The chart below shows the “triple waterfall” of the S&P500 this year, which belies the psychological journey of investors as they absorbed world events and their implications on global finance and trade. Whether this roller coaster ride is almost done or still underway is uncertain.
The key factors
The S&P 500 reached a low on June 16, and at the time of writing surged 14.5%. Where it goes from here depends on:
US economic growth,
US dollar inflation, and
Federal Reserve (the “Fed”) policies.
US economic growth
The Atlanta Fed recently raised its Q3 2022 GDP forecast to 2.5%, possibly due to stronger-than-expected domestic purchasing figures in Q1 and Q2.
Other forward-looking indicators are less promising. News of corporate layoffs, less optimism among small businesses and flagging demand for mortgages indicate a weakness in the wider economy.
The International Monetary Fund forecast that US GDP growth will more than halve to 2.3% in 2022, and again in 2023 to 1.0%. Global and US economic growth may remain sluggish in 2022 and 2023. This would erode corporate profit margins and earnings, and hence stock market valuations.
US dollar inflation
The prospect of double-digit inflation has raised widespread concern this year in western economies that got accustomed to low, stable and manageable inflation over the past two decades.
As global supply shortages normalize, some price pressure may be lifted, particularly for gasoline, industrial metals, lumber and grain.
But core inflation (i.e. excluding food and fuel) may take longer to address. The mere expectation of inflation can cause “unanchored inflation,” regardless of fundamentals. If everyone expects prices to rise, businesses will raise prices and workers will demand raises. All else equal, if inflation expectations rise by 1%, actual inflation will also rise 1%.
Fed policies
The Fed took decisive actions this year, raising rates four times so far. But fear of a recession might lead them to halt, or even reverse, their tightening policy.
Long and intermediate bond yields seem to price in lower inflation, which supports this view. But this trend in bond prices may not reflect the prospect of continued restrictive monetary policy.
It may be too early for the Fed to relax. Real interest rates are still highly negative, and the reduction of the balance sheet remains far from its target. Therefore, the Fed is unlikely to contemplate another rate cut before December 2023.
Conclusion
The US economy may well face an extended period of low growth, persistent above-average inflation, and more restricted access to capital.
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