The S&P 500 is struggling to gain traction amid stubbornly persistent inflation and geopolitical turmoil. Despite a sharp bounce from the January drawdown, the index has not been able to sustain momentum and now rests roughly 9.5% below its all-time high. Inflation has been the key driver of sentiment over recent weeks with January's CPI report once again exceeding forecasts. Accordingly, markets have begun to price in a more aggressive response from the Fed. At the same time, the evolving situation on the Ukraine/Russia border is adding to participant anxiety.
Inflation came in at 7.5% in January vs. economists' expectations for 7.2%. Digging into the numbers, we see that goods are still the driving force behind overall inflation. Food, energy, commodity, and vehicle prices all continued to rise at a breakneck pace. Supply chains are still jammed up and contributing to the acceleration in prices. However, with Omicron passing, we are beginning to see some green shoots form in the supply chain. Delivery times appear to be peaking and some manufacturing surveys of future prices are beginning to ease. Still, the CPI report reveals that stickier pockets of inflation are building. Services rose at 4.1%. This category is largely driven by higher wages and could prove tough to break in an exceptionally tight labor market.
In response, expectations are rising for the Fed to become increasingly aggressive. Markets are now implying that the Fed is likely to kick off tightening with a 50 bps increase in March and could potentially raise another 5 times through the course of 2022. In addition, the Fed will ramp up its balance sheet runoff around the same time. 10-year treasury yields have pushed back to pre-covid highs as a result. In the equity market, the move higher in long bond yields has lent support to the relative outperformance of "value" stocks over "growth" stocks. Stocks with low price-to-earnings multiples have been in high demand compared to those with high price-to-earnings multiples. As the Fed pulls back its bond purchases, we could see yields continue to drift higher and this relationship between value and growth exacerbated.
Geopolitical tension has also been at the forefront for participants. Russian forces have continued to build up on the borders of Ukraine and invasion has been declared imminent by the US and its NATO allies. Historically, geopolitical events have led to short periods of market volatility but have had little impact on the long-term trajectory of markets. However, pockets of the market would certainly be more impacted than others by a significant incursion. With Russia a key supplier of energy to Europe, it is quite possible that we could see further disruption to global stockpiles and even high energy prices. Defense stocks are also an obvious winner.
Within our strategies, we have tilted the needle to account for the probability of inflation running higher over the next few years. We have done so by adding exposure to low P/E companies with pricing power. We have also been working to identify names that may have been overdone in the recent pullback. We believe that a distinction must be made between growth today and the promise of growth tomorrow. A company down 15-20% from its high that is expecting strong earnings growth in the coming year remains attractive in our eyes.
Preston May, CBE®
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S&P 500: Standard & Poor’s (S&P) 500 Index. The S&P 500 Index is an unmanaged, capitalization-weighted index designed to measure the performance of the broad U.S. economy through changes in the aggregate market value of 500 stocks representing all major industries.