The possibility of a recession is the biggest worry entering the third quarter.   

Stock market action, economic data and the Fed’s increasingly aggressive stance certainly suggest a slowdown is occurring and a recession could follow. The S&P 500 has had a rough first half, at one point the index was on track for the worst first-half start since 1962.   

Pessimism is everywhere you look. Consumers, business leaders, economists and my neighbors are all downbeat about the future of economic growth. Inflation has taken on greater significance in this view as the consumer inches ever closer to a tipping point on higher prices.   

The Fed’s commitment to tame inflation is leading to more confusion and uncertainty for investors. The greatest fear is that the Fed will force a recession by rapidly increasing interest rates.   

Data is showing that an economic slowdown is underway, but the depth of the slowdown is still unknown. What we do know is that a slowdown would be occurring during a period where corporations and consumers are much better positioned than they were entering the last recession.   

No doubt, things can change quickly, and the road ahead looks rocky. However, markets are forward looking – valuations have reset lower and we have endured a large decline already.   

We may be closer to the bottom than the narrative suggests.  

Can the Fed pilot a soft landing? 

The Fed has been a key agitator for the market so far this year. Rapidly rising consumer prices forced more aggressive monetary policies in June, with the central bank raising interest rates by the fastest clip since 1994. No doubt the Fed will be front and center when it comes to market action in the third quarter.  

With two regularly scheduled meetings and the Jackson Hole Economic Symposium in August, investors will be on their toes. Fed Chairman Jerome Powell has committed to combating inflation, but the market is still searching for confidence on where rates go from here. The wild swings in rate expectations in May and June taught us things can change quickly when it comes to Fed action.  

Maneuvering will be made more difficult for investors, and the Fed, as two CPI reports are released between the July and September Fed gatherings. Given recent reaction to inflation data, an intra-meeting rate hike shouldn’t be ruled out.  

Powell says the domestic economy is in decent shape, though economic data is turning south. The mid-June reading of the Citigroup Economic Surprise Index shows that indicators are at their softest level, relative to analysts’ forecasts, in two years. Aggressive policy actions and the Fed’s fresh tone come as jobless claims tick up, housing starts stumble to a one-year low, mortgage rates surge, retail sales fall and regional economic reports weaken.  

The Fed has a track record of pushing the economy into recession, but most often recessions don’t occur until after the Fed stops raising rates. Based on the latest estimated by the Fed, rates will continue to be pushed higher into 2023.  

Graph titled Fed funds rate tends to rise ahead of recessions. Yet, recessions typically occur after the Fed stops raising rates. Shows the Fed funds rate at 0% in 1954, rising to 19% in 1978 with a slow decline up until 2020. Recessions are indicated with gray bars. Source: Ally Invest, Bureau of Economical Statistics, National Bureau of Economic Research. New York Federal Reserve.

That said, with a lack of concrete direction from the Fed in the near-term, the Fed will remain the biggest risk to stocks and greatest source of volatility in the third quarter.  

Inflation’s mixed messages  

Reaching a 41-year high, inflation in May was a surprise that no one was looking forward to. The headline CPI reading showed prices increased 8.6% in the economy. Gas and food prices have been key contributors to the acceleration. The war in Ukraine and China’s lockdowns have pushed commodity prices, like oil, significantly higher in the past several months and it’s flowing into food pricing. In addition to transportation costs, the cost of labor and fertilizer are also impacting food prices.  

Inflation hurts economic growth as consumers pull back on spending. While $2 trillion of excess savings and a strong labor market help to pad wallets, consumers are reaching a tipping point when it comes to higher prices. Economists at the Federal Reserve Bank of Dallas say gas prices of $5.50 or more a gallon, which would be 79% higher than a year ago, is a game changing rate that becomes unsustainable. Drivers are already reducing the amount of gas they purchase and are driving less.  

Because wage increases haven’t kept up with the rate of inflation consumers, who have up until recently been willing to absorb higher costs, are shifting their spending habits. Furniture, electronics and online shopping are being replaced with spending on necessities and services.  

Intensifying this shift in behavior has been a change in consumers expectation for future inflation.  A University of Michigan survey revealed households expect inflation of 5.3% over the next year and 3.1% over the coming five years. Those are alarming figures compared to the paltry 1.5% average from 2009 through 2020. Consumer’s expectations for inflation can become a self-fulfilling prophecy. 

Graph titled Consumers expect more inflation in the year ahead. Inflation expectations haven't reached the current level since 1981. Shows a 5% inflation increase in 1978, rising to just above a 10% increase in 1980 with a drop to 2% in 1982, and staying in between 2% and 5% until 2002 with another decline and slowly rising to until 2022. Source: Ally Invest, St. Louis Federal Reserve.

On the other hand, the market sees inflation cooking at 2.9% over the next five years and a more comfortable 2.3% in the five years thereafter. That’s based on current bond pricing. 

The view on inflation is mixed for a few reasons. If consumers believe prices are going higher, they are more likely to purchase goods now vs. later. That demand pushes current prices higher. But there are also signs a shift in pricing power could occur in the third quarter. While demand may rise in the near-term for some things, it has already cooled in parts of the market given the move in prices and rates. Housing and goods producing sectors are feeling the pressure. Supply chain issues have slowly begun to ease, and the reopening of China should help relieve some of those constraints. Any progress toward a de-escalation of the conflict between Russia and Ukraine could further ease commodity prices, though it is hard to say how or when a resolution would culminate.  

Most important will be how companies talk about the impact of inflation on their profitability going forward.  

Margin compression  

Thus far, corporations have navigated the persistently higher inflation situation successfully. In the past year, operating margins expanded by about 100 basis points (or 1 full percentage point) to 16.3% at the end of the first quarter. That rate is well above the average 14.8% margin rate prior to the pandemic.  

The worry on Wall Street is that margin expectations for the rest of the year are elevated and need to be reduced as companies will find it more difficult to pass higher costs on to the consumer. Despite steady margin estimates over the past month, there is a possibility they will be reduced as new guidance is provided with second quarter results. As discussed, the consumer is reaching a tipping point for accepting higher prices, making the acceleration in inflation something companies will have to absorb. That said, this pressure may result in margins that are at or even above the pre-pandemic historical average.  

Graph titled Operating margins expanded post-pandemic. Near term pressures may not reduce margins as much as anticipated . Shows the S&P 500 operating margin for Q1 in 2015 at 15% going up to 16.9 % in Q4 in 2022. Whereas the average historical op. margin has been 14.8% between 2015 and 2019. Source: Ally Invest, S&P Capital IQ. Data as of June 24, 2022 

Investors don’t like it when numbers are reduced, and the reaction to this margin reset will most likely be negative, but once the guidance is digested a key risk to markets will have been removed allowing stocks to breathe a sigh of relief.  

The bottom line 

You might feel like few things are going right in the market and economy. A recession is talked about as a foregone conclusion these days and the market pullback feels like confirmation of this. These rough patches are normal in the business cycle. As volatility continues amid so many uncertainties, continuing to build your financial future is more important than ever. Buying the market at lower prices is a reliable way to grow your investments over the years and decades. As the second half gets underway, there’s hope that the worst is behind us and that better times lie ahead. 

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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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