Sharp Market Declines — Negative Wealth Effect — Underwrites Fed Policies – Strong Employment Gives Fed the Umbrella for Aggressive Policies — QT Pressures Multiples — Refocus on Earnings Leads to Stock Selectivity – Less Focus on Broad Indices — Negative U.S. and China Workforce Demographics Changes Globalization

Current High Levels of Inflation — Broadening Impact

With its May meeting, the Fed announced more aggressive tactics in its war to diffuse inflation. Figure 1 provides an updated map of that battlefield. That map shows Median CPI which, in the Cleveland Fed’s view, provides a better sense of underlying inflation than does either headline or core CPI. The chart shows that half of the median CPI components — the orange line – experienced annual price gains of 5.2%. This change compares to 4.9% annually in the prior month. Overall, despite a downtick, April CPI–the green line — came in much higher than consensus forecasts and three times the Fed’s 2% average inflation goal. These Figures suggest a long, difficult war to bring down inflation.

Figure 1

Median Consumer Price Index

Source: Bureau of Labor Statistics, Federal Reserve Bank of Cleveland, Haver Analytics

Bernanke On Stock Market Wealth Effect — Sharp Stock Market Decline — Supports Fed’s Goals Negative Wealth Effect – Likely to Slow Spending

In 2010, then-Fed Chair Bernanke wrote an Op-ed column titled: “Aiding the Economy: What the Fed Did and Why.” He wrote this Op-ed during a week when the Fed added further to its Large-Scale Asset Purchases — QE – of treasuries. His Op-ed connected higher stock prices to increasing the wealth effect: “higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending.” In contrast to QE, the Fed’s current aggressive tightening policies resulted in just the opposite – sharp equity market drawdowns and reduced consumer wealth — supporting the Fed’s goals. The net effect will reduce consumer purchasing power, likely leading to reduced spending. The key will be how fast inflation will decline from reduced spending. Most economists expect inflation, as it comes off its current peak, will decline slowly in a series of lengthy steps or lower plateaus.

Strong Employment Gives Fed the Umbrella to Pursue Aggressive Polices on Inflation – Higher Unemployment Rates May Then Signal a Change

The economy created 428,000 new jobs in April, which marked the twelfth straight month businesses added 400,000 jobs or more. Continued strong employment growth gives the economic umbrella under which the Fed can pursue its aggressive laser beam focus on inflation. This may disappoint investors who continue to expect the Fed to support financial markets. Instead, sharp market declines work to underwrite the Fed’s policies to control inflation. However, the possible future slowing of the economy would likely lead to higher unemployment rates. The resulting folding of the employment umbrella would likely signal the Fed to pull back from its aggressive policies.

Quantitative Tightening Pressures Equity Multiples – Greater Focus on Real Earnings Growth — Greater Investment Selectivity — Away from Broad Indices to Stocks and Thematic Indices

Out of the Great Financial Crisis, the Fed’s Quantitative Easing (QE) policies produced rapid growth in the M2 money supply to recharge the economy. As part of QE, the Fed’s balance sheet grew from under $900 billion to $9 trillion today. At the same time, velocity or the turnover of the M2 money supply declined rapidly (see Figured 2). Declining velocity meant not all of the monetary stimulus actually found its way into the “real economy” either through bank loans or other paths. Instead, this unused excess monetary stimulus likely flowed into the financial markets. These expansive liquidity flows likely inflated stock multiples which then drove equity markets to historic highs. In contrast, by now reducing its balance sheet, the Fed will remove financial market liquidity — Quantitative Tightening (QT) – likely pressuring equity multiples (see Figure 3). No doubt markets will rebound, but overall, equity multiples will not likely achieve similar valuation levels that historic low interest rates and explosive Federal Reserve balance sheets underwrote over the last decade. In this new monetary policy regime, investors, more than ever, will need to give greater focus on real corporate earnings growth in the absence of multiple inflation. For investors to achieve positive investment returns will require greater investment selectivity. This possible change could then lead away from broad stock indices and more so to equities and thematic stock indices.

Figure 2

The Velocity of M2 Money Stock

Source: Federal Reserve Bank of St. Louis

Figure 3

S&P 500 Blended Forward 12 Month P/E—Maximum % Drawdown

Source: Lizann Sonders, Charles Schwab, Bloomberg as of 5/9/2022

The Atlanta Fed’s Wage Growth Tracker shows median hourly wages increased over 6% annually (see Figure 4). Despite that increase, real disposable personal incomes declined as inflation rates exceeded wage increases (see Figure 5). Food and energy inflation pressures reduce what remains in the wallet, cutting back on what consumers can spend on core goods and services. Figure 6 shows real spending on goods fell 0.5% in April compared to the prior month. In another measure, the University of Michigan’s Consumer Sentiment Index showed its lowest reading in over a decade. That reading also reflects inflationary pressures eating at consumer confidence. The result will likely be slowing economic growth in the second half, with inflation likely coming off peak levels.

