Stocks drop, bonds rally and inflation stays hot 

Each week, we present our featured topics in the context of the major themes listed below from Nuveen's 2022 Outlook:Nuveen's 2022 Outlook

• U.S. economy: No recession this year, although market risks persist.
• Global economy: Both headline and core inflation likely peaked in March.
• Policy watch: Fed signals aggressive tightening, but we think fewer rate hikes will be needed.
• Fixed income: Strong credit fundamentals and attractive valuations favor taking credit risk over duration risk.
• Equities: Despite further bouts of volatility ahead, equity returns should be positive for 2022 as a whole.
• Asset allocation: We’re leaning toward “risk-on” positioning. Rebalance prudently.

Quote of the week:

"Oh sometimes skies are cloudy/And sometimes skies are blue./And sometimes they say that you eat the bear/But sometimes the bear eats you.”  –  Jim Croce, Hard time losin’ man

Are markets bearish or just normalizing?

Markets were looking for a lifeline from moderating inflation last week and, as we explain below, failed to get one. Even so, investors are now focusing less on high inflation and more on the inevitability of slower economic growth, the byproduct of tighter monetary policy from the Federal Reserve that’s needed to bring prices down. This is one reason we’re finally seeing more normal (i.e., negatively correlated) performance between stocks and bonds. Although stocks continue to slump, bonds (such as U.S. Treasuries) have been rallying, with yields moving lower. (Bond yields and prices move in opposite directions.)

Equity markets have repriced to reflect a return to pre-pandemic earnings growth and higher-than-pre-pandemic interest rates — but not a recession, the possibility of which has been making headlines. (Technically, a recession is defined as two consecutive quarters of negative GDP growth.) Late last week the S&P 500 Index came perilously close to entering a bear market (a decline of 20% or more from a recent peak), which is nearly always associated with sharp economic slowdowns. But there have also been cases, such as the mild recession of 2001, when the scope of the equity market’s fall was far greater than the severity of the economy’s downdraft. A more recent example occurred in late 2018, when equity valuations were extremely elevated. Economic growth weakened but did not turn negative, and monthly job creation remained solidly positive. Nonetheless, the S&P 500 Index tumbled 19.8%.⁴

Unlike that situation, when the Fed quickly corrected course and began to ease policy, today’s Fed seems less concerned about the magnitude of this year’s drop in stocks. In fact, it likely regards lower valuations as necessary to help confirm that financial conditions are indeed tightening, a key ingredient for slowing inflation. At the same time, neither the Fed nor the equity and Treasury markets have conceded that a recession is inevitable. Such a capitulation would likely happen only if there were clear signs of contraction in key metrics like consumer spending, business orders and home construction, all of which are still going strong.

Taking another look under the economy’s hood, we note two current dynamics, one quite normal and the other most unusual.

The first is that aggregate demand is decreasing thanks to expired fiscal stimulus. And as financial conditions tighten further due to Fed rate hikes, aggregate demand should weaken even more, which is likely to help inflation moderate over the course of the year.

The second dynamic is that relative demand is still undergoing a volatile shift, producing disinflation (a slowing of inflation) or even deflation in some areas, but rising inflation in others. Airfares, for instance, jumped almost 19% in April alone, and that increase wasn’t driven solely by higher fuel prices but also by a surge in demand for travel.⁵ On the other hand, consumers have become less keen on buying goods like new televisions or stationary bikes.

This is why we need to be careful not to overinterpret headline economic data releases. The details matter. Select parts of the economy are experiencing robust demand growth and higher prices. (This includes most of the labor market, where “prices” are in the form of wages employers must pay to attract and retain workers.) Other segments, meanwhile, are enduring significant drops in demand and lower prices.

There’s no roadmap economists or policymakers can use to navigate such large shifts in relative demand. Historical rules of thumb and correlations may not be helpful in interpreting the gyrations of this unusual economy. What can we be reasonably sure about? Demand growth is slowing, though not at an alarming rate, and inflation is likely to ease, though not very quickly back to the Fed’s 2% target.

U.S. inflation has likely peaked but is still too hot

Investors expecting and hoping for a substantial cooling of U.S. inflation in April were vexed as data released last Wednesday surprised to the upside. As measured by the Consumer Price Index (CPI):

• The year-over-year headline inflation rate was 8.3%, down slightly from March’s multi-decade peak of 8.5% yet still above forecasts for 8.1%.⁶
• Core inflation, which excludes volatile food and energy prices, jumped 6.2% over the past 12 months, a modest deceleration from the 6.5% rise in March but also above expectations.⁷
• On a month-to-month basis, April’s headline CPI fell sharply, from 1.2% to 0.3%. In contrast, core CPI (+0.6%) was double the 0.3% rise for March.⁸

This data reflects a broadening of inflation pressures, with few signs of the moderation we were anticipating. “Return-to-normal” categories like airfares and hotels showed some of the biggest price increases — not surprising, given the ongoing economic reopening. But wage-sensitive areas of the economy such as restaurants, medical services and personal care have also experienced higher inflation in recent months, belying the softening growth in average hourly earnings since January. Shelter inflation has also picked up, with rents of primary residences now back to their pre-pandemic levels and likely to exceed them as supply remains squeezed.

Meanwhile, prices on some of 2021’s inflation culprits — furniture and new cars, for example — continued to rise, thereby failing to provide the relief to consumers we expected based on the clear rotation from spending on goods to services.

On the positive side, energy prices fell 2.7% after soaring 11% in March. Still, it was no picnic at the pump for consumers, with gasoline prices up 44% for the 12 months ending in April and leaping higher again in May.⁹ In our view, the heftier cost of filling up the tank will likely impede real (i.e., after inflation) demand growth in the second quarter.

Markets on the lookout for more favorable April data showing a sharper inflation “peak” in March were caught off guard. To illustrate:

• The U.S. Treasury market had been fairly aggressively pricing out inflation recently,with the yield on the bellwether 10-year note hitting a 3½-year high of 3.12% on May 6. Yet the 10-year actually fell 8 basis points, to 2.91%, on the day of the release.¹⁰
• Breakeven levels on Treasury Inflation-Protected Securities (TIPS) rose slightly in the wake of the CPI data, but they remain lower than in March and April. (Breakevens are a gauge of expected future inflation rates and represent the difference in yields on nominal Treasuries and TIPS of similar maturities.)
• Fed funds futures, used by traders to bet on the direction of interest rates, still show only a slight chance of a 75-basis-points (bps) hike at either the June or July Fed meetings. (Increases of 50 bps at both meetings are already priced in.)

Looking ahead, markets will have only a small window of opportunity to digest May’s CPI release (due on June 10) prior to the Fed’s next meeting less than a week later. For now, April’s inflation numbers confirm the Fed’s thesis that tighter monetary policy is needed to loosen the labor market relatively quickly and that, come September, Chair Jerome Powell and his associates will be far less likely to decelerate their pace of 50 bps hikes.