Market Outlook Q2 2022 over digital graphs along a sidewalk street

It has been a rough start to 2022.

The first three months of the year were characterized by elevated volatility and big moves lower in stocks. We’re entering the second quarter with more questions about the future than answers. And the biggest debate on Wall Street is if we are headed for a recession or a rebound. This quarter might just reveal the answer to that question.

The risks to the market aren’t new. The Fed, inflation, higher oil prices, geopolitics — we’ve been obsessing over what these risks mean to future growth for months. GDP growth estimates are already moving lower, and no one believes earnings growth expectations can be sustained.

What many people aren’t talking about is the underappreciated opportunity the consumer presents. While consumer sentiment has fallen dramatically, the health of the consumer remains intact. The job market is strong, and excess cash has allowed consumers to absorb higher pricing. Companies and corporate profits have benefited. I’m expecting earnings season to surprise the consensus narrative, which expects guidance to be dour. Sure, growth will slow, but perhaps not as much as expected.

Inflation: Front & Center

Inflation fears are going nowhere fast. In the first quarter, we learned that inflation was not, in fact, transitory. Between the Omicron strand of Covid and the geopolitical conflict between Russia and Ukraine, price pressures have remained elevated, sticking around longer than anyone would like.

With the consumer feeling the pain, the Fed will remain aggressively focused on combating the rising cost of living. Interest rates will move higher through the quarter with the possibility of bigger moves by the Fed increasingly likely. The market is pricing in two half-percentage point (0.5% points) increases in the second quarter. It’s possible we will end the quarter with a Fed Funds Rate of 1.5%-1.75%.

Those expectations are working their way through the system with the bond market already doing its part to tame demand. The housing market is beginning to cool as mortgage rates rise. For the supply side of the inflation equation, the Fed has less control. And supply may be the best predictor of the true path forward for inflation.

Graph titled Inflation Expected to Cool shows the Fed’s forecast of tamer price rises, tracking PCE inflation and Core PCE inflation expectations for the following years: 2022 (PCE inflation at 4.3% and Core PCE inflation at 4.1%); 2023 (PCE inflation at 2.7% and Core PCE inflation at 2.6%); 2024 (PCE inflation at 2.3% and Core PCE inflation at 2.3%). Source: Ally Invest, Federal Reserve

Believe it or not, the consensus amongst economists is that the core Consumer Price Index (CPI) rate peaked in the first quarter. The Fed itself also believes inflation will return to more acceptable levels by 2023 and 2024.

That might feel optimistic right now, especially as easing inflation is highly dependent on the untangling of rampant supply chain issues. That said, there are some early green shoots. Key global shipping rate barometers, including the World Container Freight Index and the Freight Index from Shanghai to Los Angeles, peaked late last year and are currently trending down. Used car prices — which were key drivers of inflation early on — may have peaked in January, according to Manheim and the NADA Used Vehicle Value Indexes. Moreover, business inventories have been on the rise, contributing significantly to the solid Q4 2021 GDP growth rate. As in-stock inventory levels improve, that could help ease prices in the back half of this year. The increased shift in spending from goods to services should result in a better balance of pricing pressures between the two segments of the economy. Consider, too, that it was about this time a year ago when inflation began to kick into high gear, so year-over-year comparisons will be tougher hurdles to exceed in the months ahead. Finally, inflation running hot can have the impact of cooling demand on its own.

Ultimately, it’s going to be a rollercoaster as we monitor inflation this quarter. The greatest concerns are that inflation significantly slows economic growth and the Fed makes a misstep while trying to tame it. We’ll have better clarity on these items as the quarter progresses, but it will take time to better understand the situation.

The Resilient American Consumer

The inflation situation has consumers feeling down. But there’s a stark contrast between consumer confidence and consumer spending trends. Oftentimes, the consumer says one thing and does another.

Graph titled Consumer Sentiment Sours, Spending Soars tracks consumer sentiment against year-over-year change in consumer spending from January 2002 to January 2022. Change in consumer spending remained generally steady at about 5% before dropping to about –15% in early 2020 and then rising again to nearly 30% in early 2021 before dropping back to just over 10% more recently. Consumer sentiment shows more variation, generally staying between 80 and 100, except for a drop in 2008 into the 50s before it slowly rose back to the 90s by 2015. In 2020, it dropped again to about 70 and has since dropped further to nearly 60. Source: Ally Invest, University of MIchigan, St. Louis Federal Reserve

The latest University of Michigan gauge on consumer sentiment revealed the bleakest figure since 2011. At the same time, though, U.S. retail sales are at record-high levels with growth that is holding significantly above pre-pandemic levels. Perhaps judging the economy based on what consumers are actually doing is the way to go.

