09.19.22

Stocks wilt under high inflation, prospects for another jumbo Fed rate hike

The last week’s market highlights:

  • August’s hotter-than-expected inflation report, released last Tuesday, wiped out a hopeful start to the week for equities, with the S&P 500 losing 4.7% for the week as a whole.1 In the fixed-income arena, the 10-year U.S. Treasury yield rose 12 basis points (bps), to 3.45%, reflecting a greater likelihood that rates need to move higher and stay high longer than previously thought.2
  • Last month’s retail sales data was mixed, with lower gasoline sales but more car purchases. Core retail sales, which strip out both of these categories (and several others), were flat in August after increasing by less than first estimated in July.3
  • A successfully averted national rail workers strike helped deflate what had been a brief, sharp jump in natural gas prices. If the trains had stopped rolling, severe supply chains disruptions would likely have reemerged — adding to inflation pressure — after becoming far less commonplace over the past few months.
  • On Wednesday, the Fed is widely expected to deliver another outsized interest-rate hike. Forecasts are for 75 bps, matching June’s and July’s increases and bringing the target fed funds rate to 3.00%-3.25%. Investors will be closely watching for guidance as to how high rates might eventually climb. Futures markets now believe the Fed will stop tightening once they reach 4.4% by the middle of 2023, implying the central bank has much further to go.

Each week, we present our featured topics in the context of major themes from Nuveen’s most recent global investment outlook:Opens in a new window

  • U.S. economy: Recession has become a 50/50 proposition by the end of next year.
  • Global economy: High commodity prices threaten emerging markets and energy importers.
  • Policy watch: Central banks are tightening but now risk going too fast, too far.
  • Fixed income: Corporate credit and municipal bonds offer some recession protection and compelling value.
  • Equities: Too soon to call a market bottom with recession risks looming, but U.S. growth stocks have cheapened a lot.
  • Asset allocation: Plenty of opportunities for investors with a tolerance for volatility.

Quote of the week:

"It’s useless to put on the brakes when you’re upside down.”  –  Paul Newman

“Core” inflation surprise will keep the Fed hiking, investors unsettled

So much for July’s relatively benign inflation readings beginning a trend.

According to headline Consumer Price Index (CPI) inflation, prices rose 0.1% in August versus expectations for a modest decline. The rate of inflation over the previous year decelerated slightly to 8.3% from 8.5%. What really got the market’s attention, though, was “core” inflation, which strips out food and energy costs. It jumped 0.6% last month, twice as fast as anticipated, and rose 6.3% over the past year.4

While prices for airfares, used cars/trucks and gasoline fell, those for many more items rose, including food, medical care and household furnishings. Upswings in wages caused by the tight labor market lifted the cost of service industries such as personal care. Moreover, shelter, which includes rent and is the largest component of the CPI, continued to rise at an accelerating pace. On a potentially positive note, more-recent data from realtors such as Zillow point to rent inflation beginning to decline soon.

How will the Federal Reserve react to this report when it meets on Wednesday? We think a third straight 75 basis point (bps) rate hike is a done deal, and markets agree. That would raise the target fed funds rate to 3.00%-3.25%, its highest level since 2008.5 In our view, the only question is whether some policymakers will dissent in favor of even tighter policy (i.e., a 100 bps increase, or one full percentage point).

Inflation persistently above the Fed’s 2% target and strong asset class results rarely mix, as rapidly rising prices prompt the Fed to increase borrowing costs, hurting consumers and businesses alike. Regarding investors and what’s driving equity markets (down), see the next section.

Why can’t stocks make a lasting comeback?

A hopeful lurch upward followed by a steep descent based on bad economic data or unsettling geopolitical headlines. That’s the pattern equity investors have endured for much of 2022. The latest example: the S&P 500 Index jumped 3.6% for the week ended September 9, with all sectors finishing in the black.6 Then last week, the hotter-than-expected CPI release data dashed hopes that the Federal Reserve might scale back its policy tightening in the coming months. That led to a 4.3% drop in the S&P 500 on September 13 — its worst day since June 2020 — en route to a 4.7% loss for the week as a whole.On a wider scale, the S&P 500’s surge in July (+9.2% for the full month), lifted by optimism that inflation may finally have begun to soften meaningfully, sputtered out amid roaring CPI readings and the Fed’s ongoing hawkishness.8

Investors tend to believe that inflation is uniformly bad for stocks, but that’s not always the case. In fact, it can be quite beneficial, especially for companies able to raise prices without an equivalent upswing in input costs. That’s been true for the S&P 500’s top-performing sector for the year to date, energy (+41%).9 But when inflation meets tighter financial conditions (i.e., higher interest rates), the present value of a firm’s future earnings declines. Investors’ appetite to own riskier asset classes often dwindle as well. This dynamic has been reflected in the two worst-performing sectors: communication services (-34.2%) and information technology (-26.3%).10

Then there’s the old adage, “Don’t fight the Fed.” Throughout the year, we’ve believed that nearly all data, but inflation in particular, has been interpreted through the prism of how the Fed (and other central banks) will respond. The answer? Raise rates. Indeed, forecasts for the federal funds target rate at the end of 2022 have risen from under 1% in early January to well over 4% last week.11 This unexpected development has been toxic for equities in general and high growth companies, which tend to be interest-rate sensitive, in particular. Stocks have also struggled as investors (a) have found refuge in “risk-free” investments like cash (b) harbor doubts whether corporate earnings will meet forecasts, which are higher today than they were at the start of the year despite the slowing U.S. economy.

We share investors’ concerns about this deceleration. For stocks to rally, earnings growth will have to pick up, but that’s far from a sure thing in this challenging environment. Moreover, guidance for the rest of 2022 and beyond has turned much more cautious, potentially pressuring future earnings estimates.

This doesn’t mean we’re recommending market timing in the hopes of selling now that stock prices have fallen in August and September and buying when equities are poised to rebound. Attempts to define a projected or hoped-for inflection point to guide specific investment decisions are likely to produce disappointing results. But we do advise equity investors to keep their expectations for a sharp rally in check, as the effect of tighter policy and hotter inflation winds its way through the markets. A bumpy ride may lie ahead.

Sources:
  1. Bloomberg
  2. Federal Reserve via Haver
  3. Bloomberg, Census Bureau via Haver
  4. Marketwatch, Census Bureau
  5. Bloomberg
  6. Bloomberg
  7. Bloomberg
  8. S&P 500 Via Haver
  9. Bloomberg
  10. Bloomberg
  11. Bloomberg

This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of Nuveen LLC, its affiliates or other Nuveen staff.

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