Holding the Line

After weeks of sustained selling pressure, the S&P 500 finally appears to be making a stand. Bouncing sharply from the -20% mark, the index now sits just 13.3% below its all-time high. The improvement comes as the latest inflation reports signal a potential peak in the nominal rate of price increases. Still, inflation is far above a healthy level, and the Fed remains committed to its plans for rate hikes and balance sheet reduction. While a bounce is welcome, our stance remains cautious. There is a narrow path to a soft economic landing, but odds for a recession in the next 12 months continue to rise. 

Inflation remains high, but the latest CPI and PCE reports show that the pace is moderating at the margin. CPI slowed from 8.5% in March to 8.3% in April. PCE slowed from 6.6% in March to 6.3% in April. Still, inflation in food, energy, and durable goods has persisted long enough to seep into stickier pockets like rents and wages. Because inflation in these categories is tougher to break, the Fed is likely to press on despite market turbulence and signs of a slowing economy. 

As short-term rates continue to rise, the pressure on consumers will only pick up. The savings rate has already fallen to the pre-covid low, and credit utilization is sharply rising. Higher rates on credit cards and personal loans will further pinch consumers as prices rise. Thus far, consumer spending has held up well, but there is a limit to what consumers can endure. The longer inflation remains hot, the greater chance that expenditures and eventually corporate earnings will get hit. 

The selloff in the market this year has been led by the compression of earnings multiples. As inflation and long-term interest rates increased, the rate at which a company’s future earnings were being discounted increased as well. Growth stocks were particularly vulnerable to this phenomenon and were hit the hardest. In recent weeks, we have seen a bit of a reprieve in the level of long-term interest rates. With the 10-year treasury yield falling roughly 40 bps, stocks have been able to bounce from oversold conditions. If rates can stay below 3%, we may have seen the worst of the multiple compression. 

Going forward, we will need to see what happens with the earnings portion of the equation. Right now, earnings for the S&P 500 are projected to grow around 8% for the year. If that pace comes to fruition, stocks are likely undervalued. If inflation continues to bite consumer and business confidence, earnings growth could fall, meaning more pain for the equity market. We will be paying close attention to the health of consumers. 

Thanks, 

Preston May, CBE®
Research Analyst