Consider that household balance sheets are in fantastic shape. We can look to indicators such as the debt-to-disposable income ratio and total household savings. Those figures suggest consumers are in a healthy position to handle higher prices for food and energy than they were in, say, 2014 when oil prices were steadily above $100 a barrel. Americans still have ample excess cash in their coffers to the tune of more than $2 trillion by some estimates, according to Bloomberg.

Graph titled Healthy Consumer Balance Sheets shows that debt-to-income ratio is near a historic low by tracking household debt service payments as a percentage of disposable personal income. From July 1981 through July 2007, the percentage has been between 10% and 14%. It then drops to just below 10% by July 2013, where it approximately remains until dropping closer to 8 and 9% in the years since 2019. Source: Ally Invest, St. Louis Federal Reserve

Additionally, the job market is strong, offering many opportunities and, in many instances, higher pay. Consumers feel optimistic about their job prospects, too. No doubt inflation has added pressure to consumers — credit card balances are beginning to increase, and savings rates have dropped from high levels. The consumer likely won’t be able to absorb elevated prices significantly longer.

Earnings and Valuation – Against the Grain

So far, we’ve been able to consistently count on the consumer. Strong retail sales — even after stimulus and aid money have largely ceased — helped drive top-line revenue growth over the past few quarters. Inflation is playing an increasing role in sales growth, but corporations have been able to navigate the higher cost environment well, leading to record operating margins in 2021.

That trend is likely to have continued in the first quarter of 2022, but investors will be most focused on whether the outlook lives up to high consensus expectations. Despite all the obsession about the risks to the market, earnings, sales and operating margin estimates for 2022 have all moved higher since the start of the year. Corporations are struggling with inflation, supply chain issues and the labor market shortage, but expense management has been a bright spot over the past several quarters. That, along with support from the consumer, should lead to a good quarter for earnings. Sure, the outlook may be trimmed in a cautionary effort, given the continuous state of uncertainty, but it’s quite possible the bears are disappointed the outlook isn’t worse.

The stock market is much less expensive today than it was a year ago. Stock price weakness has driven valuations lower to better align with historic trends. The forward 12-month price-to-earnings (P/E) ratio of the S&P 500 of 20x is in-line with its five-year average valuation, or about 15% less expensive relative to the average P/E in Q1 2021. By longer-term measures, that valuation is still a premium, but sales growth and margin expansion remain elevated, supporting the current multiple.

It’s always better going into earnings season after a period of weakness and amid lower valuations. The crowd, however, remains a tough one. A good quarter and a steady outlook might not be enough to reward individual stocks. It could be enough to help alleviate fears of a recession or the Fed throwing things off track. And a stable market is better than an extremely volatile market.

Graph titled S&P 500 Forward P/E Ratio Returns to Average shows that stronger earnings and high margins support valuation. The S&P 500 forward P/E ratio five-year average is 19.5x, rising from about 14x in 2012 to nearly 20x in 2018 when it dropped back to about 14x before rising back to about 20x. In March 2020, it dropped again before rising to nearly 26x. Since then, it has dropped back closer to the average, close to 20x. Source: Ally Invest, S&P Capital IQ

The Bottom Line

The first quarter’s stock market drop, along with other factors, might have you worried about the risk of a recession. We’ll get some clarity as the second quarter unfolds. This will be a transitionary period. Recent market trends, the macro environment and stability of corporations should provide some confidence that we’re on the right track. And don’t count out the consumer — they may just be what gets us through this slump.

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Headshot of Lindsey BellLindsey Bell, Ally’s chief markets & money strategist, is an award-winning investment professional with a passion for personal finance and more than 17 years of Wall Street experience. Bell’s unique ability to connect the dots between data and real life and craft bite-sized money ideas that people can use and apply stems from her deep background as an analyst, researcher and portfolio manager at organizations including J.P. Morgan and Deutsche Bank. She is known for demonstrating why and how an understanding of all things money improves a person’s finances and overall well-being. An ongoing CNBC contributor, Bell empowers consumers and investors across all walks of life and frequently shares her insights with the Wall Street Journal, Barron’s, Kiplinger’s, Forbes and Business Insider. She also serves on the board of Better Investing, a non-profit focused on investment education.

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