Volatility inflates as U.S. inflation stays hot

The U.S. equity market hit another rough patch and continues to struggle with the same forces that have been dogging it for much of the year: hot inflation and concerns about its potential knock-on effects.

The S&P 500 and Nasdaq fell 4.3 percent and 5.2 percent, respectively, on Tuesday following a disappointing consumer inflation report. These are the biggest single-session losses since June 2020, which was soon after the most acute stage of the COVID-19 crisis. Roughly half of this summer’s bounce has eroded.

While headline inflation is starting to recede, so far the pace has been slow. The Consumer Price Index (CPI) registered at 8.3 percent year over year in August. This is lower than the previous two months, but higher than Wall Street economists’ 8.1 percent consensus forecast.

Also, the important core CPI rate, which excludes food and energy, jumped to 6.3 percent year over year and is near the peak level reached in March. Economists had expected it to rise in August, but not by this much.

Inflation remains at lofty levels

U.S. Consumer Price Indexes (year-over-year change)

Line chart showing that after a period of relatively steady inflation around 2%, the headline and core consumer inflation rates dipped during the COVID-19 crisis in 2020, and then went on to surge starting in early 2021. The peak in core inflation was reached in March of this year at 6.5%, and the peak in headline inflation was reached in June at 9.1%. Since then, the headline rate has drifted down to 8.3%, and the core rate drifted down some but then rose again to 6.3% in August.

• CPI headline rate
• Core CPI (excludes food and energy)

Source – RBC Wealth Management, Bloomberg; monthly data through August 2022

This market calls for patience

We do not think this is the time for long-term investors to turn bearish on stocks or throw in the towel just because inflation has yet to be fully extinguished. The market has been grappling with this issue since January, and it was the cause of a deeper decline in the spring through early June.

We have not expected this problem to get resolved quickly, and there could be more bouts of market volatility until it becomes clear that inflation will eventually head down toward more normal levels.

When it comes to equity positioning, we think four factors will require some patience:

• First, more Fed rate hikes are in the offing. Before the disappointing August inflation data, the futures market expected the Fed would hike rates by 50 or 75 basis points (bps) at its September 20–21 meeting. Expectations now look for a 75 or 100 bps move, with about a 1-in-4 chance the central bank makes the larger move. Futures prices indicate likely additional hikes in November, December, and the first quarter of next year, which would ultimately lift the fed funds rate to about 4.50 percent. This is almost 100 bps above the expectations one month ago, and the level is relatively high considering fed funds began this year near the record low rate of just 0.25 percent. Meanwhile, the 10-year Treasury yield has risen to 3.45 percent and the 30-year mortgage rate has jumped to 6.19 percent.
• Second, aggressive Fed tightening could aggravate recession risks. Three of our seven recession indicators are already signaling that risks of an economic contraction in 2023 are on the rise . We think recession risks will continue to climb as the Fed hikes rates further and higher borrowing costs begin to weigh on economic activity. U.S. recessions have always been accompanied by equity bear markets of varying degrees. They typically get underway some months before the recession officially begins – on average, about five to seven months before. The market seems like it is already wrestling with this possibility.
• Third, S&P 500 earnings could decline, and margins and P/Es could contract. This is the main reason we think equities were so hard-hit by Tuesday’s inflation news. While the market has already priced in a lot of bad news, we believe it could take more time for these risks to be fully priced in – in other words, a longer period of churning and volatility, and perhaps more downside.
• Even if earnings growth holds up in the remaining quarters of this year and the end result comes close to the 2022 S&P 500 consensus forecast of $225 per share, we highly doubt the $244 per share 2023 consensus forecast will be reached if economic growth slows meaningfully and especially if a full-blown recession materializes. During the four previous inflation-driven recessions, S&P 500 earnings fell an average of 17.7 percent from peak to trough, as discussed in our article titled, “As earnings go, so goes the market.”
• If history is a guide, we also think a recession would prompt the lofty S&P 500 profit margin to retreat markedly. Furthermore, if inflation lingers above the Fed’s two percent target rate for some time, the S&P 500’s price-to-earnings (P/E) ratio could compress to around 15x the forward consensus earnings estimate, below the 17x average of the past 10 years.
• Fourth, the Ukraine crisis now poses additional, wider risks. Given Ukraine’s recent military offensive, we think the stakes of the conflict have risen and the associated economic and geopolitical risks have deepened and broadened. The leadership of Russia, along with key segments of the population, no longer perceive that they are merely fighting the Kiev leadership and Ukrainian military equipped with NATO weapons. Top Russian Security Council officials are now much more frequently communicating via formal statements and social media that they believe NATO itself is confronting Russia by using the “hands and feet of Ukrainians” as its soldiers. Importantly, Russian security officials also assert the West’s ultimate goal is for the Russian state to break up into multiple segments. From our perspective, NATO and Russia relations have recently reached a new bottom and are at the lowest point in history. To us, this makes it more likely the conflict in Ukraine will drag on for some time. At a minimum, we think this would have negative consequences for the greater European economy and would be a headwind for global growth due to the sanctions confrontation.

Portfolio playbook

The market seems like it’s coming to the realization that inflation and the related challenges will not lift overnight, and economic conditions could deteriorate further in the next six months.

For long-term investors, we continue to recommend holding Market Weight (neutral) exposure to U.S. equities, and we would include a mix of defensive and growth stocks, with a tilt toward quality stocks. This is designed to balance lingering recession risks with the possibility that the eventual ebbing of inflationary pressures and slowing growth next year could provoke a change of heart by the Fed at some point in 2023.

Keep in mind, during periods of economic duress – often when headlines are at their worst and investor sentiment is rather negative – early hints of economic green shoots typically spark new bull market cycles even before recessions end. And the period surrounding U.S. midterm elections has historically brought some welcome surprises for the U.S. market.