The first six months of this year have been unpleasant from an economic view, but the last week has been a very positive one for the equity markets. Many people have difficulty understanding that markets move up and down in anticipation of the future. If the current news is negative, but the markets anticipate improvement in some way, markets may move up as the sense of improvement evolves. That is why the stock market is up today. Gas prices have declined somewhat, and inflation is starting to look that it may taper down the road.

The amount of time it takes for stocks to return to prior highs will be largely determined by the path of inflation. LPL Research expects perhaps 1.5 percentage points to come off core consumer prices by year-end—the latest reading for the Fed’s preferred inflation measure, the Core Personal Consumption Expenditures (PCE) Index excluding food and energy for May, was 4.7%. Lower inflation tends to bring higher stock valuations. The market clearly does not expect 8 – 9% inflation to persist based on current stock valuations, but whether inflation eventually settles at 3% or 4% will go a long way toward determining how much higher stock valuations can go from current levels.

If the U.S. can generate some economic growth in the second half as inflation falls and recession fears subside, we would expect valuations to get a nice lift by year-end. But will profit margins be a drag? Current margins may support above-average valuations, but cost pressures remain intense as inflation has been stubbornly slow to come down. Labor markets are still tight. Commodity prices are still elevated even though some commodity prices recently declined. Supply chains are improving but remain a challenge, keeping prices for certain inputs elevated. Revenue growth is expected to slow with the economy, leaving less cushion for companies to hit their margin targets. These potential headwinds to profitability may make it difficult for corporate America to maintain its current high-single-digit earnings growth pace, but our base case calls for steady earnings gains through 2023.

What could it mean if history repeats, and the Republicans take over both the House and Senate this coming November? Well, one of the best scenarios under a Democratic President is Republican control of Congress, with the S&P 500 up an average of 16.3% during those years—hard for investors to ignore. What if the Democrats hold onto the Senate, but lose the House (the second most likely scenario)? That combination has also been quite strong for stocks historically, with the S&P 500 gaining 13.6% on average during those years.

We remain optimistic. Stock and bond valuations have become much more reasonable, and even, in places, historically low. Potentially helping things along, some historical patterns relating to midterm years, the election, and seasonality may even offer support toward the end of the year.

Please contact us if you have any questions. We assume more market volatility is coming our way but know that longer term we are upbeat about our investment prospects. ~Mark and Elise

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