Fed credibility intact as inflation hits new peak

Markets continue to be driven by hopes and fears about inflation, central bank policy, and economic growth. It will take some time for a clear picture to emerge.

But the past week brought further signals on all three fronts:

US consumer price inflation increased 9.1% year-over-year in June, its highest level since November 1981. Gasoline and food prices drove headline US CPI up 1.3% month-over-month, compared with expectations for a 1% jump. Stripping out food and energy, the core measure of inflation increased 0.7% month-over-month and 5.9% year-over-year, only a slight moderation from May’s 6% annual pace.

In response, markets moved to price in a more aggressive, front-loaded Federal Reserve rate hiking cycle. Compared with prior to the CPI data, December fed funds futures priced in as much as an additional 33 basis points of Fed tightening this year. However, the extent of these expectations and the chances of a 100bps hike at this month’s FOMC meeting were both scaled back after Fed officials Christopher Waller and James Bullard said they favored a 75bps hike.

Market pricing also implies that the Fed will be able to stop hiking as soon as February, as slower growth brings inflation down, and that the central bank could cut rates in 2023.

Concerns about the impact of aggressive rate hikes on economic growth and corporate profits were highlighted last week by weaker earnings from some big US banks as the second-quarter reporting season got underway. JPMorgan Chase reported a larger-than-expected 28% fall in quarterly profit after it made a USD 1.1bn provision for potential credit losses in the face of growing risks of a recession, compared with last year when it released USD 3bn from its reserves. Morgan Stanley’s profits declined by a larger-than-expected 30% on weakness in its investment banking business in the face of lower global deal activity.

After falling for much of the week, the S&P 500 rebounded 1.9% on Friday to pare its weekly decline to 0.9%. The inversion of the 2-year/10-year US yield curve deepened to –21 basis points, with 10-year yields declining 16.5bps on the week. The US dollar reached parity against the euro for the first time since 2002, but depreciated into the end of the week as sentiment toward risk assets improved.

What do we think?

Price developments in fixed income markets in the wake of the US CPI data suggest that the market is beginning to believe more front-loaded Fed tightening can subdue inflation, even as it continues to hit new multi-decade highs.

The Fed has indicated its intent: The word “inflation” appeared in the latest FOMC minutes 89 times while the word “recession” did not appear once. Markets appear to view the Fed’s intentions as credible, and market-based measures of inflation expectations have remained contained. In addition, the latest University of Michigan survey showed long-run inflation expectations fell to 2.8% per year, down from 3.1% in June.

All else equal, the risk of our “stagflation” scenario—in which markets begin to fear the Fed losing control of inflation—appears to be receding.

In the wake of the CPI data, equity investors seemed more concerned that the impact on consumer spending of high inflation and the Fed’s efforts to contain it could weigh on economic growth and corporate profits. However, we note that part of the reason financial sector profits are down this year is due to large loan-loss reserve releases last year, which boosted bank profits to unsustainably high levels.

More generally, we do think that corporate profit growth is likely to slow given the challenges posed by the highest inflation in 40 years, a hawkish Federal Reserve, a strong dollar, the war in Ukraine, and rolling China lockdowns.

But we don’t think profit growth is declining sharply. Rather, we anticipate incremental pockets of weakness related to slowing consumer spending, still-difficult supply chains, cost pressures, and currency headwinds. Not all companies will be affected equally. Segments of enterprise tech spending, demand within industrials, and higher-end consumer spending all appear to be holding up.

Our expectations for forward profit estimates, which are below consensus, remain unchanged. For full-year 2022 and 2023, we expect S&P 500 earnings per share of USD 227 (8% growth) and USD 235 (4% growth), respectively. Our sense is that many investors think S&P 500 earnings will be even lower than our forecasts; if the economy slips into a recession, we would likely review our estimates.

How do we invest?

Markets are likely to remain volatile in the coming months and trade based on hopes and fears about economic growth and inflation. A more durable improvement in market sentiment is unlikely until there is a consistent decline both in headline and in core inflation readings to reassure investors that the threat of entrenched price rises is passing.

Against this uncertain backdrop, we advise investors to build a portfolio that is resilient under various scenarios:

• Invest in value. Inflation is set to remain above central bank targets in 2022. Based on analysis stretching back to 1975, value sectors tend to outperform growth stocks when inflation is above 3%, which is likely to be the case for some time. We think value would perform particularly well in our “soft landing” scenario, as increased confidence that corporate earnings can stay resilient supports some of value’s cyclical sectors, including energy. We also favor the UK market, which has a high weighting toward value sectors.
• Add to defensives and quality, make use of volatility. To build up defenses against a potential “slump,” in which weaker economic data drives lower corporate profit expectations and further downside in stocks, we believe investors should add exposure to quality-income stocks, the healthcare sector, resilient credits, and the Swiss franc. Capital-protected strategies may also allow investors to use volatility to work in their favor and mitigate potential downside risks.
• Manage a Liquidity strategy and diversify with hedge funds. As the basis of a strong portfolio, to manage the risk of forced selling, earn yield, and prepare for potential future opportunities, investors should build and manage a Liquidity* portfolio, sized to meet 3–5 years of cash flow needs. This will likely consist of a mix of cash, cash alternatives, and short-duration bonds. Investors should also consider an adequate allocation to hedge funds, which have the potential to deliver performance, even if bonds and equities both are falling.

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*Timeframes may vary. Strategies are subject to individual client goals, objectives and suitability. This approach is not a promise or guarantee that wealth, or any financial results, can or will be achieved.