If you are wondering about the market’s year-to-date performance and the direction of the economy, we should start with a discussion of inflation.
Inflation has reached levels not seen since the early 1980s, most recently 8.6% year-over-year. For the economy to flourish in the long term, the Federal Reserve (Fed) needs to get inflation under control. Why is that? When inflation is low, interest rates stay low. This encourages companies to fund growth through borrowing and allows consumers to afford loans more easily for purchases of homes, cars, and other big-ticket items. Growing companies and growing consumer demand lead to job growth and income growth, resulting in a virtuous cycle. On the other hand, higher inflation erodes purchasing power and leads to higher interest rates which chokes off borrowing, resulting in an economy that struggles to grow. In addition, rapidly rising prices have the greatest impact on low wage earners who often spend more of their income on necessities.
The Fed is determined to bring inflation back to 2%, and it plans to do so by temporarily slowing demand, which was overheating thanks to massive fiscal and monetary stimulus during the pandemic. They will slow demand by temporarily raising interest rates. So far, the central bank has bumped up interest rates three times, with the June increase of 75 basis points (3/4 of a percent), the biggest hike since 1994. And several more increases are likely in the second half of 2022. The Fed understands there will be short-term pain because of higher interest rates and its actions risk causing a recession. But they are committed to putting the economy back on a more sustainable, long-term growth footing.
Investors are feeling some of that pain as the market reacts to higher interest rates and the likelihood of economic weakness and lower earnings in the near term. The first half of 2022 was a difficult period for the market, with a -19.96 total return for the S&P 500. The index entered a bear market on June 13, when it declined 20% from its previous peak of 4797, reached on January 3, 2022.
Slowing Inflation Without Breaking the Back of the Economy
If you read the news headlines, which typically report indicators of current economic activity, the signs seem positive. Unemployment is low, home prices are still rising, and industrial production seems fine. However, those are lagging indicators of economic activity. The market focuses on leading indicators, and those are flashing yellow and, in some cases, even red. In fact, some signs suggest that the economy may be heading toward recession.
According to the University of Michigan consumer sentiment index, consumer confidence is at an all-time low. Not surprisingly, retail sales declined 0.3% in May. Because consumers are paying higher prices, they are buying fewer items. And with mortgage rates over 6%, we are seeing signs that the housing market is softening. The housing market feeds into many other parts of the economy, and a slowdown in housing can have a far-reaching impact on economic growth. While the unemployment rate is low, we’ve recently seen an uptick in layoffs. Initial unemployment claims have been inching up and at 231,000 they are about 40% above the low level hit last Spring. When weekly claims reach 400,000, that suggests a recession is ahead. We’re still a long way from that, but the numbers bear watching.
On the positive side, corporate earnings remain resilient. The current consensus of earnings growth for this year is 10.6% and 9.2% for next year. However, we are watching for signs of weakening. In an economic downturn, earnings estimates will almost certainly be reduced. As we mentioned earlier, this year’s decline in stock prices is the market’s way of adjusting for the possibility of lower earnings ahead. So, lower earnings are at least partly reflected in the market’s current level.
Looking Beyond the Bear Market
Despite periodic declines, stocks have remained the best asset class for maintaining purchasing power and building wealth over the long term. Over the last 25 years, the S&P 500 has generated an annualized return of 7.97%, despite the bear markets of 2000-2002, 2008-2009, the short Covid-related drop in 2020, and the current decline. As a result of this year’s decline, market valuations are starting to look attractive. The S&P 500 price/earnings ratio is 15.80 times estimated earnings compared to a 10-year average of 16.94. Lower prices and more attractive valuations are presenting opportunities in stocks that might have been too expensive previously.
One such example is Entegris (ENTG). Although it has gotten beaten up this year, its long-term prospects remain strong. Entegris supplies products and systems for manufacturing semiconductors. As more chip facilities are built around the world, the growth opportunities for Entegris continue to improve.
Another attractively valued stock is Toro (TTC), a long-time Mairs & Power holding. A key market for Toro is equipment for maintaining golf courses, which has enjoyed a revival in interest thanks largely to COVID. Toro is currently beta-testing autonomous fairway mowers, which can help golf courses maneuver through a tight labor market. Toro also plans to introduce an autonomous electric lawn mower; think of a Roomba-like machine that mows your grass. The company has pivoted nicely in the consumer market, developing equipment such as snowblowers and chain saws that are powered by 60V batteries. And Toro’s 2019 acquisition of utility construction equipment maker Ditch Witch should benefit the company going forward thanks to increased spending on infrastructure and rural broadband.
The Energy sector is up 35% this year and you might be wondering what we’re doing with Energy stocks. As always, we are taking a long-term view, and we have serious concerns about fossil fuel demand in the long run. Instead, we are looking for companies that will benefit from shifts in the long-term trends in energy supply and demand. One such company is Littelfuse (LFUS), which benefits from alternative sourcing of energy, and electrification in several end markets, and we discussed the topic recently in our article titled, Mairs & Power’s Inside Look – The Traditional Energy Sector.
Once inflation recedes, and interest rates decline, the economy and markets will begin another cycle of growth. The current inflationary pressures have been caused by multiple factors. Excessive demand, which The Fed is tackling, is only one. Supply constraints caused by Covid shutdowns in China and labor shortages in the U.S. have also pushed inflation higher. As Covid recedes or moves from pandemic to endemic, we expect that China will re-open its economy and supplies of goods are likely to return to normal, further easing inflationary pressures.
Cycles are inevitable, and there will be times, typically of short duration, when the economy weakens and the market contracts. History shows that the best strategy for handling bear markets is to focus on the long term and invest in growing businesses with durable competitive advantages. That’s the approach we use in constructing portfolios to withstand periodic declines in the market. Learn more today about how we invest.
Top 10 Fund Holdings (subject to change)
S&P 500 TR Index is an unmanaged index of 500 common stocks that is generally considered representative of the U.S. stock market. It is not possible to invest directly in an index.
The term basis points refers to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01%.
The Michigan Consumer Sentiment Index is a monthly survey of consumer confidence levels in the United States conducted by the University of Michigan. The survey is based on telephone interviews that gather information on consumer expectations for the economy.
The price-to-earnings ratio is the ratio for valuing a company that measures its current share price relative to its earnings per share.