Economic and Market Environment

Second Quarter 2022

THE FIRM'S OUTLOOK: SUMMARY AND CONCLUSION

The Economy

  • After a clear path to recovery over the last two years, the economy is now facing multiple uncertainties.
  • Inflation, running at a 40-year high, is the greatest economic concern. It has the potential to disrupt or end the economic recovery/expansion cycle.
  • The Federal Reserve (Fed) is in the very early stages of fighting inflation. It is uncertain how successful they will be.

  • The orderly transition of the economy back to normalcy is being disrupted by inflation. This year, economic growth should be lower, inflation higher, and interest rates higher.
  • A strong consumer, with high cash balances and improved wealth through stocks and homes, undergirds the economy.
  • We still expect an eventual return to more normal economic conditions of moderate growth, low inflation, and full employment.

Stocks and Bonds

  • After producing extraordinary returns over the last five years, stocks turned mixed-to-down in the first quarter. After a significant correction, they rallied strongly toward quarter end.
  • Rising interest rates, fueled by Fed policy shifts and higher inflation, are now presenting headwinds for equities.
  • Bond yields have risen across the yield spectrum. The benchmark 10-Year U.S. Treasury note now yields 2.35%.
  • The yield curve has flattened and is inverted at several points on the maturity spectrum. It is desirable to avoid inverted yield curves as they can be a predictor of recession. The important 90-Day to 10-Year relationship remains strongly positive.
  • The extent to which bond yields rise over the next several years will be determined by the outcome of the inflation issue and longer-term growth prospects for the U.S. economy.
  • The Russian invasion of Ukraine is a reminder that financial markets are always subject to geopolitical developments. We believe high-quality, liquid investments are the best hedge against these developments.
 

UNCERTAINTY: A PERVASIVE INFLUENCE

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  • There are always economic and market uncertainties that investors are forced to deal with.
  • Currently, the number of uncertainties is unusually large, leading to unsettled conditions in both stock and bond markets. Above, we highlight a few of the uncertainties.
  • We count INFLATION and FED POLICY among the more important of these uncertainties.

ECONOMIC TRANSITION MONITOR: ADJUSTMENT REQUIRED

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  • The transition from a Covid-influenced economic recovery to normalcy is taking longer than expected.
  • Much higher than expected inflation is the main culprit.
  • High inflation has caused adjustments to the outlook: slower growth, higher inflation for longer, and higher federal funds rates to combat inflation.
  • The return to a more normal economic environment has been pushed out by one year, to 2024. The outlook remains uncertain.
  • These projections represent the best thinking of the Federal Reserve members and Bank presidents. They are certainly subject to error, as are all projections, and we use them merely as a frame of reference when thinking about the future course of the economy.

INFLATION AND FED POLICY: THE BIG CONFLICT

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  • The resolution of the inflation problem is highly uncertain.
  • The Fed is attempting a “soft landing” for the economy, a difficult task.
  • Inflation expectations over the long term may become untethered, requiring more aggressive action.
  • Persistently high inflation could lead to a wage/price spiral.
  • All of the above are realistic risks that could have negative implications for stocks and bonds.

INFLATION: RUNNING TOO HOT

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  • Both headline Consumer Price Index (CPI) and core CPI (excluding food and energy) are currently at 40-year highs as measured year over year.
  • Disruptions resulting from the Russia/Ukraine war are likely to push inflation higher over the coming months.
  • Inflation is expected to peak later this year and decline somewhat by year end as supply chain pressures ease.
  • Measured on a month over month basis, both inflation measures are no higher than levels of last fall. This is encouraging.

OIL: AN IMPORTANT INFLATION FACTOR

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  • Oil prices have been exceedingly volatile, mostly to the upside. Global demand for oil exceeds production as companies reduced exploration and production during the Covid pandemic. It takes time to ramp up production.
  • The price of gasoline, a commodity used by almost all consumers, is up sharply. It can shape expectations about future inflation but can also crimp demand.
  • In the past, high oil prices have been capable of inflicting severe damage to the economy. However, that capability has been diminished, as energy as a percentage of total consumption has declined substantially. This should limit the influence of oil in this cycle.
 

MONETARY POLICY: THE FED'S BIG PIVOT

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  • The Fed’s toolbox contains three tools: federal funds, balance sheet, and forward guidance.
  • To date, we have forward guidance on federal funds with specific targets but no guidance on the balance sheet.
  • The Fed is under pressure to employ all of its tools aggressively. Yet, it wants to achieve a “soft landing” in which inflation moderates without too much effect on growth.
  • Soft landings are difficult to pull off. We wish the Fed the best of success.

