Is high inflation, or the efforts of central banks to contain it, about to induce a recession? Or can policymakers deliver a soft landing? And have equity markets fully discounted these risks?
This debate appears to be the cause of the recent volatility in equity and fixed income markets.
As investors adjust to an unappetizing growth-inflation policy mix, however, we think the real question is whether consumer and corporate fundamentals are strong enough to absorb it, and whether sentiment has become bearish enough to create long-term value.
A ‘Softish’ Landing
Over the past week, various U.S. Federal Reserve officials have suggested that their first 50-basis-point rate hike in 20 years is likely to be followed by more, but that a 75-basis-point hike isn’t currently on the table.
At the same time, they seem to recognize that threading the needle between inflation and recession is getting harder; their goal now appears to be a “softish” rather than a soft landing. We should remind ourselves that a soft or softish landing doesn’t necessarily mean jobs won’t be lost and economic pain won’t be inflicted.
Last week’s U.S. CPI data did little to settle the hard-or-soft-landing debate.
At 8.3%, year-over-year inflation declined from its peak in March, but not as much as expected. Goods inflation declined while services inflation was mixed, with car and truck rental increases easing but air fares accelerating. More worryingly, housing rents, which make up 30 – 40% of the core and headline baskets, are rising faster than at any time since 2006, with no sign of slowing.
Looking more broadly, Europe’s economy is exposed as the war in Ukraine enters what looks to be a grinding stalemate, while Asia’s economy is exposed to the fallout from ongoing COVID-19 lockdowns in China.
That may seem like a confusing picture, but it’s got some simple foundations.
The U.S. economy grew by 5.7% in 2021. The Fed’s latest forecasts for 2022 and 2023 are 2.8% and 2.2%, respectively. We think this is a somewhat optimistic outlook, but even so, a 3.5-percentage-point decline would be equivalent to many a peak-to-trough cyclical slowdown. Regardless of whether we get a hard or soft landing, that is a steep approach to the runway in trying to “land this plane.” As for inflation, everybody knows it’s at a 40-year high and proving more persistent than expected, and that central banks are now committed to getting on top of it.
Moreover, remember that reported GDP growth is real GDP growth: As inflation eases this year, it will amplify the decline in the nominal economy, which includes corporate earnings—turning a 3.5-percentage-point real decline into perhaps a six- to eight-percentage-point nominal decline.
Bottom line: The Fed needs to increase rates to slow inflation, and we expect this will result in slower economic growth and pressure on earnings.
We believe that explains why, for the first time since the Great Financial Crisis, the S&P 500 Index has been down for six consecutive weeks. The steep run-up in real Treasury yields has taken particularly large bites out of longer-duration growth stocks: Large-cap technology stocks, including high-quality names like Amazon, are down some 30 – 40% since their peaks around the end of last year—wiping out a lot of the gains made through the pandemic. According to Bloomberg, Goldman Sachs’ Non-Profitable Tech Index has lost almost 70% of its value since its peak in February 2021, and is down more than 60% since November last year. From cryptocurrencies to unprofitable tech stocks, there has been a dramatic reevaluation of the more speculative corners of the market.
Against that, first-quarter corporate earnings have been solid, and better than analysts’ expectations. In particular, margins held up for most companies, reflecting their ability to pass rising costs onto customers. That, in turn, reflects the ongoing strength of consumer spending against a buoyant jobs market, even as surveys begin to reveal rising concern over inflation and rising mortgage rates.
Are we there yet?
Where does that leave us?
A month ago, we were “Cautious, Not Bearish.” We’ve favored getting defensive and lowering the beta risk in equity portfolios.
We think the market may have gotten ahead of itself in pricing for an imminent recession, which may provide the springboard for a rally over the coming months, especially in beaten-up growth stocks. Various market sentiment indicators suggest an extreme level of bearishness, and positioning in quantitative portfolios and hedge funds is very conservative.
That said, we continue to favor defensive, lower-beta stocks and sectors and quality. While we don’t think a U.S. recession is a near-term risk, we do face a substantial inflationary slowdown that is only just getting underway. We recognize that the possibility of a recession in 2023 is very real, though it is not our “base case.”
While we may see a rally in the next few months, we remain in a period of significant recalibration of risk-asset pricing as the Fed, and other central banks, tighten financial conditions. As a result, there is likely to be continued volatility as investors tread for the bottom of this cyclical sell-off. We have yet to see the “All Clear” sign.
In Case You Missed It
- China Consumer Price Index: +2.1% year-over-year in April
- U.S. Consumer Price Index: +0.3% in April month-over-month and +8.3% year-over-year (Core CPI increased 0.6% month-over-month and 6.2% year-over-year)
- U.K. 1Q 2022 GDP: +0.8% quarter-over-quarter
- U.S. Producer Price Index: +0.5% month-over-month and 11.0% year-over-year in April
What to Watch For
- Tuesday, May 17:
- Eurozone 1Q 2022 GDP (Second Preliminary)
- U.S. Retail Sales
- NAHB Housing Market Index
- Japan 1Q 2022 GDP (Preliminary)
- Wednesday, May 18:
- U.K. Consumer Price Index
- Eurozone Consumer Price Index
- U.S. Housing Starts and Building Permits
- Thursday, May 19:
- U.S. Existing Home Sales
- Japan Consumer Price Index