Economic and Market Environment

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

• 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.

• 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.

• 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.

• 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.

• 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.

• 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.

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