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Brian Levitt | June 10, 2022

U.S. inflation reaches 40-year high, putting further pressure on the Fed to tighten policy

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.

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Some references are U.S. centric and may not apply to Canada.

Commissions, trailing commissions, management fees and expenses may all be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Please read the simplified prospectus before investing. Copies are available from your advisor or from Invesco Canada Ltd.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.

All investing involves risk, including the risk of loss.

An investment cannot be made in an index.

Past performance is not a guarantee of future results.

In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.

The U.S. Consumer Price Index (CPI) measures change in consumer prices as determined by the U.S. Bureau of Labor Statistics. Core CPI excludes food and energy prices while headline CPI includes them.

The NASDAQ Composite Index is the market capitalization-weighted index of approximately 3,000 common equities listed on the Nasdaq stock exchange.

A basis point is one hundredth of a percentage point.

The yield curve plots interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates to project future interest rate changes and economic activity. A flat yield curve is one in which there is little difference in the yields for short-term and long-term bonds of the same credit quality. In a normal yield curve, longer-term bonds have a higher yield.

The opinions referenced above are those of the author as of June 10, 2022. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.