Investing
Will central banks have to cause a recession to tame inflation?
We’re answering the top questions on investors’ minds—and what they mean for portfolios.
Our Top Market Takeaways for February 11, 2022.
Markets in a minute
Gradually and then suddenly.
The biggest story so far this year (and this week, and yesterday) in markets is that central banks are going to be fighting realized inflation more aggressively than they have in decades.
In today’s note, we wanted to review the latest news and put it in the context of the big picture in a quick Q&A format.
We will also answer the most important question, which is probably this: Will central banks have to cause a recession in order to tame inflation?
[Q] What is the latest on inflation?
[A] The latest Consumer Price Inflation data came in at another 40-year high, and there were very little signs of easing price pressures. Goods inflation continues to soar: Apparel and used car prices rose by over 1% in January from December. On the services side, rent inflation accelerated to a 50 basis points (bps) month-over-month pace in January. In all, it seems like price pressures broadened across components.
It makes most sense to analyze the inflation numbers on a month-over-month basis at this point because the near-term trend seems most important for central bank policy (not to mention the base effect issues of comparing a pre- and post-vaccine economy), but it still helps to look at the year-on-year numbers to get a sense of just how different the pace of change is now from how it was before the pandemic.
For example, medical care costs are now actually rising at a slower pace than they were in February 2020. Used car prices are the best example of the opposite. They were in decline in February 2020, but are now up over 40% on a year-on-year basis. And 23 out of the 24 major components of the Consumer Price Index have gained more than 2% (around the Federal Reserve’s long-term target) over the last year.
[Q] How did markets take the news?
[A] Not well, and the bond market took it worse than the equity market. Two-year Treasury yields, which are very sensitive to changing perceptions of Fed policy, surged by ~22 bps, their largest daily move since 2009. Ten-year Treasury yields topped 2% for the first time since the summer of 2019, and investment grade bonds lost ~92 bps.
In equities, the S&P 500 lost about 2% (after a strong rally on Wednesday), but the most important information is probably contained (as it usually is) beneath the surface. Mega cap tech stocks underperformed (the NASDAQ 100 was down almost 2.5%), and homebuilders, which usually suffer when interest rates rise, lost over 4%.
Cyclical stocks outperformed, with banks and metals and mining stocks the standouts. Another observation: The high growth/speculative cohort of stocks that were at the epicenter of the January volatility are ~15% above their lows from two weeks ago, despite the hot inflation data and more aggressive bond market expectations for Fed policy. This suggests that a lot of pain was already in the price for these names.
[Q]: Does the latest inflation data change things for the Fed?
[A] We thought the Fed was going to be on the move soon, but now it seems like it will act with even more urgency. It seems like it will raise rates at consecutive meetings through the summer, and we expect it will approach 1% on fed funds before reassessing based on the latest data.
[Q]: Will the Fed raise interest rates by 50 bps in one go? (It hasn’t since 2000)
[A] It could. St. Louis Fed President James Bullard suggested yesterday that he was in favor of a 50 bps move, and markets are more or less priced for one right now. If we don’t see real pushback on the idea from other Federal Open Market Committee members over the coming weeks, we should expect it.
[Q]: Will it take a recession to tame inflation?
[A] This is the one million dollar question. We laid out our thinking after the December CPI print, and our view is more or less the same today: We think there are enough ways for inflation to recede toward more tolerable levels without an intervention from the Fed that causes a material downturn. Private rental inflation metrics are already falling rapidly, the labor market should see more supply as Omicron recedes, the net percentage of firms planning to raise selling prices has fallen for two consecutive months, and there is softness emerging in some of the goods that benefited from pandemic-era demand (check eBay for Peloton bikes, or Costco for outdoor deck heaters). Goods deflation could happen gradually, then suddenly.
It is also important to think about what level of interest rates will start to materially slow the economy. Mortgage rates have already risen to a place where we estimate they will start to cool the housing market, but the supply/demand imbalance and strong wage growth will still likely be a support for the sector. We will be watching the data in rate-sensitive categories closely, but our take at the moment is that the economy can handle rates that are a bit higher than what the market currently suggests.
[Q]: How should my portfolio be positioned?
[A] The Fed is going to be a headwind for investors, but the economy looks phenomenal. Only 4% of the small businesses that responded to the NFIB survey reported that weak sales were their biggest problems, the lowest level on record. Corporate earnings from companies such as Uber, Disney and MGM suggest that pent-up demand for “real life” activity is robust. Household debt service as a percentage of income is at one of the lowest levels on record. Consumer card spending is accelerating. Importantly, given all this inflation talk, corporate margins in the United States are set to expand for the sixth consecutive quarter. So far, the “wage-price spiral” has been all bark and no bite.
We believe nominal wage, revenue and profit growth will run at a healthy pace this year. When we put this together with a view that the Fed will be focused on fighting inflation with higher interest rates, we feel comfortable with our overweight to stocks relative to bonds.
As we noted in our outlook for this year, portfolios that are positioned for a reprise of mediocre demand and tepid inflation are at risk. Focusing on quality businesses with secular demand tailwinds that generate their revenues from the real economy (such as technology infrastructure, banks and higher-end consumer spending and mobility) seems important. Sectors such as healthcare that have a long history of generating stable profits in all economic environments also seem attractive to us in the event the Fed does go too far.
The bright side of these interest rate moves: Investors are starting to get more viable tools to use in portfolios. Since the Fed cut rates to zero in March 2020, it was hard to consider core fixed income or cash with a straight face. Given the sudden change in yields so far this year, both are starting to look like realistic options. If you have been underweight to core fixed income, congratulations. Now may be time to start adding back gradually.
[Q]: Any parting words?
[A] Glad you asked! Two years ago, a once-in-a-century pandemic effectively stopped the global economy overnight. In the United States, over 20 million workers lost their jobs in a single month, more than double the jobs lost during the entire Global Financial Crisis. Since then, the Fed and the federal government have intervened with historic stimulus that has prevented a damaging and self-reinforcing downturn.
We are now only ~1 million workers short of pre-pandemic levels, the U.S. economy grew at its fastest pace in 40 years last year, household net worth is at all-time highs, and workers are seeing exceptionally strong demand for their labor. Through it all, global equities have delivered a close to 16% annualized return since the end of 2019.
The side effect of that rapid recovery is inflation.
There will be more volatility as the Fed calibrates policy to a booming economy and a waning pandemic, but in the end, we think investors will be rewarded for navigating the turbulence.
All market and economic data as of February 2022 and sourced from Bloomberg and FactSet unless otherwise stated.
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