Markets Sell Off as Inflation Bites Hard: What Investors Need To Know
The equity and credit markets are currently in a desperate search for signs that inflation has peaked or is in the process of peaking. Unfortunately, the May consumer price index (CPI) report released on June 10 not only showed no signs of this but further exacerbated concerns inflation rates are continuing to move higher.
Coming in at a staggering year-over-year rate of 8.6%, headline CPI posted its highest level since December 1981, representing an unexpected increase from the April report of 8.3%. While core CPI (ex food and energy) did decline to an annualized rate of 6.0% from 6.2% the month previous, it provided little to no solace for investors as bond yields jumped, stocks sold off fiercely, and consumers were left to ponder the highest overall rate of inflation since the days before Joe Montana won his first Super Bowl.
Against this backdrop, we believe investors should consider the following points pertaining to the current economic environment:
Probability of declining inflation rates in the months ahead. While predicting the precise peak of any inflationary cycle, particularly one as torrid as this, is extremely challenging, we believe there is still a good probability core inflation rates can moderate into the 4% range by year end. This would be based on further monetary tightening by the Federal Reserve, a shift in consumer preferences from goods to services as COVID transitions from pandemic to endemic status, loosening of global supply chain constraints, and the reversal of worker shortages as many of those who departed the labor force last year are now seeking returns amidst changing economic conditions.
The Fed will have to increase its pace of rate hikes. Prior to the May CPI report, markets had downgraded probabilities of faster and higher rate increases following expectations of 0.50% federal fund rate hikes at the upcoming June and July meetings. Given the May CPI report, we believe the Fed will now need to seriously consider a revised and upward pace of rate increases, perhaps taking the fed funds target range to a lower bound of 3.5% by year end.
Recession risk has increased. While still far from a foregone conclusion, it is nonetheless more apparent the risk of recession has increased. We categorize this risk into two segments. The first being the risk of a relatively mild supply-oriented recession in the immediate months ahead. The second being that of a more severe demand-oriented recession sometime between now and the end of CY 2023. We attribute about a 20% probability to each for an overall 40% risk of recession by the end of next year.
War in Ukraine and global oil prices continue to be wild cards. While the human tragedy in Ukraine transcends the markets, investors are still forced to gauge its inflationary impact, which continues to be meaningful. Following the European Union decision to join the U.S. in banning Russian oil and imposing a phased-in embargo as part of a new round of sanctions, we would expect this further constraint upon global supply to further pressure oil prices upward into the summer months, potentially challenging the earlier March highs. This unfortunate combination of war and its additional impact upon energy and other commodity-based markets presents further global economic uncertainties.
In addition, we believe investors should also consider the following points pertaining to the current market environment:
Stocks have likely fallen to opportunistic levels. While many are focusing on calling a market bottom, we would instead emphasize identifying long-term entry points for stocks reflecting purchase levels at which there is a relatively high probability of above average longer-term returns over multiyear time frames. We believe following the market sell-off since the year began, and short of future persistent inflation at current levels combined with a severe demand-driven recession stunting economic and earnings growth for about two years or longer, that major stock indexes are now at or very close to such entry points.
Corporate earnings estimates are still holding up. As of June 14, aggregate bottoms-up analyst estimates for S&P 500® net operating earnings growth in both CY 2022 and CY 2023 reflect approximately 10% annualized growth. Strong sentiment over the past few months seems to be that these numbers will soon have to be lowered. However, this is yet to occur. If it does not, and CY 2022 concludes without such expected negative revisions, perhaps resulting from a redistribution of earnings growth between sectors rather than a cumulative decline throughout them all, we believe stock prices will likely move higher.
Recent rise in bond yields present income opportunities. Against the recent backdrop of rising interest rates and widening credit spreads, corporate bond yields have ballooned in the past several months. In fact, longer-term investment-grade bond yields are now averaging more than 5% (June 14 ICE BofA BBB US Corporate Bond Index Effective Yield), representing approximately 2½ times that of last October. High-yield bonds are averaging more than 8% yields (June 14 ICE BofA US High Yield Index Effective Yield), close to twice that of last autumn’s level. In the event inflation moderates in the year ahead and a severe recession is avoided, these yields could represent some of the best income opportunities in recent memory.
In summary, equity and credit market investors should probably brace for more volatility as the rapid pace of inflation, combined with higher interest rates and recession fears, plays out in the months ahead. As we have said before, this is clearly not a market for faint hearts or short-time horizons. However, during this time we believe there are opportunities for stock investors with longer-term horizons to benefit from favorable entry points and for bond investors to lock in attractive yields as these bear market concerns ultimately resolve in the year or so ahead.
Investments are subject to market risk, including the loss of principal. Asset classes or investment strategies described may not be suitable for all investors.
Past performance does not guarantee future results.
Equities are subject to market risk meaning that stock prices in general may decline over short or extended periods of time. Indexes are unmanaged and an investor cannot invest directly in an index.
Fixed income investing is subject to credit rate risk, interest rate risk, and inflation risk. Credit risk is the risk that the issuer of a bond won’t meet their payments. Inflation risk is the risk that inflation could outpace a bond’s interest income. Interest rate risk is the risk that fluctuations in interest rates will affect the price of a bond. Investing in floating rate loans may be subject to greater volatility and increased risks.
Growth stocks typically are particularly sensitive to market movements and may involve larger price swings because their market prices tend to reflect future expectations. Growth stocks as a group may be out of favor and underperform the overall equity market for a long period of time, for example, while the market favors “value” stocks. Value investing carries the risk that the market will not recognize a security’s intrinsic value for a long time or that an undervalued stock is actually appropriately priced.
Investments in global/international markets involve risks not associated with U.S. markets, such as currency fluctuations, adverse social and political developments, and the relatively small size and lesser liquidity of some markets. These risks may be greater in emerging markets.
The COVID-19 pandemic has caused substantial market disruption and dislocation around the world including the U.S. Economies and financial markets throughout the world are increasingly interconnected. Economic, financial, or political events, trading and tariff arrangements, terrorism, technology and data interruptions, natural disasters, and other circumstances in one or more countries or regions could be highly disruptive to, and have profound impacts on, global economies or markets.
The information included in this document should not be construed as investment advice or a recommendation for the purchase or sale of any security. This material contains general information only on investment matters; it should not be considered as a comprehensive statement on any matter and should not be relied upon as such. The information does not take into account any investor’s investment objectives, particular needs, or financial situation. The value of any investment may fluctuate. This information has been developed by Transamerica Asset Management, Inc. and may incorporate third-party data, text, images, and other content to be deemed reliable.
Comments and general market-related projections are based on information available at the time of writing and believed to be accurate; are for informational purposes only, are not intended as individual or specific advice, may not represent the opinions of the entire firm, and may not be relied upon for future investing. Investors are advised to consult with their investment professional about their specific financial needs and goals before making any investment decisions.
Transamerica Asset Management, Inc. is an SEC-registered investment adviser. The funds advised and sponsored by Transamerica Asset Management, Inc. include Transamerica Funds and Transamerica Series Trust. Transamerica Asset Management, Inc., is an indirect wholly owned subsidiary of Aegon N.V., an international life insurance, pension, and asset management company. 1801 California Street, Denver, CO 80202, USA