What Will Drive Return?
Earnings drive stock prices over time. This simple truth is evident in the past century’s market performance. Over the past 100 years, both the S&P Composite index and S&P Composite index earnings gained about 6-7% per year. The profits, along with the market’s appraisal of the value of those earnings, rose and fell year-to-year. Sometimes, those swings in earnings and valuations were large, creating excitement and anxiety.
What drove the earnings growth? Fortunately, we see an excellent and rational cause for the growth in earnings. As the chart below shows, we can trace growth in stock prices to economic growth (Chart A below). And economic growth is rooted in “real” phenomena like gains in productivity and workforce. We also see that earnings are partly driven by inflation. This last part helps explain why, over time, stocks provide some inflation protection.
Chart A Long View: Stock Market & Economy
In the two years after the start of the pandemic, the U.S. economy went from bust to boom. After losing 20 million jobs in early 2020, the government undertook policies to inject 40% more money into the economy by the following year (Chart B below). Notice that the increase in money supply is more significant than we saw during the 1970s by a wide margin. However, the surge in money was not matched by a similar rise in the supply of goods and services.
Chart B Money Supply Growth (2-Year Change in M2)
We know this because the economy’s total value is now larger than some estimate the economy should be able to produce. Today, the economy is estimated to be about $25.7 trillion, much larger than the Congressional Budget Office’s (CBO) $25.3 estimate of potential output. This means that the economy, operating about $400 billion above potential, is overheating.
Compounding the issue is recent data on productivity. The Bureau of Labor Statistics productivity estimate shows significant weakness. This data shows productivity (output per hour) declining at a -2.4% rate, the most significant contraction since the 1970s. Another source, the Federal Reserve’s (Fed) staff, recently cited lower productivity as the main reason for reducing their estimate of the economy’s potential output. This cut to the estimate suggests that the Fed needs to tighten more than they did before the adjustment.
A rapid expansion of money against a backdrop of weakening productivity set the stage for inflation. The roots of the inflation problem we are now experiencing are not new. We have seen this movie before.
What’s Happening Now
Since last spring, we are no longer seeing outsized additions to the money stock. Money supply growth has flattened out recently, and some parts of the supply chain are returning. Imports from China, for example, are up about 16% over a year ago. There is some reason, therefore, to expect the inflation curve to start to bend down.
To bring down the growth in the inflation rate, the Fed has been aggressively raising interest rates. When they meet this week, they are widely expected to increase rates by a further 0.75%. We now see the central bank as exercising a “restrictive” monetary policy. As policy tightens, the odds of an outright recession grow.
A favorite early indicator of recession is the “yield curve.” A favorite measure of the changing yield curve is seen below (Chart C below). The graph shows the difference between the 3-month U.S. Treasury bill and the 10-year U.S. Treasury bond. Typically, longer-term rates are higher than shorter-term rates as investors demand greater compensation for taking on the risk of a longer-term investment. Investors would accept lower rates for the greater risk of owning longer-term bonds because they expect the economy to falter. In most cases that bond the bond market made this bet in recent years, recession followed.
Chart C Yield Curve Turns Negative
Since the start of the summer, we see that the yield curve is again worried about a recession. Last week, the curve fell below zero, a situation that preceded several previous recessions. Concurrently, we are seeing other signs of a slowdown. The Institute for Supply Management’s Purchasing Manager’s Index (PMI) is dropping. Through October, the index fell to just above 50 from over 60 in 2021. Similarly, the Conference Board’s Leading Economic Index fell each month from March through September.
The performance of different types of companies leading the market is also interesting. From mid-2020 through mid-2022, when inflation was on the upswing, lower-quality stocks generally beat high-quality. When inflation was accelerating, low-quality stock returns clearly exceeded high-quality stock returns. Now, we are starting to see an opposite pattern. The market is beginning to favor higher quality (more defensive) stocks over lower quality (riskier) stocks. We define quality based on debt, asset profitability, and profit consistency.
Since early summer, when markets began to focus on recession dynamics, leadership shifted to higher quality. The WCA High Quality index of companies is roughly flat from June through October, while the WCA Low Quality index is down 7%. In our view, this divergence in quality performance is consistent with evolving data trends and market perception of risks.
We cannot know for sure what comes next. The cycle is evolving rapidly from a focus on inflation and an overheating economy to a concern about weakness. S&P 500 earnings forecasts are up about 7% from a year ago, but that growth is falling fast. For several months, the growth rate has been declining by about 1-2% per month. If the economic outlook continues to darken, earnings growth continues to slip, and interest rates continue to press higher, the bullish case for stocks will be tougher to make.
Ultimately, we expect the current problems to resolve and give way to growth and positive returns, as we have seen in the past. Whether that turning point arrives soon or further off, we continue to recommend a focus on high-quality companies. If it turns out that inflation fades, the recession is avoided, and markets rally, we see no reason why higher-quality companies would not participate in a rally. On the other hand, if troubles continue or deepen from here, the market is likely to look for durable, flexible, and predictable companies.
Kevin R. Caron, CFA
Senior Portfolio Manager
Senior Portfolio Manager
Steve Lerit, CFA
Senior Risk Manager
Paul Clark, CFA
Senior Portfolio Manager
Municipal Fixed Income
Senior Portfolio Manager
Municipal Fixed Income
Internal Relationship Manager
Director, External Sales and Marketing
External Sales and Marketing
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