By Joseph Wu, CFA
Inflation remains arguably the most important factor shaping the macro backdrop, because how it evolves will directly influence the pace of monetary policy tightening and, in turn, the economy and markets. While inflation in Europe is likely to remain more problematic due to an ongoing energy crisis with no resolution in sight, recent inflation data for the U.S. and other major economies that suggest price pressures may be cresting represent an auspicious development. Encouragingly, lower commodity prices, less supply chain congestion, and slowing growth should continue to provide some inflation relief over the coming quarters.
Although we believe price pressures should start to moderate, the speed at which inflation will ease remains highly uncertain; some dynamics suggest it could take considerable time for inflation to reach levels that are palatable for central banks. Focusing on the U.S., a combination of robust wage growth and elevated measures of “sticky” inflation—based on changes in the price of goods and services for which price changes are normally infrequent—signal that underlying core price pressures remain uncomfortably high, as shown in the chart at right. Accordingly, Federal Reserve policymakers recently reiterated their “unconditional” resolve to return inflation to a two percent target by continuing to raise rates and withdraw liquidity via quantitative tightening at a fairly brisk pace for the foreseeable future.
Inflation remains too high for comfort
Line chart showing the U.S. core PCE inflation index and the Atlanta Fed’s Core Sticky Consumer Price Index on a year-over-year basis since 1988. The latest monthly readings of 4.6% and 5.6%, respectively, remain significantly higher than the Fed's long-term inflation target of 2%.
- U.S. PCE Core Price Index y/y change
- Atlanta Fed Core Sticky CPI y/y change
- Fed's 2% inflation target
Source - RBC Wealth Management, Bloomberg; monthly data through 7/31/22
Will corporate fundamentals stay resilient?
The world economy has lost substantial momentum this year, sagging under the weight of tighter financial conditions as higher borrowing costs and stubbornly elevated inflation have hampered both consumer demand and business activity. But we think the Fed’s continued interest rate hikes despite GDP downgrades since the beginning of the year have shown it is willing to continue tightening amid growth headwinds, and futures markets expect further rate hikes in coming quarters. Accordingly, we believe risks to the economic outlook remain skewed to the downside (see upper chart at right).
Global growth has downshifted as financial conditions tighten
Line chart showing the JPMorgan Global Manufacturing Purchasing Managers’ Index (PMI) overlaid with the 12-month change in the Goldman Sachs U.S. Financial Conditions Index (FCI) since 2007; the FCI is shown inverted to highlight the tendency for the PMI and the FCI to move together. Since mid-2021, global PMI has decreased as the financial conditions index has tightened.
- JPMorgan Global Manufacturing PMI (LHS)
- Goldman Sachs U.S. Financial Conditions Index (y/y change, RHS, inverted)
Note: A PMI (Purchasing Managers’ Index) level of 50 demarcates expansion from contraction. For the financial conditions index, a falling line (higher values) implies tightening conditions.
Source - RBC Wealth Management, Bloomberg; monthly data through 8/31/22
While the number of downward revisions to analysts’ earnings forecasts has ramped up in recent months, consensus EPS projections have held up much better (see lower chart at right) than the deceleration implied by the decline in global manufacturer sentiment and the sizable downgrades to 2022 GDP growth forecasts for major economies. The ongoing global growth slowdown nonetheless suggests corporate earnings are likely to remain vulnerable to negative revisions in the near term.
Profit estimates show resilience despite softening economy
Consensus forward 12-month EPS estimates
Line chart showing the evolution of forward 12-month consensus earnings-per-share (EPS) estimates for the S&P 500 and the MSCI All-Country World Index, year to date. Corporate profit forecasts remain reasonably resilient and are slightly higher now than at the start of the year.
- S&P 500 (LHS)
- MSCI All-Country World Index (RHS)
Source - RBC Wealth Management, Bloomberg; weekly data through 9/6/22
Will the U.S. economic expansion endure?
Setting the tone for the rest of the world, the U.S. economy has sharply decelerated this year, prompting worries of an imminent recession. But with households still buttressed by a sizable cushion of savings and the labor market showing strength with ample job openings, the immediate risks appear to be mostly contained and a “soft landing” scenario remains possible, in our view.
Nevertheless, we believe the probability of a U.S. recession will likely continue to build, in part because the Fed’s intention to guide interest rates to a restrictive level would further squeeze financial conditions and curb economic activity. Meanwhile, RBC Global Asset Management’s latest U.S. Business Cycle Scorecard
Balancing opportunities and risks
Against this backdrop of unusually high macro uncertainty, many global leading indicators are still trending unfavorably, while the Chinese economy is strained by pandemic lockdowns and property market woes and U.S. political risk is likely to flare up as the midterm elections draw closer. We therefore believe investors should maintain a moderately defensive and flexible stance in portfolio positioning, with a focus on relative value opportunities.
For equity markets, we believe earnings delivery will be crucial. In an environment of slower but still positive economic growth, we think earnings could remain resilient over the next 12 months and help provide fundamental support for share prices. In a recessionary environment, however, profits are likely to decline meaningfully. As we laid out in the August Global Insight, the previous 11 U.S. recessions since the 1950s saw S&P 500 earnings fall by an average of 23.6 percent.
Meanwhile, we believe the opportunity set in fixed income markets—where expected returns appear increasingly reasonable thanks to substantially higher bond yields and modestly better compensation for credit risk compared to a year ago—has vastly improved. On a relative basis, the yield advantage that equities commanded over corporate bonds has also sharply diminished over the past year, as the chart at right shows. Moreover, we think the significantly higher starting yields available today can provide more of a cushion to absorb further rises in rates, as well as helping to strengthen the diversification capacity of bonds in relation to equities.
Relative value has moved in favor of fixed income
Column chart showing the current forward earnings yield for the MSCI All-Country World Index and the S&P 500 Index, and the yield to worst for the Bloomberg U.S. Corporate Index and the Bloomberg U.S. Corporate High Yield Index, compared to a year ago and the average since 2002. On a relative basis, the yield advantage that equities commanded over corporate bonds has sharply diminished over the past year.
- Average since 2002
Note: Earnings yield is the inverse of the forward price-to-earnings ratio. IG = investment-grade; HY = high-yield. Bond yield refers to yield to worst for the Bloomberg U.S. Corporate Index (for investment-grade bonds) and the Bloomberg U.S. Corporate High Yield Index Value (for high-yield bonds).
Source - RBC Wealth Management, Bloomberg; weekly data through 9/6/22
RBC Wealth Management, a division of RBC Capital Markets, LLC, Member NYSE/FINRA/SIPC.