As U.S. inflation reaches a 40-year high, Global Market Strategist Brian Levitt shares what this could mean for the current business cycle, equities, fixed income, and the outlook for the rest of 2022.
U.S. inflation has climbed to its highest rate in 40 years, driven by rising food and energy costs as well as higher costs of shelter. Over the past year, the headline Consumer Price Index (CPI) has climbed by 8.6%, putting pressure on the U.S. Federal Reserve (Fed) to further tighten policy to restore price stability.1
U.S. Core CPI, which excludes food and energy, appears to have peaked as the inflation rate on durable goods comes down. Nonetheless, the run rate remains higher than expected as higher costs for commodities and services continue to rankle the markets and put pressure on the Fed.2
Market sentiment began to deteriorate again when the news was announced Friday morning amid expectations of tighter monetary policy, driven by declines in the tech-heavy Nasdaq Composite Index.3
- The market is now expecting nine to 10 interest rate hikes between now and early 2023, with 50 basis point hikes priced in at the next three Federal Open Market Committee (FOMC) meetings.4
- Interest rates climbed across the U.S. Treasury yield curve with 2-year rates advancing significantly more than 10-year rates. A flattening yield curve should be viewed as a warning sign of future economic woes but is typically not a sign that a recession is imminent.5
- The U.S. dollar is rallying as expectations of higher rates in the U.S. and the potential for a deterioration in economic activity has investors allocating capital to the U.S. greenback.6
Implications
The risk to the current business cycle is elevated. Cycles don’t end on their own volition but rather the demise is almost always the result of tighter policy. We would expect volatility to remain elevated as policy uncertainty persists and for financial conditions to tighten.
Our outlook calls for inflation to moderate over the course of the year driven by base effects and slowing consumer demand, but we recognize that the risks to that call are elevated. We are comforted by the recent moderation in goods prices but recognize that service and commodity inflation remain stubbornly high.
The markets, since mid-March, have been signaling that the economy is in more of an expansionary phase (stocks outperforming bonds, high yield credit outperforming Treasuries, value outperforming growth, interest rates and commodity rising higher).7 Nonetheless, the economy is likely to slow as the Fed tightens policy and as the consumer grapples with higher food prices and the higher cost of rent.
In the slowdown phase of the cycle, we still modestly favour equities but recognize that volatility persists amid policy uncertainty, returns become more modest, and the range of outcomes within equity indices becomes more extreme. We would expect higher quality businesses with pricing power and greater visibility of earnings to likely outperform as financial conditions tighten.
Bottom line
Inflation and Fed tightening hasten the end of business cycles. We still believe our base-case scenario will come to fruition, in which inflationary pressures ease as consumer demand slows and supply-chain challenges recede as workers return to the factory floors. However, we recognize that the probability of a “persistent inflation” scenario, in which central banks tighten too aggressively and choke off economic growth, remains very elevated.
1 Source of all data in the paragraph: U.S. Bureau of Labor Statistics, 5/31/22.
2 Source of all data in the paragraph: U.S. Bureau of Labor Statistics, 5/31/22.
3 Source: Bloomberg, 6/10/22.
4 Source: Bloomberg, 6/10/22. As represented by the Fed Funds Implied Futures.
5 Source: Bloomberg, 6/10/22.
6 Source: Bloomberg, 6/10/22.
7 Source: Bloomberg. From mid-March to May 31, 2022. Stocks are represented by the S&P 500 Index. Bonds are represented by the Bloomberg U.S. Aggregate Bond Index. High yield credit is represented by the Bloomberg U.S. High Yield Bond Index. Treasuries is represented by the Bloomberg U.S. Treasuries Index. Value is represented by the Russell 1000 Value Index. Growth is represented by the Russell 1000 Growth Index. Interest rates is represented by the 10-year U.S. Treasury. Commodities is represented by the Goldman Sachs U.S. Commodities Index.
