The U.S. economic roller coaster appears headed back to its boring home base, after a rollicking ride of thrills and fears that leaves investors queasy. Media commentators speculate whether the deeper dives constituted a recession. Despite headlines, the recession designation (or not), is irrelevant, as job and earnings growth on the track ahead will be a more useful metric for stocks.
Investors should find the next economic ride less frightening. The New York Fed Weekly Economic Index estimates +3.1% real economic growth for the rest of the year, and the Atlanta Fed’s GDPNow predicts +1.3%. Atlanta correctly forecast negative real GDP for the first half of 2022, so its estimates may prove more reliable. Population and productivity growth promote new economic activity over the long term. Unfortunately, working-age population growth has slowed (less than 1%), and productivity growth appears muted. While we hope pandemic-era changes—such as increased robotics use—will improve productivity, we think economic growth will fluctuate around 2% in coming years.
Against the backdrop of slower growth, we expect corporate earnings to fall below its long-term growth trend. Corporate profits historically expanded at a 6-7% annualized rate; we expect that rate to drop to 5% annually for an extended period. Near-term, earnings estimates for the S&P 500 for 2022 have been reduced to $227 but remain above early-year projections. Those earnings expectations represent a Price/Earnings ratio (P/E) of 18x. Analyst consensus for 2023 is $245, representing a P/E of 17x.
Equity valuation metrics have recovered in recent weeks, partly due to easing concern over inflation and interest rates. While metrics like P/E remain near the historical average, that history includes periods of high interest rates which suppress valuations. We expect inflation slowly to subside. As it does, valuation metrics should improve.
Our research shows that 2-3% inflation is ideal for earnings growth and valuation multiples. Lower inflation rates likely coincide with a weak economy and minimal earnings growth. Any higher and growth might hold up, but multiples will contract. Are we returning to the 1970s, with persistently high inflation? It’s a scary scenario that led to high interest rates and crushed equity values.
Down from recent highs—and still below 3.00%—the U.S. Ten-Year reflects expectations that inflation is peaking. Money supply growth has slowed, commodity prices have cooled, supply chain problems are easing, inventories are building, and transportation costs have declined. The pace of decline and the ultimate destination for inflation is tough to predict, but we expect falling inflation to dramatically lower the odds of the 1970s scenario. Current estimates for CPI, to be released on August 10th, point to a month-over-month reading for July of 0.2%, down dramatically from the 1.3% posted for June.
Companies have done a commendable job generating growth in the tough first half of the year. While growth may slow, logistical problems are easing and likely providing stability to margins. The path of the economy and jobs ultimately will influence realized results.
Growth requires a healthy job market, since consumer spending heavily drives the U.S. economy. The economy created 372,000 new jobs in June, which was in line with the average for the prior three months. The latest figures show over 500,000 newly created jobs in July. That robust level of job growth is inconsistent with a recession. Jobless claims have ticked up but remain normal. The July 30th weekly report of 260,000 jobless claims remains consistent with non-COVID months over the past ten years. Jobs offered fell to 11 million openings, down from a peak of 12 million. That’s nearly double the 5-6 million offers that prevailed during the prior ten years (excluding COVID). The job market remains healthy, only a bit off the boil from a few months back.
COVID created a massive economic roller coaster ride, but the ride is ending. We expect the near term to throw some curves. The intermediate and longer term should resemble the pre-COVID era, characterized by slow growth and the ability for individual companies to find ways to generate organic revenue growth, while carefully managing profit margins against myriad challenges.
This communication contains the personal opinions, as of the date set forth herein, about the securities, investments and/or economic subjects discussed by Mr. Teeter. No part of Mr. Teeter’s compensation was, is or will be related to any specific views contained in these materials. This communication is intended for information purposes only and does not recommend or solicit the purchase or sale of specific securities or investment services. Readers should not infer or assume that any securities, sectors or markets described were or will be profitable or are appropriate to meet the objectives, situation or needs of a particular individual or family, as the implementation of any financial strategy should only be made after consultation with your attorney, tax advisor and investment advisor. Data for illustrations were sourced from Bloomberg and Macrobond. All material presented is compiled from sources believed to be reliable, but accuracy or completeness cannot be guaranteed. © Silvercrest Asset Management Group LLC
