Inflation Continues, and the Data We’re Watching

April CPI Remains Near 40-Year Highs 

This morning’s CPI report showed April inflation up 8.3% y/y, slightly lower than the +8.5% reported in March, but still near the highest levels since the early 1980s. Core CPI, which excludes the more volatile prices of food and energy, was higher than expected, up 6.2% y/y. Shelter costs, which are about 1/3 of CPI, rose at their fastest pace since 1991, as increases in housing prices and consequent increases in rent work their way into the economy. The net result is that, while wages are up, inflation-adjusted earnings, a measure of buying power, are actually down -2.6% y/y. 

Chart 1: CPI¹ 

Strong Economy, But Volatility and Inflation Are Ruling the Day 

The Volatility index (VIX) has remained elevated, above its 10-year average, every day this year since January 5. Market uncertainty has generated negative performance in just about every asset class year- 

to-date, with the notable outliers being commodities, +25.7% year-to-date, and energy, +38.3% year-to-date. The volatility has been driven by uncertain global macro and geopolitical environments and remains heightened, even as economy remains fundamentally healthy. 

Both consumer spending and business investment accelerated in Q1. The consumer, which represents 70% of GDP, maintains healthy demand, in large part from pandemic-era excess savings and, more recently, from higher wages. Healthy consumer demand and continued supply shortages are spurring business investment toward adding capacity and improving supply chains.  

The biggest risk to the economy right now – beyond the uncertain geopolitical environment – is inflation. The Fed is (finally) moving more aggressively to curb rising prices; time and data will tell if they are successful executing a “soft landing” (more on that later). 

Many companies have been resilient and have adapted successfully to the high inflation environment. High quality companies have been focused on strengthening balance sheets, passing through higher costs and managing supply chains. And earnings continue to grow. With more than 90% of companies in the S&P 500 reporting Q1 earnings, expectations are for 12.2% y/y Q1 EPS growth. That’s 36% higher than the 10-year quarterly average. 

Chart 2: Quarterly EPS Growth (% y/y)² 

Multiple Contraction and Tech Driving Downturns 

Despite strong economic and corporate fundamentals, multiple contraction has driven negative performance across most sectors. Next-twelve-months (NTM) price-to-earnings (P/E) for the S&P 500 is now 17.1x, compared to 19.7x at the end of March and 21.5x to start the year. Decline in NASDAQ Composite aggregate valuation is even more dramatic, down to 23.3x from 31.6x to start the year. Both indices are now valued below their five-year average on an NTM P/E basis. 

In addition, many of the tech and growth companies that had previously led momentum throughout the bull-market cycle have underperformed year-to-date, and several have seen significant valuation declines due to sales and earnings disappointments. (See our recent “Avoiding the Noise and Paying Attention to What’s Really Moving Markets” for more information on that topic.) 

Despite this downward momentum trend from a concentrated group of past outperformers, plenty of companies continue to generate healthy profits. Good, experienced management teams execute on price/cost strategies and supply chains, while other management teams have never faced a macro slowdown and are struggling to adapt. 

Watching the Credit Markets 

Credit markets tend to be in front of heightened risk scenarios and if analyzed appropriately can provide good indication of what’s ahead for the economy and equity markets. While we have seen the occasional warning sign, the current market does not forecast a near-term recession. We did see brief periods of yield curve inversion (where longer-dated bonds yield less than shorter dated bonds – often a harbinger of recession); however, more recently the yield curve has steepened, with the spread between the 2-year and 10-year Treasury currently at 48 bps, and the spread between the 3-month and 10-year Treasury currently at 210 bps. 

At the same time, credit spreads, the comparison of corporate bond yields to Treasury yields, are widening, which is often a sign of increasing risk. CCC-rated credits are 800 bps over Treasuries vs. a historical average of 900 bps, and compared to: 1,420 bps in 2011 (Euro debt crisis), 2,000 bps in 2015 (false Fed liftoff) and 1,125 bps in 2018. Credit spreads have widened with rising rates, and we’re watching closely, but no alarm bells have rung. 

Our Base Case is No Recession in 2022: The Data We’re Paying Attention To 

Ultimately, Fed policy is likely to be the key driver of whether the U.S. economy heads into recession and will be dependent upon the Fed’s ability to execute a “soft landing” – hiking interest rates and reducing inflation without a recession. It’s hard to do. A soft landing has only been executed three times in the history of rate hike cycles. This means that in the 11 past rate hike cycles, eight ended in with (at least a mild) recession. Median projections anticipate that the Fed can lead a soft landing, with core inflation falling to 4.1% at year-end and 2.4% in 2023, and unemployment staying steady around 3.6%.³ 

A recession in 2022 is not our base case because of the strength of the consumer. Healthy consumers can sustain near-term inflation pressures because of higher savings, wage growth and job availability. Businesses can manage because of the unique pent-up demand scenario. But persistent inflation is a serious risk, and hence why the Fed is acting fast to get ahead. 

2023 could spell a different scenario, and there’s a lot that can happen between now and then. 

We’ve stressed how we, and the Fed, are staying data-dependent, so here is an update on recent economic datapoints we follow: 

Inflation Stays Hot 

• Expect this to continue, even if we’re at peak 
• As noted above, CPI increased 8.3% y/y during April, with core CPI up 6.2%. Inflation has slowed modestly but is still at some of the highest rates in 40 years. 
• March Personal Consumption Expenditures were up 6.6% y/y and increased at an annualized rate +10.9%. Food and energy played a large role in the rising costs and, excluding those categories, Core PCE was up 5.2% y/y and increased at an annualized rate +3.6% in March. 

Labor Costs Accelerating in Q1 

• Good for consumers able to earn higher wages, though a sticky component to further inflation 
• Employee Cost Index increased at an annualized rate +5.8% in Q1 
• Unit Labor Costs increased at an annualized rate +11.6% in Q1 

Jobs Exceeding Potential Employees 

• Good for consumers able to find decent paying jobs, bad for business productivity 
• 3.6% unemployment in April – low level of unemployment explained by high job availability and higher wages 
• Total nonfarm job openings reached new highs in April 
• 62.2% labor force participation rate in April – still below pre-pandemic level of 63.4%. This represents percent of population working or seeking work 

Business Expansion 

• Leading indicator that the economy remains healthy, resilient 
• Both manufacturing and non-manufacturing sectors continued expansion in April – marking the 23rd month of continuous expansion 

Markets like these require adjustment and tend to penalize panic. The famous Warren Buffett said, “Be greedy when others are fearful; be fearful when others are greedy.” We continue to watch the data for signals to the economic outlook, and we continue to look for high quality at low prices. 

Sources

1. FactSet (chart)
2. FactSet (chart)
3. Fox Business

Disclosures

Investment Solutions at Hightower Advisors is a team of investment professionals registered with Hightower Securities, LLC, member FINRA/SIPC, & Hightower Advisors, LLC a registered investment advisor with the SEC. All securities are offered through Hightower Securities, LLC and advisory services are offered through Hightower Advisors, LLC. This is not an offer to buy or sell securities. No investment process is free of risk and there is no guarantee that the investment process described herein will be profitable. Investors may lose all of their investments. Past performance is not indicative of current or future performance and is not a guarantee. In preparing these materials, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public and internal sources; as such, neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Hightower shall not in any way be liable for claims and make no expressed or implied representations or warranties as to their accuracy or completeness or for statements or errors contained in or omissions from them. This document was created for informational purposes only; the opinions expressed are solely those of the author, and do not represent those of Hightower Advisors, LLC or any of its affiliates.