Latest Economic Review: Sunpointe Illuminations

Threading the Needle

What is driving much of the equity volatility in the first half of 2022? Market participants are trying to figure out if the US Federal Reserve can engineer a “soft landing” of its planned interest rate hiking cycle without throwing the economy into recession. There are some big name firms with wildly opposing views – some say that recession is unavoidable; others say the Fed can still fight inflation without economic contraction. And, yes, there are some other exogenous events such as supply chain challenges, the war in Ukraine, China’s Covid policies and others that can add fuel to the recession fire. Looking ahead, though, there are (at least) three economic scenarios that will impact future equity market performance in different ways.

The first and “rosiest” scenario is one in which the Fed is indeed able to thread the needle and engineer a soft landing and avoid a recession. With unemployment rates low and economic activity high, this scenario has a reasonable chance of playing out. Under this regime, equities likely stabilize and begin their long-term trend upward faster than the next two scenarios.

The second scenario that could play out is a deflationary recession in which monetary tightening works to reduce prices but demand and growth decrease. Data suggests that a recession will be hard to avoid. Over the past 70 years, every time inflation has exceeded 4% while unemployment has been below 5%, the U.S. economy has gone into a recession within two years. Today, inflation is at 8.3% and unemployment is at 3.6%. In this case, equities likely have further to fall because earnings get dragged down, assuming PE ratios stay in line with long-term averages.

The final scenario is an inflationary recession, also known as stagflation. While this is probably the least likely of the three scenarios presented here, it is one that could do the most damage to equities and the one that most market participants are not preparing for. If we return to that 1970’s style economic period, there could be a material contraction in PE ratios. From 1973 to 1982, the price-to-earnings ratio fell from 18x to 11x, resulting in a negative 2% annualized real return during that stagflation time period. Interestingly, commodities fell a cumulative 40% over the period due to a sluggish economy. What did create value during that period was real estate. REITS returned 13% gross of inflation, and 4% net because rental income was passed through to investors. Gold was very volatile during that period but did earn a 9% real return.

We do not know (no one knows) which scenario will play out. However, in the event a stagflation period emerges, investors have the opportunity now to prepare. Many client portfolios have built in gains and selling will trigger taxes leaving less flexibility. But if one has the opportunity to allocate to assets that can protect during a stagflation environment, it indeed may be a good time to do so. We will keep you informed as data is released and these (or other) scenarios emerge.