Can Markets Move Higher with Inflation Finally Heading Lower?
By Mitchell Anthony
December 23, 2022
Financial markets have been extremely volatile throughout most of 2022 as high inflation shocked the economy and central banks around the world reacted with significantly higher interest rates. The inflation battle has taken significant time to even dent inflation and the path out of the crisis is still unclear. As a result stocks, bonds, and commodities have all been volatile as inflation and the cost of money is critical to the success of an economic cycle.
Inflation peaked in October and has begun to tilt lower but the path back to the feds target of 2% inflation is still very uncertain. Fixed-income securities have declined in value substantially throughout most of the year as the fed pushed rates higher although the decline has paused over the last few months. Equities have followed a similar path but a modest rally has begun several times that is now again struggling. Yields on treasuries have quadrupled this year reaching as high as 4.5% but falling back to 3.7% today.
The equity market has ebbed and flowed since the June bottom and three rebounds have occurred. While the first two failed, the third has been quite strong narrowing the S&P 500 loss to -18% YTD.
It is clear that investors are anxious to return to stocks still remembering how good the returns were for the last decade. However inflation problems continue to obstruct anxious stock investors. Further, company specific problems have developed for the corporate superstars that have led the economy and the market for the last decade. There are several tech and Internet titans that are under siege. Amazon perceived to be the world’s greatest company has now found that its house is out of order. They have far too much retail capacity and have over-expanded their business as though the pandemic fueled recovery would go on forever. We’ve also discovered that the new CEO Jassy lacks the vision of his predecessor Bezos. Amazon’s web service division which has been the primary driver of their stellar growth for the last five years has now encountered a bit of a slowdown because two of their major customers have found their businesses in decline. Crypto and the mortgage businesses are on the sidelines of this economic cycle today. Additionally, Amazon continues to pour money into questionable product lines such as “Alexa” which takes a toll on their earnings. They are not the only one to fall victim to this problem but most of us have put them on a pedestal as a company who would never make errors such as this. With the economy in a broad slowdown the entire retail sector is under siege with most having problems with inventory management and supply chain consistency. Amazon is still a great company but they have lost their momentum and it is unclear how much time it will take to regain the growth rate of the past cycle or if it is even achievable again.
Google and Facebook are also still great companies but likewise have developed some problems over the last decade that have dimmed the outlook for these titans. Similar to Amazon, headcount was expanding like the Covid recovery would continue indefinitely. Facebook lost its way by focusing on the meta-verse while their core business was under siege by changes to Apple’s iPhone privacy settings.
Netflix is adding a new revenue stream through an advertising model that has shown tremendous promise as they have stumbled with domestic membership growth. This, along with a gloomy outlook for global growth has caused the valuation to get cut in half despite a very strong rate of growth for earnings.
Apple is dealing with regulatory headwinds that are challenging their ability to keep their monopolistic app store intact. Their business model is quite strong and their products are almost perceived to be as stable as milk and cereal in the diet of Americans.
These corporate superstars still have secular tailwinds that will push them for many years to come, however the secular tailwinds might not be enough to allow them to avoid a substantial decline in earnings as we move through this recession.
The problems noted above with the FAANG superstars is also common in many other parts of corporate America. The economic boom of the last decade caused more than a few corporate CEOs to take their eye off the ball and miss the next turn. This recession will give all of these players a chance to reset their business plans and make the best of the next decade.
Inflation is now tilting lower and optimism has risen that this inflation cycle will end quickly.
Expectations in the market for inflation over the next year are now near the feds target of 2.5%. This is lower than even what the Fed is projecting! The Fed is expecting a slow and bumpy decline to 2.5% that will take two years or more while the market expects it to be almost linear over the next year. Structural problems with labor will likely keep inflation from returning to 2.5% as currently expected by investors. The structural problems involve a shortage of labor due to a slowdown in immigration, unexpected retirements of baby boomers, and the fact that Covid related stimulus is still keeping workers at home and demotivating them from returning to work. Current expectations in market prices reflect extreme optimism for inflation. Futures and swap prices for CPI inflation levels by late next year show investors believe inflation will be down to 2% within 12 months.
The Fed has said that it expects to raise rates well above 5% and keep them there for an extended period, whereas the market is betting that rates never get above 5% and that the Fed will change to a policy of cutting rates by the end of 2023. Obviously there is a difference between the fed speak and the market speak. Someone here will be proven wrong. It may well be that the truth lies in the middle as is typical. We believe high interest rates will likely persist for another 12 to 18 months or until inflation is anchored at 2.5%. We look to the horizon for signs that the structural problems with labor are resolving but see nothing significant yet. There are other signs that the economy is feeling the grip of higher interest rates and undoubtedly this will work its way into lower prices in the year ahead. The housing industry has slowed dramatically but prices have only just begun to decline broadly down and are down about 10% from the peak price achieved nationwide. Overall the service side of our economy has been very resilient and no signs of a slowdown have been visible in the service sector. Employment is now starting to show some weakness as layoffs are rippling through other industries outside of services. Wage gains while elevated are easing back now.
The outlook for the financial markets and the economy
We believe the rally in the stock and bond markets are due to pause if it hasn’t started already. The equity market could make new highs with further news on inflation and more importantly improvement in the structural problems with labor and employment. This seems like wishful thinking for the time being.
The leadership in the market has changed from growth stocks to value oriented type names. Consumer Staples, healthcare, financials, and aerospace and defense have taken the lead and will likely continue to lead the market as we move through this period of modest growth over the next few quarters. Bond prices will likely turn lower and yields turn higher as the inflation proves to be more difficult than the optimists currently believe possible.
Both the stock and bond markets will likely be range bound with limited upside and modest downside as there is a strong balance in the marketplace between optimism and pessimism. There actually is more of a bias toward optimism currently.
We sit in a relatively heavy cash position and have increased our positions in consumer staples, financials and healthcare. We have decreased our positions in tech and the FAANG names a bit further.
We remain optimistic.