The Economy's Mixed Signals

Recession fears and volatility have rocked the markets, but it’s not all bad news.

By
Samuel Park
Director of Fundamental Research, Pacific Life Fund Advisors
&
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Key Takeaways

  • Many headwinds, including a potential recession, have weighed on market sentiment.
  • While a recession—as defined by academic terms—may happen, a healthy job market, continued consumer spending and strong corporate performance may mitigate its impacts.
  • Volatility may linger as investors seek a market bottom.

Equity markets continued to fall in the second quarter of 2022 with the S&P 500 Index down 16.1%. Growth stocks experienced the largest quarterly loss, while large-cap value held up moderately better. Rising rates continued to hurt growth, as investors shunned overvalued companies.

Within fixed income, emerging market bonds faced large losses, as Russian exposures detracted from performance. Short-duration bonds held up much better than their longer-duration counterparts. Credit exposures were also headwinds over the quarter.

Outlook

Inflation fears, geopolitical uncertainty, tighter monetary policy, and earnings concerns will continue to weigh on market sentiment as investors gauge recession risks. This will likely mean that market volatility will linger as investors seek a market bottom.

Debates of recession risk have taken precedence as the market turmoil continues to rattle investors. Every recession is different, but whether the U.S. is technically in a recession (two consecutive quarters of negative GDP) will depend on how the economy held up in the second quarter. In the first quarter of 2022, U.S. GDP fell 1.6%. Although that was a sharp reversal from the 6.9% increase in the fourth quarter, the downshift came as federal stimulus programs ended and rising inflation pared back consumer sentiment and corporate profits. Furthermore, trade detracted over 3% from the first quarter GDP.

Despite the robust employment rate, we could be in a technical recession if there is enough softness in consumer and business spending, investment and trade flows. However, it should be noted that recessions typically follow periods when the unemployment rate begins to rise. So far, the unemployment rate continues to fall, even though it’s at historic lows.

Unemployment Rates Over Past 30 Years
Source: FactSet as of 6/30/22

The strong employment conditions also allow consumers to continue to shop at a strong pace.

Consumer Spending Over Past Decade
Source: FactSet as of 7/1/22

U.S. consumers still have savings from the federal stimulus payouts, which has helped buffer some of the effects from higher prices. Furthermore, the combination of tight employment and higher inflation is reflected by the rise in wages in recent quarters. In the past two recessions, wage growth peaked around 4%. However, wage growth has surged far past that level in recent quarters.

Wage Growth Over Past 30 Years
Source: FactSet of 6/30/22

Thus far, U.S. consumers seem able enough to handle higher prices. However, inflation has been more persistent than many had foreseen only a few quarters ago. This has caused the Federal Reserve (Fed) to react aggressively to tame inflation. The risk is that the Fed could slow the economy more than needed to control inflation.

The supply-chain congestion is not the only culprit to higher inflation. The Russian-Ukrainian War also has continued to contribute to the elevated inflation around the globe. Commodity prices, especially crude oil, had been elevated. Inflation is expected to remain high if commodity prices remain elevated. Nonetheless, we should see some relief as commodity prices normalize to the downside.

Commodity Prices and CPI Over Past Decade
Source: FactSet as of 7/8/22

The Biden administration is also considering removing tariffs to provide relief on inflation. However, a Peterson Institute study found that the direct impact from removing all additional tariffs on Chinese imports would only lower the U.S Consumer Price Index (CPI) by approximately 25 basis points. Given that inflation is currently running above 8%, removing tariffs on Chinese goods will likely have only a minor impact.

Despite the elevated level of inflation, the S&P earnings-per-share forecasts look relatively healthy, and companies appear to have been able to absorb higher wages and interest rates.

S&P 500 Earning Per Share
Source: FactSet as of 7/8/22

However, there are concerns about their ability to take on even higher wages and interest rates. This has caused angst surrounding the upcoming earnings season. Nonetheless, strong corporate balance sheets should help absorb rising interest rates … for now.

Much rest on the Fed’s shoulders as it attempts the all-elusive soft-landing. The Fed cannot allow inflation to run rampant, since it would crush consumers. Since consumption represents two-thirds of U.S. GDP, an overly thrifty consumers may only hurt the economy. Therefore, the Fed needs to raise rates aggressively for being late to fight this inflation. On the other hand, raising rates too high could choke the economy as well. Although higher rates are needed to fight inflation, they will be restrictive on profit margins. Since smaller companies are more exposed to floating-rate loans on their balance sheets, we’ve reduced our small-cap exposures. Nevertheless, we believe it’s very important to remain diversified in these wild market swings.

Definitions

The The Bloomberg US Aggregate Bond Index is composed of investment-grade U.S. government and corporate bonds, mortgage pass-through securities, and asset-backed securities and is commonly used to track the performance of U.S. investment-grade bonds.

Earnings per share are a company’s profit dividend by the number of outstanding shares ot its common stock.

The MSCI EAFE Index is designed to measure the equity-market performance of developed markets in Europe, Australasia, and the Far East.

The Redbook Index is a sales-weighted of year-over-year same-store sales growth in a sample of large US general merchandise retailers representing about 9,000 stores.

The S&P 500 Index is a market capitalization-weighted index of 500 widely held stocks often used as a proxy for the U.S. stock market.

Any performance data quoted represent past performance, which does not guarantee future results.

Pacific Life Fund Advisors LLC is the manager of the Pacific Funds Portfolio Optimization Funds. The views in this commentary are as of the publication date and are presented for informational purposes only. These views should not be construed as investment advice, an endorsement of any security, mutual fund, sector or index, or to predict performance of any investment. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are subject to change without notice as market and other conditions warrant. All third-party trademarks referenced belong to their respective owners.

All investing involves risk, including loss of principal.

Investors should consider a fund’s investment goal, risks, charges, and expenses carefully before investing. The prospectus and/or summary prospectus contains this and other information and should be read carefully before investing. The prospectus and/or summary prospectus contains this and other information and should be read carefully before investing. The prospectus can be obtained by visiting PacificFunds.com.

Pacific Funds are distributed by Pacific Select Distributors, LLC (member of FINRA & SIPC), a subsidiary of Pacific Life Insurance Company (Newport Beach, CA), and are available through licensed third parties. Pacific Funds refers to Pacific Funds Series Trust.

Pacific Life Insurance Company is the administrator for Pacific Funds. It is not a fiduciary and therefore does not give advice or make recommendations regarding insurance or investment products.

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