All Clear?

by Larry Hatheway| May 31th, 2022

The origin of the phrase ‘all clear’ dates to World War I, when the London Metropolitan Police used the term to signal the end of an air raid warning.

For investors in 2022, the question they must now be asking themselves is whether an ‘all clear’ has been issued in the form of ‘peak inflation’, paving the way for them to return with gusto into global equity markets.

Last week emphatically broke a losing streak for global equities, highlighted by a nearly 7% gain in the US S&P500. Momentum appears to be extending into the post-Memorial Day holiday week. Fueling investor enthusiasm is the arrival of a belief that ‘peak inflation’ has arrived, which found validation in last week’s reported decline in year-on-year core PCE inflation. The marked shift in investor sentiment was apparent across asset classes. Yield curves have re-steepened, commodity prices have resumed rising, and equity markets have bounced back sharply, suggesting that market participants expect improved global growth. Inflation expectations have fallen in both market measures and surveys. And, perhaps most important, Fed rate hike expectations have receded as reflected in sharp declines in two-year Treasury note yields.

It ties together. If inflation has crested and will now fall, the Fed will not have to tighten the screws on growth as much as previously feared, producing the desirable outcome of declining inflation and ongoing growth.

But are those sentiments correct? Does peak inflation herald a strong and enduring rebound of equity markets? Or could this prove to be a false market recovery?

To be clear, we are unsure about the answers to any of the preceding questions. But we only know that getting the answers right will be crucial to market and investment performance over the remainder of this year.

So, let’s briefly examine each question in order.

Has US inflation peaked? The answer is most probably that it has. The reasoning follows from two observations.

First, high US inflation over the past year was mostly due to adverse supply side shocks and supply rigidities, coupled with 18 months of unprecedented peacetime fiscal stimulus. Monetary policy has played a secondary and rather unimportant role. Yet fiscal policy is already turning contractionary and supply-side shocks are not being repeated. After all, Ukraine can only be invaded by Russia once, and Russia can only be sanctioned once. As fiscal largesse recedes and supply shocks are not repeated, inflation will crest and then decline, particularly as base effects bring down year-on-year measures of inflation.

Second, the surge in inflation experienced over the past 12 months is not becoming entrenched. That is what market and survey measures of inflation expectations suggest. Neither consumers nor businesses expected inflation to remain elevated, and nor do financial market participants. Moreover, although nominal wages are rising at their fastest clip in a generation, they are not keeping pace with price increases. Accordingly, real wages are falling. The result is likely to be a slowdown in household spending leading to further declines in price pressures and some increase in unemployment, which will stymie the ability of workers to then demand additional wage hikes. Put another way, the dreaded ‘wage-price spiral,’ where prices increase as a result of higher wages, is not evident.

But does that automatically mean that ‘peak inflation’ heralds a bull market recovery of equity markets? All else being equal — which is a significant caveat — the answer is yes, once again for two reasons.

First, falling inflation lowers the equity risk premium. When inflation surges, risk premium must rise to account for greater business cycle risks to corporate profits, interest rates and other fundamentals that drive market valuations. Falling inflation produces the opposite result, enabling multiples to expand.

Second, falling inflation also warrants a more measured pace of Fed rate hikes, potentially creating preconditions for a ‘soft landing’, namely an episode of Fed tightening not followed by an economic recession.

But could this nevertheless prove to be a false market recovery, one destined to trip up bullish investors? Absolutely, for the reason few analysts and market pundits are now watching, namely the risk of an earnings recession.

It is important to note that earnings recessions — periods of negative corporate profits growth — are more common than economic recessions. That is because corporate profit margins are highly cyclical, meaning that profits growth is far more variable than economic growth. Since the mid-1950s, there have been a half dozen more profits recessions than economic recessions.

And the problem is that an earnings recession may already be underway in the US. If one strips away the earnings contributions from the energy and materials sectors, US S&P500 corporate earnings growth already slowed to 5% in the first quarter of this year. Importantly, that was before US final demand was fully impacted by the effects of falling real wages, fiscal drag, and rising market rates of interest. (Remember that the fall in first quarter real GDP growth was due entirely to shifts in inventories and surging imports, not to weakness in consumer or business spending.) As final demand cools in the coming quarters due to falling real wages, a slowing US housing market and probable cutbacks in business investment spending, it becomes conceivable that profits growth could turn negative for many sectors by the second half of the year, perhaps even in the current quarter. After all, year-on-year profits growth among financials has already turned negative.

If negative earnings growth were already factored into stock market prices, a profits recession might not be a big risk. But the consensus of analyst expectations is nowhere close to an earnings recession outlook — not for 2022 or 2023. And, as we have already seen, the compression of market multiples seen thus far in 2022 has mostly reflected fears of inflation and Fed tightening, not weakness in profits.

In sum, all else being equal ‘peak inflation’ is unambiguously positive for capital markets. But all else is not equal. ‘Peak inflation’ is not an ‘all clear’. Ignoring risks to profits in key sectors, and perhaps for the market as a whole, would be a mistake. Market sentiment is appropriately shifting, but as enthusiasm replaces despair, investors should not forget the importance of identifying the shifting nature of risk.

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