Improving US inflation boosts equities

The S&P 500 rallied 5.9% last week, its best weekly performance since June, after lower-than-expected US inflation data rekindled hopes of less aggressive rate hikes from the Federal Reserve. The 10-year Treasury yield fell 35 basis points, while the 2-year yield dropped 33bps—their largest weekly moves since the early stages of the pandemic in March 2020.

The headline US consumer price index rose 0.4% month-over-month in October, less than the 0.6% consensus forecast by economists. The core rate, which excludes volatile food and energy prices, rose 0.3%, half the pace seen in both September and August. The year-over-year rate of inflation also slowed, to 7.7% for the headline reading, the first time it has been below 8% since February. This is down from a peak of 9.1% in June. The core rate slowed to 6.3% in October year-over-year, from 6.6% in September.

Cooling inflation added to a mounting consensus in markets that the Fed will be able to slow the pace of monetary tightening at its next meeting in December, with a 50bps hike seen as likely after four consecutive 75bps increases. Investors also scaled back expectations for a peak in rates to around 4.9% in June 2023.

With yields falling, the tech-heavy Nasdaq advanced 8.1% over the week while the Dollar Index (DXY) fell 4%.

Technical flows also supported the S&P 500’s post-CPI rally, with investors buying call options for upside exposure and systematic strategies adding to risk positions as a result of market momentum and falling volatility. Earlier in the week, concerns about crypto exchange FTX—which later filed for bankruptcy protection—had prompted a risk-off move in markets.

What do we expect?

The moderation in the pace of inflation is a welcome development. While it is still far too early to declare the inflation threat over, there were several positive aspects to the data. Excluding shelter, core inflation was flat on the month. While the cost of shelter rose 0.8% month-over-month, this reflects the lagged effect of an overheating market that peaked last year. More timely data on new leases suggests that rent inflation is slowing. Shelter prices, which account for around a third of the overall CPI basket, may rise strongly for a few more months, but should slow after that. In addition, core goods prices were negative, falling 0.4% in October, adding to evidence that the excess demand for goods during the pandemic has continued to subside.

However, it’s unlikely that the Federal Reserve will consider its job done on inflation.

1. The Fed will want to see several consecutive months of tamer inflation before considering a pivot to a more dovish stance. Services inflation, at 0.5% month-over-month, remains a concern. And Fed Governor Christopher Waller emphasized that the October CPI release was “just one data point,” and cautioned that inflation remains “enormous.”
2. The Fed needs to see signs of a cooling labor market. The latest employment data for October, with strong jobs growth and unemployment only fractionally above a 50-year low, did not provide much reassurance that any slowdown is occurring as of yet. Wage growth is elevated. The Atlanta Fed’s three-month moving average is down from 6.7% in June. But at 6.3% for September, this is well above the level that would be compatible with the Fed hitting its inflation target. Meanwhile, job openings rose in September, as measured by the JOLTS release, with about 1.9 available jobs for each unemployed person.

The bottom line on monetary policy is that the October inflation data will make it easier for the Fed to justify a more modest 50bps hike in December. But we still think the Fed is likely to raise rates by at least another 100 bps in total before it pauses the hiking cycle. Meanwhile, the cumulative impact of prior rate rises will continue to weigh on economic growth and corporate profits.

With the exception of a spike at the onset of the pandemic, the Chicago Fed’s National Financial Conditions Index is close to its tightest since the global financial crisis, and the impact of this is becoming more apparent in lending behavior and markets. November’s Fed quarterly Senior Loan Officer Opinion Survey showed that 39% of banks are tightening lending standards for commercial and industrial loans. The current tightening trend has accelerated sharply over the last year and suggests further downward pressure on S&P 500 profits in the quarters ahead.

How do we invest?

Taking all this into account, we still view the risk-reward outlook for equities as unfavorable over the next three to six months. We do not think the macroeconomic prerequisites for a sustained market rally are in place yet. However, last week demonstrated that sharp swings in investor sentiment can drive periodic bounces. Market volatility is likely to remain elevated, and we favor strategies that add downside protection while retaining upside exposure. We recommend focusing on the more defensive areas of each asset class.

Within equities, we like capital protection strategies and quality-income stocks, along with the healthcare and consumer staples sectors—which should be relatively resilient as economic growth slows. In currencies, we like the safe-haven US dollar and Swiss franc relative to sterling and the euro, while in fixed income we prefer high-quality and investment grade bonds relative to US high yield.

With inflation still well above central bank targets, we retain our preference for value stocks, which outperformed growth stocks by 18 percentage points in the first 10 months of 2022 (based on MSCI indexes). Energy remains one of our preferred global equity sectors. Regionally, we like the cheaper and value-oriented UK and Australian equity markets relative to US equities, which have a higher exposure to technology and growth stocks, and where valuations are higher.

High equity-bond correlations this year have underlined the importance of seeking alternative sources of returns, for example in hedge funds. Macro strategies delivered an average return of 11.5% in the first 10 months of 2022, based on HFR data, and we expect them to continue to perform well in volatile markets.

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