Equity markets continue to struggle under the weight of higher inflation and interest rates. After a roller-coaster week, the S&P 500 settled at its low mark for the year. The index now sits firmly in correction territory, roughly 14% below its all-time high. Markets are finding traction difficult with a Fed bent on breaking inflation, deteriorating technical trends, and bearish investor sentiment. Despite decent earnings, consumer strength, and a robust labor market, fears of a recession continue to creep higher. There remains a path to a soft landing, but the Fed is going to need some outside help.
Inflation continues to run hot, and a first-quarter increase in unit labor costs of 11.6% is doing little to ease concerns. The Fed continues their path of rate hikes and quantitative tightening with a 50 bps increase at the May meeting. The problem is that a gradual increase in the Fed funds rate likely will do little to slow inflationary pressures driven by severe supply disruptions. Without an end to the war in Ukraine or an easing of China’s zero-covid policy, it will be difficult for the Fed to break inflation at their current pace. There is a growing risk that the Fed will be forced into a more aggressive tightening cycle. This is a dramatic shift from the ultra-accommodative Fed of the last decade. Growth stocks, in vogue over that same time frame, are finding this environment quite difficult.
There are bright spots, however. Though US consumers are being pressured by higher prices, their spending has held above the pre-covid trend. Consumers are also not hurting for work. There remain roughly two job openings for every unemployed person in the country. As the Fed increases rates, these job openings could absorb some of the shock. With solid spending and robust employment, earnings are holding up okay as well. Companies are still growing sales and earnings at a rate higher than analyst expectations. Unfortunately, earnings have not been enough of a catalyst for the broader market to overcome the effects of multiple compression.
We continue to take refuge in stocks that are DEEP. Companies that are Domestic, Essential, Energy immune, and that have Pricing power remain attractive. In addition, we favor what we would consider ‘short duration’ equities. These are companies that produce significant levels of cash flow today and return it to investors via dividends and buybacks. In a world of rising rates, earnings today are especially worth more than earnings tomorrow. We believe such stocks are best positioned for the pressures ahead.
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.