Commentary | 1Q 2022
2021 Q1 Market Recap
In the first quarter of 2022, the market retreated in the face of significant threats to economic stability. On the surface, the threats resembled those encountered in the 1970’s, a period that saw very unfavorable stock market returns. Inflation increased, interest rates rose, real growth slowed, and economic policies threatened to reduce growth further.
Nominal corporate profits rose an estimated 4.5% on a year-over-year basis, but after adjusting for inflation, profits declined about 3.0%. If the estimated nominal increase is accurate, it will represent the lowest increase since the fourth quarter of 2020. The price to earnings ratio for the S&P 500 Index stood at approximately 36 times trailing twelve months earnings at the end of the quarter. The current P/E Ratio is significantly above the historical average of about 20. Further tepid increases in profits are likely to make it difficult to sustain the current P/E Ratio for the Index.
Estimates for real GDP growth in the first quarter average about 1.7% at an annualized rate on a quarter versus previous quarter basis. If this estimate is accurate, growth has slowed substantially from that of the fourth quarter of 2021 when real quarter versus previous quarter growth was 7.0% at an annual rate. The estimates for real growth for all of 2022 center on a rate of slightly less than 3.0%, a decline from the 5.7% experienced in 2021.
Other measures of economic activity support the belief that the economy is growing, but the growth rate is not robust. Industrial production has been rising since April of 2020. While the current rate of growth is positive, it is well below the peak reached in April of 2021. Total employment has risen since April of 2020, however total employment has not yet risen to the level reached just prior to the economic contraction produced by policy responses to the COVID-19 pandemic. Unemployment has fallen to 3.6% from a high of 14.7%, but the labor force participation rate remains below the April 2020 level.
While real growth has been declining, inflation has been increasing. In January of 2021 inflation was running at about a 1.4% rate, by February of 2022 the rate of inflation had risen to 7.9%, the highest rate in the last 40 years. The Fed announced some time ago it would begin an effort to prevent persistent inflation.
The primary driver of inflation has been the rapid expansion of the money supply during two episodes of threats to economic stability. The first episode began with turmoil in the financial markets in the 2008/2009 period and the recession that followed. The more recent episode took place in early 2020 as a severe economic contraction followed the institution of policies meant to reduce the severity of the COVID-19 pandemic. In both episodes, the Fed attempted to lessen the severity of economic dislocations by expanding the money supply and increasing liquidity. By the end of 2020, the Fed had added over five trillion dollars to its balance sheet and the money supply had increased rapidly. Inflation remained below the Fed’s targeted rate of 2.0% until recently, largely as a result in the decline in the velocity at which money circulated. When the velocity stopped declining, the rate of inflation increased.
The Fed Goes for a Hike
The Fed has announced it will raise the Fed Funds rate to lower the threat of further increases in the rate of inflation. The Funds rate, which was as high as 2.5% in July of 2019, was nearly 0.0% for the period from March of 2020 to March of 2022 at which time the target for the rate was raised to approximately 0.25%. Further increases in the rate are expected as the Fed moves to reduce the rate of inflation.
The Fed’s chosen method for reducing inflation is controversial. There is general agreement among monetary economists that inflation is a monetary phenomenon brought about by increases in the rate of growth of the money supply. There is little or no evidence that targeting interest rates is a reliable method for reducing the rate of growth of the money supply or lowering its level. The Fed has expanded the rate of growth of the money supply for more than a decade by increasing the size of its balance sheet, the monetary base. Reducing balance sheet holdings is a more effective way of combating inflation than is raising rates and hoping the money supply contracts or its rate of growth slows.
The last time the Fed was confronted with the problem of controlling inflation at the current level was in the late 1970’s and early 1980’s. The Fed’s policies produced a Fed Funds rate of over 20.0% and a recession. No one is forecasting rates at the 20.0% level will be required to end the current episode of rapidly rising prices, but there is some small probability a recession will occur in the next twelve to eighteen months.
In the initial stages of the Fed’s shift to fighting inflation from providing liquidity, interest rates have risen all along the yield curve and the curve has flattened in the two-to-ten-year segment. The spread between the two-year and ten-year government obligations has shrunk to less than 20 basis points. Thirty-year bonds now yield only about 2 basis points more than ten-year obligations. A flattening of the yield curve has been thought to presage a slowdown in economic activity.
The outlook for economic conditions over the near term is obscured by potential changes in economic policies and global conflicts. The Biden administration has once again raised the prospect of increasing tax rates on corporations as well as individuals. Among the proposals on the table is a tax on unrealized capital gains. If enacted, this tax will raise the cost of capital as it stimulates the sale of assets and makes capital investment less attractive than it is now.
Increasing tax rates are not the only potential drag on economic activity. Senator Amy Klobuchar (D-Minnesota) has assembled a bi-partisan coalition to support her American Innovation and Choice Online Act (AICO). The AICO seeks to regulate the activity of “covered platforms” which would include all platforms with a market capitalization over $550 billion. There are other criteria, but the intent is clear, the bill will regulate the activities of big tech companies like Meta. This sort of populism has roots going back to the nineteenth century when the Standard Oil Trust was the target of populist agitation and legislation as well as anti-trust lawsuits. The AICO echoes the impulse as well that led to anti-trust lawsuits brought against IBM, Eastman Kodak, Xerox, and other large companies in the 1970’s. The IBM prosecution extended from 1969 through 1982 when it was dropped. The prosecution was an expensive distraction for the company.
The effort to burden large successful companies with additional regulations has the potential to hamper the progress of the economic recovery now underway, and will inevitably seek cures for problems that do not exist. This was the case in the 1970’s and it likely will be the case should the AICO become law. Technological innovation will make the legislation obsolete as it made the many antitrust actions of the 1970’s obsolete.
The event with the most potential to destabilize markets and economic activity is not primarily in the realm of economics. The Russian invasion of Ukraine presents a potential for a much broader war as well as disruptions in the supply of important commodities such as wheat and oil. At this time, market participants can do little but react to events as they unfold. There is no obvious end to the conflict and its consequences are not well bounded.
Comparisons of current economic conditions with those of the 1970’s are worth considering, however a repeat of the unfortunate policy decisions that led to the economic malaise that characterized the earlier period seems unlikely. Most significantly, the Fed is not likely to repeat the mistakes made in the 1970’s, and it is unlikely the changes in the tax code which are most harmful to economic activity will find enough support in Congress to become law.
Sources: S&P Dow Jones Indices, US Bureau of Labor Statistics, CBOE, Bureau of Economic Analysis
The information and statistical data contained herein have been obtained from sources, which we believe to be reliable, but in no way are warranted by us to accuracy or completeness. This report includes candid statements and observations economic and market conditions; however, there is no guarantee that these statements, opinions, or forecasts will prove to be correct.