- Recent inflation was higher than expected, but forward expectations remain anchored, in our view.
- We think elevated inflation will support earnings.
- With this backdrop, we believe large tactical moves become potentially treacherous.
In the book “Alexander and the Terrible, Horrible, No Good, Very Bad Day” by Judith Viorst, a favorite amongst RiverFront’s Investment Team (and some of our children), a central theme is that bad days (or weeks in this case) do occur and must be dealt with, but they do not define our long-term reality. Tuesday’s Consumer Price Index (CPI) print is a good opportunity to apply this wisdom to our investing methodology. The inflation data was a setback whose short-term impact was felt immediately; however, its longer effects are less obvious. When looking under the hood of the CPI report, there are some particularly concerning trends in the housing costs. We believe this number weighed heavily on markets because housing tends to be a stickier component of inflation, in our view. To make a bad week worse, logistics company FedEx preannounced large earnings misses and withdrew its fiscal year outlook, citing high costs and a slowing global economy. While some of FedEx’s issues may be company-specific, we believe the miss could also be seen as a harbinger of global recession given FedEx’s status as one of the world’s largest shipping and logistics companies. The S&P 500 posted its worst week since June with a fourth decline in the past five weeks , including weakness Friday that took the index slightly below the 3900 level of technical support we laid out in the Weekly View: The Fed, The Fears, and The Facts two weeks ago.
Understanding the Ripple Effects of CPI
Given that Jerome Powell and the Federal Reserve (Fed) have been perfectly clear that the inflation side of the Federal Reserve’s dual mandate is more important to them right now than full employment, last week’s CPI number meaningfully adjusted the market’s expectations for the Fed’s policy decision. Using Federal Fund Rate futures, we believe it is possible to calculate the market’s imbedded expectations for future Fed actions. Prior to last Tuesday’s August 2022 data release, the market’s prediction for the September 21st Federal Open Market Committee (FOMC) meeting was a hike of 75 bps with a probability of 91%. After last week, the market is now still expecting a 75-bps hike, but with only a 69% probability. The major difference between these two predictions is that prior to the data release, the market was expecting virtually no chance of a 100-basis-point hike, while now that number has climbed to 31%.
From the fixed income futures market reaction, we can begin to see the concerns behind the equity market’s drawdown. If the Fed follows a path which involves more hiking of their policy rate, growth-oriented securities such as equities tend to lose intrinsic value using the discount rate. Put simply, the discount rate is a measure of the opportunity cost of investing in a stock and is used when valuing equities to put future earnings power into current terms. Since this discount rate is highly correlated with interest rates, when the Fed increases the rate, they also put downward pressure on the equity market. The more that the intrinsic value of a particular stock is tied to long-term expectations of above-average growth, the more forceful the downward pressure is on valuation. Hence, speculative growth stocks have seen the strongest downside price momentum this year.
Inflation Now Vs. Later: Not Losing the Forest Through the Trees
While the concerns stated above are very real and we believe will likely lead to volatility in both the fixed income and equity markets in the short term, it is important to not lose sight of long-term investment prospects. One way to monitor the fixed income market’s longer term inflation expectations is through something called US Treasury Inflation-Protected Securities (TIPS) breakeven rate. The TIPS breakeven rate is the difference in yield between the inflation protected security (the TIP) and the regular Treasury bond. This difference can be thought of as the bond market's collective future expectation of inflation. Figure 1 is a 1- and 10-year view of inflation based on this metric.
While the 1-year expectation for inflation (the blue line above) ticked up on the August inflation print, its level is muted compared to earlier this year. Additionally, while long-term inflation expectations (the orange line above) are above Chairman Powell’s stated goal of 2%, one can see that they remain relatively tame. We believe this signals that the bond market is expecting long term inflation to be brought under control through a combination of Fed actions already taken, as well as those that are already factored into Wall Street’s expectations. Additionally, we believe supply chain improvements will help ease inflationary pressures.
The bar chart (below) illustrates realized annual growth of sales and revenue by quarter through present time, as well as analyst expectations of future growth. While growth is expected to slow in the coming quarters vs 2021 (something we anticipate as well), it’s remains positive for three out of the next four quarters. This comes despite significant revisions downward in recent months.
In our 2022 Outlook we pointed to some analysis that suggests higher-than-average inflation historically has been correlated with higher-than-average corporate earnings, particularly for companies who can successfully pass higher costs onto their end markets. Thus, we believe that earnings in nominal terms will remain resilient in the back half of 2022. We would also point out that the current pessimism in the markets identified in last week’s Weekly View: Tactical Rules Are Mixed But Waving The Caution Flag means it is likely that extremely pessimistic sentiment is weighing on these estimates.
Implications for Portfolios: Hope is Not a Strategy, but Neither is Fear
In conclusion, we believe that the negative sentiment caused by the Fed’s pivot earlier this year, COVID-19’s lingering effect on supply chains and the war in Ukraine has caused an environment where each bit of bad news can make it feel like the sky is falling. While the short-term inflation and growth data have been challenging, it is important to remember that a single data point is not necessarily predictive of future conditions. While we see some reasons for the market to remain bearish short-term, we think earnings are strong enough at present to make a further market pullback difficult to trade successfully.
For investors with a shorter time horizon, short-term volatility is a bigger concern. Therefore, our shorter horizon portfolios, which tend to be more risk-adverse, maintain a slight underweight positioning to both equities and interest rate sensitivity. The shorter-horizon portfolios also maintain a slight overweight to cash for tactical flexibility and as a risk ‘shock absorber’. We may look to reinvest cash opportunistically by extending maturities on the fixed income side.
For investors with a longer time horizon, short-term volatility cannot be ignored but should not trump long-term opportunities and themes. To this end, our longer horizon, more risk-tolerant portfolios are roughly neutral to equities with a higher portfolio yield than benchmarks. In these portfolios, we maintain a focus on security selection as well as risk mitigation through alternative yield strategies and foreign currency hedging. We have conviction in shorter-maturity high yield fixed income. While currently a volatile asset class, we believe the yield advantages will outweigh this volatility over time. On the equity side, we maintain an underweight to consumer themes and an overweight to sectors such as energy and high-quality technology, very different business models whose earnings nonetheless we believe can continue to grow against an inflationary backdrop.