iCapital Market Pulse: On inflation, Fed between a rock and a hard place

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This week’s consumer price index (CPI) release of annual inflation data for January is expected to come in at 7.3%.¹ This is once again a new four-decade high. Inflation erodes the purchasing power of your money and disproportionately hits low-income consumers, who spend 94% of disposable income on essentials items like groceries, shelter, utilities, and gasoline.² With these essentials costing more and more—a basket of these goods and services is 7.9% more expensive than in December 2019—that leaves little room for other discretionary purchases.³ Yes, wages have been rising too, but have not kept pace with inflation, and real wage growth has slowed lately.⁴
 

It is no wonder that consumer sentiment in the University of Michigan’s January 2022 survey slipped to its lowest level in 10 years.⁵ Respondents’ expectations for real income and personal finances deteriorated and sentiment on buying conditions for large household durables and cars slumped to all-time lows.⁶ This week’s report on consumer confidence is expected to match January’s downbeat assessment.

The market consensus expects inflation to peak in the first quarter of 2022 and ease from there.⁷ Still, the great concern about inflation is finally prompting the Federal Reserve to act—with a series of upcoming rate hikes and balance sheet tapering. The problem with that for the market? To slow inflation, the Fed’s going to have to slow demand.

Never in the last 40 years have we seen such accommodative policy with such high inflation, as shown below. The Fed must act and understandably this is making markets nervous. For more than 10 years since the Global Financial Crisis amid record Fed balance sheet expansion and record-low real federal funds rates, we’ve heard a consistent message from the Fed—there is no need to worry about inflation because if it ever were to become a concern, they have “powerful” tools to control it—i.e., rate hikes. Well, the use of these tools is warranted now.

Why should the markets be nervous about the Fed? Because it cannot slow inflation without slowing demand. Since the Fed cannot use monetary policy to solve supply chain issues—such as those with new and used cars, furnishings, houses, semiconductors and more—they will use rate hikes to slow demand. Indeed, U.S. personal consumption spending on durable goods had risen an unprecedented 34% above pre-pandemic levels (or 73% from the collapse in demand in April 2020) by the end of 2021,⁸ and these supply-constrained categories are estimated to have added 145 basis points to annual inflation in January 2022.⁹

The good news from an inflation perspective, but bad news for companies that have benefited from this demand, is that we are already seeing slower growth in several cyclical sectors. For example, February’s U.S. PMI Manufacturing Index dropped to its lowest level since October 2020 on soft demand conditions and labor shortages.¹⁰ New orders rose at the slowest pace since September 2020.¹¹ Retail sales have been strong but the recent slowdown bears watching.¹²

Good for inflation, but downside risk for earnings estimates

FactSet recently flagged that quarterly earnings estimates fell in the first quarter of 2022 after six consecutive quarters of upwards revisions. ¹³

Similarly, the global earnings revision ratio (which measures the number of analyst upgrades versus downgrades) has been declining since last fall.¹⁴ Upwards earnings revisions are no longer a tailwind to equity market performance, and we see risks building that slowing demand and the upcoming rate increases could create further downside to current consensus earnings estimates, which would further dampen equity market performance. On the plus side, as the pandemic eases so should supply chain challenges, but with demand for goods already paring back we think it is unlikely that demand bounces back sharply—especially with financing costs likely to rise.

That said, there is dispersion beneath the surface. Downward revisions have been common in several value and cyclical sectors, like industrials and materials, along with bond proxies, such as utilities and consumer staples. But we are still seeing positive revisions in energy, real estate, and info tech. This is likely to be the story of the year—a slowdown in cyclical parts of the economy, but continued growth in secular parts like digital transformation.

However, since the start of the year, there has been a rotation out of growth and into value, with value outperforming growth to the greatest extent seen since 1995.¹⁵ Fund managers have shifted out of tech and into banks and industrials.¹⁶ Nevertheless, with downward earnings revisions in mind we prefer to take profits in value and cyclicals and rotate into secular growth in software and semiconductors, structurally well-positioned energy, and airlines—the last of the reopening trades.

We would advise balancing that with assets that can work when most other things are not: High-quality dividend-paying stocks, private credit, and real estate could offer needed yields to help weather volatility and rising rates.