Mid Year Outlook - Our Economy
We believe the domestic economy will continue to grow this year, albeit slower than we expected six months ago. Other than the anomaly of a negative print in first quarter gross domestic product (GDP), we think the economy has sufficient momentum to offset the inflationary pressures. Our base case forecast includes an inflation rate that moderates as supply bottlenecks improve and we potentially get some closure to the Russian war with Ukraine. Our most likely scenario is the economy avoids an official recession, as growth is expected to notch just above 2% in 2022 with another downshift to under 2% in 2023. These are annual figures so intra-year economic activity could be quite volatile as the Fed becomes more aggressive in the tightening cycle.
Inflation will most likely be significantly above the Fed’s long-run target of 2%. Inflation rates will likely cool throughout this year, but the cool down period will be long and slow. Some inflation pressures should subside as China adjusts its COVID-19 policy and supply chains improve. A slowing housing market could also eventually ease inflationary pressures later this year and into 2023.
Stocks will face a number of headwinds in the second half of the year, but the amount of turbulence will likely depend on the pace at which inflation falls. Volatility may persist, but an improved macroeconomic environment may set the stage for higher valuations, further earnings growth, and solid gains for stocks over the rest of the year. The challenge comes from predicting how fast inflation will come down. Our year-end fair value target for the S&P 500 is 4,300–4,400, based on a price-to-earnings ratio of 18–19 and our 2023 S&P 500 earnings per share forecast of $235.
The value proposition for core bonds is that they tend to provide liquidity, diversification, and positive total returns to portfolios. Unfortunately, none of those values is 100% certain all the time. Like all markets, fixed income investing involves risks and, at times, negative returns. However, despite the historically poor start to the year, the value proposition for core bonds has actually improved recently. With the big jump in yields that has already taken place this year, we believe core bonds look as good as they have in quite some time. As rate hikes work their way through the economy and slower growth starts to get priced in, we could see the 10-year Treasury yield end the year between 2.75–3.25%.
One of the things we knew coming into this year was that 2022 will be a midterm year—and those have historically not been kind to stocks. In fact, since 1950, midterm years have seen the largest peak-to-trough pullback of the four years of the presidential cycle, with the S&P 500 Index down 17.1% on average during the year. The good news is, one year off those lows, stocks have been up more than 32% on average. And the S&P 500 has been higher a year after every midterm election since 1950—18 out of 18 years—with an average gain one year later a very solid 14.5%. It looks like a divided government is in the cards, which markets have historically liked.
Losses across both stock and bond markets in 2022 have left many searching for ways to further diversify exposures. While alternatives cover a wide range of approaches, several have helped fill that gap, and may continue to do so over the rest of the year. We continue to believe our preferred alternatives implementations—event-driven strategies, market neutral strategies, and relatively conservative low volatility strategies—have the ability to act as a source of ballast during such periods of high volatility.
Commodities have garnered support from both demand and supply, and we believe upward pressure on prices will likely persist for at least the next several months. Demand has gotten a lift as the global economy emerged from the pandemic. Sanctions on Russian energy exports have kept oil and gas prices elevated. Ukraine is an important global supplier of agricultural commodities such as corn and wheat, putting upward pressure on food prices. From an investment perspective, we would favor energy.
As we enter the second half of 2022, the factors that led to a sharp and nearly uninterrupted ascent for the U.S. dollar such as a hawkish Fed and demand for safe havens may begin to reverse. In the intermediate term, easing inflation from unsnarling of supply chains postCOVID-19, aided by China’s reopening, could help push the dollar lower.
Securities and advisory services offered through LPL Financial, a Registered Investment Advisor. Member FINRA/SIPC. Longleaf Wealth Management Group, LLC and LPL Financial are separate entities.