Inflation Hits Hard Again: What Investors Need to Know
In this article we review:
- Recent higher than expected inflation data creating market volatility
- What this new data could mean in terms of Federal Reserve rate hikes in the months ahead
- Potential impacts to the equity and fixed income markets over the upcoming year
- Recession probability and severity scenarios during the year ahead
Inflation for the month of August provided the type of surprise investors certainly do not like to see when, on September 13, the consumer price index (CPI) report exceeded expectations, sending interest rates climbing and stocks tumbling. With a year-over-year headline reading of 8.3% and a core (ex food and energy) measure of 6.3%, both numbers were well above consensus forecasts. As a result, the S&P 500® fell more than 4% and the 2-year Treasury bond yield rose to 3.78%, its highest level in more than 15 years.
Given this unwelcome news and its ripple effects across the markets, we believe key focus points for investors should include:
The path toward moderating rates of inflation looks now to be elongated. While the headline CPI number fell from its 8.5% reading of July, that decline was less than expected, and more disappointing was the 0.4% rise in year-over-year core CPI from July’s 5.9% level. This seemed to infer the downward pace of inflation is not yet fully established, as many had previously thought, and the road to core rates getting on a directional path toward the Federal Reserve’s 2% long-term inflation goal could be a longer one than recently believed to be the case.
While we see core rates of inflation ultimately moderating into the 4% range in the upcoming year, it is now important to recognize this path will likely be choppy and extend into CY 2023. Our thesis of core inflation mitigating over the year ahead is based on Fed rate hikes weakening demand, labor markets softening, and supply chain bottlenecks easing to some extent as the economy further shifts from goods to services. Nonetheless, given this recent data and the directional reversal of core CPI, investors should now be prepared for core inflation to remain above the 4% threshold into 2023.
Fed rate hikes are likely to come faster and in higher magnitudes. Following the CPI report, the federal funds futures market immediately priced in expectations of higher rate increases in the months ahead as the Fed will clearly need to take a more aggressive stance to combat inflation in its upcoming meetings between now and year-end. In addition, the concept of any monetary easing in 2023 now seems to be a distant probability.
Look for long-term interest rates to rise in the months ahead and for the yield curve to remain inverted. We expect the long end of the yield curve to continue rising as seen in the 10-year Treasury yield, which has now eclipsed 3.45% (September 13 close 3.47%). However, we expect short-term rates to rise more, resulting in a continued inversion of the two-year to 10-year yield curve, historically an accurate indicator of a pending recession.
The probability of the Fed achieving a soft landing has declined considerably. Taking into account the impact inflation is likely to have on consumer activity along with rising expectations of higher interest rates in the months ahead, we rate the probability of the Fed engineering a soft landing for the economy, defined as successfully curtailing inflation while avoiding a full-fledged recession, as now being remote.
The larger question looming is how severe an awaiting recession might be. At the current time, we lean toward a moderate downturn more along the lines of recessions incurred in 1990–1991 and 2000–2001 that lasted less than a year and saw peak-to-trough GDP declines in the 1% range. Should 3Q 2022 GDP growth — currently tracking at only slightly positive annualized growth of less than 1% (Atlanta Fed GDP NOW September 15) — slip into another negative growth quarter, this could add fuel to the debate as to whether a more prolonged and severe recession could be developing.
We anticipate corporate earnings estimates for 2023 to be revised downward in the months ahead and for stock volatility to remain high. Official bottom-up estimates for CY 2023 S&P 500 net operating income continue to hold at approximately 8% growth (FactSet Earnings Insight, September 9). We would expect those forecasts to be revised close to flat growth by year-end. In addition, while we see stocks as mostly range-bound between now and year-end, perhaps in a band of approximately 3,700 to 4,200 on the S&P 500, we believe price variability within that range to be high for the remainder of 2022. We are maintaining our year-end 2022 price target on the S&P 500 of 4,050.
We are adjusting our year-end expectations for both short- and long-term interest rates. We now expect the lower bound on the federal funds rate to conclude the year at 4.25%, and we see a realistic range on the 10-year Treasury yield within this time frame to be 3.75%–4.0%, reflecting a fully inverted yield curve.
We continue to believe the equity and credit markets could be setting up well for 2H 2023, potentially coinciding with core rates of inflation mitigating into the 4% range, the Fed‘s tightening cycle concluding, a prolonged and severe recession averted, and corporate earnings growth setting up for a healthy rebound in CY 2024. However, until then, as we have said on many occasions before, this will certainly not be a market for faint hearts or short time horizons.
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The 2-year Treasury rate is the yield received for investing in a U.S. government-issued Treasury security that has a maturity of two years.
The 10-year U.S. Treasury bond is a U.S. Treasury debt obligation that has a maturity of 10 years.
Dow Jones Industrial Average: The average performance of certain blue chip stocks, generally regarded as an indication of how the market at large is performing.
S&P 500® Index: An unmanaged index of 500 common stocks primarily traded on the New York Stock Exchange, weighted by market capitalization.
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