Here, the damage is real, but it has largely been done.

Another thing to watch is net trade. In the first quarter, for example, the national economy shrank due to a sharp pullback in trade, with exports up by much less than imports. But here as well, much of the damage has already been done. Data so far this quarter shows the terms of net trade have improved substantially and that net trade should add to growth in the second quarter.

So, as we move into the second half of the year, the foundation of the economy—consumers and businesses—is solid. The weak areas are not as weak as the headlines would suggest, and much of the damage may have already passed. While we have seen some slowing, slow growth is still growth. This is a much better place than the headlines would suggest, and it provides a solid foundation through the end of the year.

The Markets

It has been a terrible start to the year for the financial markets. But will a slowing but growing economy be enough to prevent more damage ahead? That depends on why we saw the declines we did. There are two possibilities.

Earnings. First, the market could have declined as expected earnings dropped. That is not the case, however, as earnings are still expected to grow at a healthy rate through 2023. As discussed above, the economy should support that. This is not an earnings-related decline. As such, it has to be related to valuations.

Valuations. Valuations are the prices investors are willing to pay for those earnings. Here, we can do some analysis. In theory, valuations should vary with interest rates, with higher rates meaning lower valuations. Looking at history, this relationship holds in the real data. When we look at valuations, we need to look at interest rates. If rates hold, so should current valuations. If rates rise further, valuations may decline.

While the Fed is expected to keep raising rates, those increases are already priced into the market. Rates would need to rise more than expected to cause additional market declines. On the contrary, it appears rate increases may be stabilizing as economic growth slows. One sign of this comes from the yield on the 10-year U.S. Treasury note. Despite a recent spike, the rate is heading back to around 3 percent, suggesting rates may be stabilizing. If rates stabilize, so will valuations—and so will markets.

In addition to these effects of Fed policy, rising earnings from a growing economy will offset any potential declines and will provide an opportunity for growth during the second half of the year. Just as with the economy, much of the damage to the markets has been done, so the second half of the year will likely be better than the first.

The Headlines

Now, back to the headlines. The headlines have hit expectations much harder than the fundamentals, which has knocked markets hard. As the Fed spoke out about raising rates, and then raised them, markets fell further. It was a tough start to the year.

But as we move into the second half of 2022, despite the headlines and the rate increases, the economic fundamentals remain sound. Valuations are now much lower than they were and are showing signs of stabilizing. Even the headline risks (i.e., inflation and war) are showing signs of stabilizing and may get better. We may be close to the point of maximum perceived risk. This means most of the damage has likely been done and that the downside risk for the second half has been largely incorporated.

Slowing, But Growing

That is not to say there are no risks. But those risks are unlikely to keep knocking markets down. We don’t need great news for the second half to be better—only less bad news. And if we do get good news? That could lead to even better results for markets.

Overall, the second half of the year should be better than the first. Growth will likely slow, but keep going. The Fed will keep raising rates, but maybe slower than expected. And that combination should keep growth going in the economy and in the markets. It probably won’t be a great finish to the year, but it will be much better overall than we have seen so far.

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