Figure 4

Wage Growth Tracker — Three Month Moving Average of Median Wage Growth, Paid


Source: Current Population Survey, Bureau of Labor Statistics, Federal Reserve of Atlanta

Figure 5

Us Real Disposable Personal Income US$ (Bn)

Source: The Daily Shot

Figure 6

U.S. Real Consumer Spending (Billions of 2012$)

Source: Bureau of Labor Statistics, NY Fed, Haver Analytics

Strong U.S. Dollar —Weak International Economies – Both Lead to Earnings Surprises for Global U.S. Corporations — Domestic Corporations Advantage

The U.S. dollar shows continued strength, in part, reflecting the relative strength of the U.S economy, increasing U.S. interest rates, and its traditional safe-haven role for global investors (see Figure 7). Recently, the International Monetary Fund (IMF) reduced its 2022-23 economic forecasts for most regions of the world (see Figure 8). In its forecasts, only the U.S. will show a marginal improvement in 2023. Weakening international economic forecasts–particularly for Europe – combined with a strong U.S dollar will penalize the earnings of U.S. corporations with international subsidiaries. The penalty for U.S. global corporations occurs when converting their international subsidiaries’ foreign currency earnings into U.S. dollars for reporting purposes. According to Bank of America Global Research, information technology and materials represent the highest foreign exposure sector weights for S&P 500 companies (see Figure 9). Therefore, corporations predominantly operating in these two sectors will prove most vulnerable to currency exchange conversion risks. Many times in the past, the currency impact caught
investors by surprise. This time will likely prove no different. With the current uncertain international economic and geopolitical outlook, investment emphasis should be placed on companies with primarily domestic businesses.

Figure 7

Dollar Exchange Rates (Index 2015=100)

Source: Federal Reserve Board via Haver Analytics

Figure 8

IMF Growth Revisions — 4/2022 vs. 1/2022

Source: Blackrock Investment Institute, IMF World Economic Outlook

Figure 9

S&P 500 Companies by Foreign Exposure: The Ratio of Foreign Sales to Total Sales

Source: Bank of America Research

Negative Workforce Demographics for China and the U.S. —Changes Globalization Deflationary Impact – U.S. Corporations Gradually Shift from Lowest Cost to Best Cost

Economic growth depends on both workforce and productivity growth. Our past Commentaries pointed out that U.S. productivity would suffer in this decade as it faces the slowest labor force growth in fifty years (see Figure 10). An even more difficult workforce decline faces the second largest global economy — China (see Figure 11). For perspective, China joined the WTO in 2001, which enabled it to, in effect, globally export its low-cost labor in the form of products. China’s export of low-cost labor underwrote globalization’s deflationary influences. In our view, China’s export of low-cost labor also contributed to rising inequality in developed countries. The chart in Figure 13 from Goldman Sachs Global Investment Research supports that possibility. The reversal of these workforce demographics in the two largest economies will likely lead to important changes in globalization. The most important change would be that China focuses on exporting products further up the value chain with less labor content than in the past. That shift would likely reduce China’s critical contribution to the deflationary impact of globalization. At the same time, U.S. corporations, to offset a high-cost labor short environment and improve productivity, will need to step up their capital investments in digital technologies and automation. In addition, based on recent global turmoil, more of that investment will be spent to expand and build North American facilities – “best costs” vs. lowest cost. Such capital investments will enable corporations to achieve both a competitive advantage and increased profitability.

Figure 10

U.S. Labor Force Growth by Decades

Source: Truist Advisory Services, Reuters Graphics

Figure 11

China Workforce Population Change (16-59 Years Old)

Source: Un, Macquarie Research

Figure 12

Periods of Increasing Globalization Saw a Rise in Inequality — (Ratio—United States)

Source: Goldman Sachs Global Investment Research, Distributional National Accounts

Investment Conclusions

Equities — Economic Slowing — Energy — Security — Displacement and Replacement

Economy – Less accommodative monetary policies will likely produce an economic slowing later this year and into 2023. Therefore, investors should selectively seek out economically defensive stocks in such sectors as health care, consumer non-durables as well as quality companies that can show consistent earnings and dividends growth through this period. In support, according to a recent Barron’s article, since 1936, dividends contributed 36% of total returns. However, over the last decade, dividends made just a 15% contribution. With higher interest rates, dividend growth will be needed in order for equities to remain competitive with higher interest rates on debt. If not, stock prices will suffer.

Energy – The “Putin Shock” could lead to a rethinking of energy security and electric generating systems reliability along with updating “Green” planning to reach realistic economic scale. Those changes could result in expanded investments in the energy industries, including fossil fuel, “Green,” and nuclear.
Businesses servicing those industries should also benefit.

Security – The growing security “alliance” between the two great Eurasian powers—China and Russia– will likely prove beneficial to companies supplying defense and cybersecurity equipment and services. The Ukraine war will prove a testing laboratory, similar to the Spanish Civil War, for new military strategies, tactics, and advanced weapons. This shift will likely force countries to make major reassessments of what weaponry they will acquire and substantially increase their defense spending. Both domestic and non-U. S defense companies will likely benefit from a long-term period of greater emphasis on defense.

Displacement and Replacement – The “Putin Shock” will also lead to a broad list of displacements and replacements. For example, uncertain grain and oilseeds production from Russia and Ukraine should benefit companies broadly providing increased productivity using precision farming technology systems and equipment. The same will also prove true for developing new sources of key hard commodities. In the latter case, new sources of key hard commodities will prove critical to meet demands from alternative energy and electric vehicle industries.

Fixed Income and Alternatives — Our prior Commentaries suggested long-duration fixed-income investments would prove unattractive during a period of high inflation and historically low interest rates— that view proved correct. Now, with aggressive actions by the Fed to bring down inflation, economic slowing will likely follow. A slowing economy will, over time, increase the attractiveness of fixed-income securities. With a flattening yield curve, shorter-duration Treasury notes should prove effective to offset higher equity market uncertainties. As recommended in previous Commentaries, a select group of alternative investments also fits that portion of the portfolio historically committed to fixed income.

Both the potential for increasing political and economic disruption from the “Putin Shock” and/or renewed outbreaks of COVID add greater uncertainties, than normal to these conclusions.