It has been a rough start to the year for risk assets with the S&P 500 off 7%+ and US small cap stocks and US growth stocks down even more. Most investors continue to cite the hawkish pivot by the Fed and the backing up in bond yields as the primary catalysts for the pullback. Away from the stock market, the Omicron variant has weighed on growth as supply chains remain stressed, particularly coming out of China, while inflation is causing most companies to expect higher expenses in 2022, especially wages. Finally, geopolitical tensions are elevated as the West tries to discern Russia’s intentions toward Ukraine.
As we think about the markets and the economy, we are reminded that—while distinct—they are linked, with economic conditions ultimately reflected in share prices, helped higher by growing revenues and earnings, or helped lower by declining revenues and earnings. Of course, there is the historic phenomenon of the market as a leading indicator, inflecting higher while the economy is still struggling and inflecting lower while growth is still robust.
That said, while a high single digit pullback in equity prices is never enjoyable, we don’t believe recent market weakness is indicative of a coming recession; in fact, given the health of the US consumer, growth should accelerate as the Covid case count comes down—as we hope and expect. And while stocks have stumbled, broader indicators of financial health remain on firm footing, including the Chicago Federal Reserve’s National Financial Conditions Index, a comprehensive look at financial conditions in money markets, debt and equity markets, and traditional and “shadow” banking systems (see chart). Positive values of the NFCI indicate financial conditions that are tighter than average, while negative values indicate conditions that are looser than average. Historically, the index has moved above zero and into positive territory as the US economy slides into recession, as companies and consumers find it more difficult and more expensive to access capital. Today, the index is well below zero, indicating financial conditions remain broadly supportive of the economy, a dynamic that should help drive ongoing growth in corporate revenues and earnings, and higher prices for US stocks.