OVERALL DEMAND: A PERMANENT CHANGE?

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  • The future direction of both interest rates and inflation hinges on the level of demand in the economy.
  • Over the long term (50 years), overall demand has been shrinking. This constitutes a secular trend.
  • Due to aggressive fiscal and monetary policy during the Covid pandemic, demand has accelerated sharply over the last two years.
  • The question: once the fiscal excesses of the Covid period are assimilated, will demand return to its long-term trend?
  • If real GDP growth can be sustained at only 2%, we believe demand relative to supply should be eventually brought back into balance, leading to a stable inflation environment.

CONSUMPTION: PLENTY OF DRY POWDER, BUT WILL THEY SPEND?

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  • The combination of Covid fiscal relief and very strong housing and stock markets coming at a time when consumption was limited due to social immobility, has left consumers in a very strong position.
  • These resources should buttress economic activity at a time when monetary and fiscal policy is turning less stimulative.
  • The series to the left are skewed to the upside by income and wealth inequality but, nevertheless, represent a strong support under the economy.
  • Sagging consumer sentiment, now at a 10-year low, raises the question: will consumers spend it?

COMMON STOCKS: THEY ARE CHEAPER

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  • Price to Earnings ratios (P/E) are the most frequently used valuation measure of common stocks.
  • Changes in P/E represent changing estimates of forward earnings and changes in price.
  • The message of this chart is clear. P/E ratios have become more reasonable due to stagnant-to-falling stock prices and increasing forward earnings estimates.
  • Rising interest rates typically are a headwind for stocks, and the recent sharp increase in the 10-Year Treasury yield has likely been a limiting factor for stock prices.
  • At near 19 times forward earnings, the S&P 500 P/E is still above its longer-term average, but less so than at the beginning of the year.

THE YIELD CURVE: IT HAS A MESSAGE

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  • Normally, the yield curve is upward sloping as longer maturities command a higher yield than shorter maturities. This relationship can be reversed to an inverted yield curve, although rarely does this occur.
  • The importance of an inverted yield curve is that it can be a signal that a recession is approaching. The logic is that lenders are disincented to lend when their borrowing costs are higher than yields on loans, causing a sharp contraction in lending activity.
  • The yield curve flattened considerably in the first quarter and has recently inverted at several points on the maturity spectrum.
  • We show two yield curves: the 10-Year Treasury to 3-Month Treasury has been the better predictor of recession, and its message is not currently disturbing.

DISCLOSURE STATEMENT

Crawford Investment Counsel, Inc. (“Crawford”) is an independent registered investment advisor. More information about the advisor including its investment strategies, objectives and fees can be found in its Form ADV, Part 2 which is available upon request.

Past performance is not indicative of future results. All investments carry a certain degree of risk of loss, and there is no assurance that an investment will provide positive performance over any period of time. This material is distributed for informational purposes only. The statements contained herein reflect opinions, estimates and projections of Crawford as of the date hereof, and are subject to change without notice. Forecasts, estimates, and certain information contained in this commentary are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Any projections herein are provided by Crawford as an indicator of the direction Crawford’s professional staff believes the markets will move, but Crawford makes no representation such projections will come to pass. Crawford makes every effort to ensure the contents have been compiled or derived from sources believed reliable, and contain information and opinions that are accurate and complete; however, Crawford makes no representation or warranty, express or implied, in respect thereof; takes no responsibility for any errors that may be contained herein or omissions; and accepts no liability whatsoever for any loss arising from any use of or reliance on this report or its contents. Crawford reserves the right to modify its current investment strategies and techniques based on changing market dynamics or individual portfolio needs.

The opinions expressed herein are those of Crawford Investment Counsel and are subject to change without notice. This material is not financial advice or an offer to sell any product.

Forward-looking statements cannot be guaranteed. This document may contain certain information that constitutes “forward-looking statements” which can be identified by the use of forward-looking terminology such as “may,” “expect,” “will,” “hope,” “forecast,” “intend,” “target,” “believe,” and/or comparable terminology. No assurance, representation, or warranty is made by any person that any of Crawford’s assumptions, expectations, objectives, and/or goals will be achieved. Nothing contained in this document may be relied upon as a guarantee, promise, assurance, or representation as to the future. CRA-21-401