Mid-Year Outlook: U.S. Stocks and Economy

• Consumers' strength and confidence being tested by inflation (especially on the goods side of the economy)
• Rise in labor force participation
• Rolling over in profit margins
• Federal Reserve's tapering to pick up speed
• Carnage in narratives-driven and speculation-hyped market segments
• Earnings becoming "less hot"
• Quality-oriented factors will be relative outperformers
• Households' elevated equity exposure bodes ill for equity performance
• Elevated optimistic sentiment to act as a contrarian signal
• Indexes to "catch down" to 2021's under-the-surface weakness
• Higher intra-market correlations and greater tail risks

Let's start with a quick update on market weakness so far in 2022. Unlike last year—when index declines were muted, but churn/weakness under the surface was more pronounced—this year so far has brought much more weakness at the index level (with underlying churn still extreme). This is shown in our crowd-favorite drawdowns table below.

The chief reason for the Fed's aggressive posture is undoubtedly the hotter inflationary environment. The most acute pressures have come from the goods side of the economy—courtesy of the forced, rapid shift in spending habits during the pandemic and reeling supply chains. Services inflation has also started to move up in a more sustained manner, as shown below.

• Services components of inflation metrics like the Consumer Price Index (CPI) command a heavier weight than goods components; thus, a sustained increase keeps headline inflation at a more elevated level.
• A significant reduction in goods inflation may result in a continued compression of (mainly goods-oriented) companies' profit margins.
• Any hit to margins and (subsequently) profits may slow wage growth to a swift degree, ultimately leading to a slower recovery in labor force participation.

If consumer confidence remains persistently dour, we think that housing demand destruction may kick in sooner rather than later, effectively bringing down rental costs. Mortgage payments have soared this year, as shown below, while the backlog of unsold homes has risen for four consecutive months. In fact, the increase in the backlog from 6.9 months to 9.0 months was a two standard-deviation move. There has never been an inventory backlog of nine months or more without a recession near or underway (hat tip to David Rosenberg of Rosenberg Research).

Longer-term, we remain very optimistic about the investment/capital spending side of the economy, regardless of the likely near-term softness. However, near-term, companies are likely to keep spending/investment in check until the macro backdrop improves.

Another risk of reining in inflation is the implicit reduction in companies' profit margins, which are highly correlated with headline inflation metrics like CPI. Several goods-oriented companies have already started to cite headwinds, if not already seeing large hits to margins as inventories have soared. Any significant and persistent reduction in margin growth would likely lead to a bit of a vicious circle of weaker profits, slower wage growth, reduced hiring, and eventual layoffs. Unfortunately, we have already started to see some wobbling in the labor market, as initial jobless claims turned higher in March and job cuts are now rising year-over-year for the first time since the beginning of 2021, as shown below.

Finally, on the economy, a recent Domash and Summers paper detailed the fact that, historically (since 1955), when the average quarterly inflation rate rose to above 5%, the probability of a recession over the subsequent two years was more than 60%. Over the same span, when the unemployment rate dropped below 4% the probability of recession over the subsequent two years was about 70%. Combining the two, there has never been a quarter with average inflation above 4% and the unemployment rate below 5% that was not followed by recession within the subsequent two years.

Ideally, we want to see a very elevated percentage of stocks rallying together to feel more confident, although a couple of shorter-term breadth indicators—based on stocks above their 10-day moving averages and five-day advancers vs. decliners—both gave short-term bullish signals last week.

What's interesting is the spread between what investors (and/or consumers) are saying and what they're doing. The University of Michigan Consumer Sentiment Index peaked in April of 2021 and is now at levels not seen in more than a decade. On the other hand, AAII's April survey about its members' asset allocation showed nearly 70% was allocated to equities—just shy of the 71.4% high-water mark this cycle from November 2021. The data is shown below, courtesy of Ned Davis Research. Even though the two surveys are measuring different groups and asking different questions, they have tracked each other closely over time—until a year ago. History suggests the divergence is unlikely to persist. Near-term, we would expect the allocation to equities to catch down to the more dour sentiment about the economy.

The Confidence Spread recently reached the upper decile of historical (since 2000) readings. Historically, when the spread crossed above 63% for the first time in three months, the forward returns for the S&P 500 were generally strong—especially over the subsequent two months. It suggests a further rebound could be in the offing near-term.

We are looking for better news on the inflation front before expecting the Fed to consider a breather in terms of rate hikes. We are also looking for stronger market breadth—including a high percentage of stocks moving higher together. In the meantime, this is not a market likely to reward excessive risk-taking and we continue to recommend adhering to the disciplines of diversification (across and within asset classes) as well as the power of periodic rebalancing (which forces investors to add low and/or trim high).

We continue to recommend that stock-picking-oriented investors focus more on factors than sector or traditional-style indexes. Given high inflation, rising short rates, and weakening growth outlooks, factors we believe will continue to perform better in relative terms are strong free cash flow, healthy (cash-rich, low-debt) balance sheets, positive earnings revisions, and low volatility. Lastly, when markets become more volatile and weakness takes over from strength, we always remind investors that panic is not an investing strategy.