Transcript

Amanda Agati:

In this special edition of "#Adding Alpha," we share some thoughts on the recently released May CPI report and what the market believes the Fed will need to do in order to tame inflation going forward.

On Monday, June 13th, the S&P 500 entered bear market territory, which is when stocks dropped 20% from a recent high.

This is a first for investors since the onset of the pandemic back in the spring of 2020.

We're still sticking with our view that inflation should be peaking soon, despite the much-higher-than-expected CPI inflation rate for May.

Core CPI that excludes food and energy, after all, did go down in the latest report.

But now the spread between headline and core is the widest since the summer of 2008.

Even in the 1970s and 1980s stagflation period, the spread was never this wide.

May's CPI report really convinced investors that the Fed remains well behind the inflation curve and are going to have to do a lot more than what is currently priced in.

It's effectively catalyzed the market downdraft since the CPI report, as the market is now trying to recalibrate tighter financial conditions and higher-than-expected interest rates with valuations.

What makes this year so unusual is the 20-year average spread between the two year and the Fed funds rate is only about 25 basis points.

It's very, very tight by historical standards, but during this current cycle, we have a very significant differential.

It's over 200 basis points right now.

So the bond market is taking forward guidance from the Fed very seriously.

It usually reacts one meeting at a time, but all of a sudden this year, the bond market is adjusting to months of Fed policy changes effectively all in one shot.

Everything is happening at warp speed this cycle.

The thing that continues to keep me up at night is that the Fed is being forced to raise rates to fight effectively an unwinnable battle.

It's used to raising rates to curb inflation because of an overheating economy.

This time around, growth is already slowing, but it's commodity prices pushing inflation higher and a whole host of other exogenous forces.

Are rate hikes going to ramp up oil production or encourage farmers to grow more wheat?

The concern is that the Fed raises rates to aggressively because it's fighting a battle it can't ultimately win.

That is, the policy tools in the toolkit are ineffective at settling down some of these exogenous forces, and ultimately it impacts economic growth.

We do believe we are entering that realm of possibility now.

The yield curve spread between the Two-Year and 10-Year Treasuries narrowed to just 10 basis points on Friday following the CPI report.

Part of that is because of the front end rapidly adjusting to expectations of more rate hikes, much more so than longer term rates coming down because growth expectations are faltering.

They really aren't falling down at all.

And while chatter is building around a potential yield curve inversion, don't forget it's really the three-month to 10-year spread that has greater predictive power and is nowhere near inversion at a positive 177 basis points as of this recording.

The key question for investors is whether this is the start of a new serious leg down in markets.

From a P/E multiple perspective, the S&P 500 has already dropped five multiple points since the start of the year.

That's in line with the 2018 peak-to-trough decline that we experienced.

And even the 2020 sell off at the onset of the pandemic saw six multiple points of decline.

In our view, we'd have to see a material reset on earnings estimates to justify valuations following further from here, as in an outright earnings recession needs to be part of the equation, not just slightly slower but still positive growth expectations.

We think a forward P/E range on the S&P 500 of about 15 to 17 times is fair value based on where interest rates are and based on where financial conditions are sitting today.

But it's certainly hard to see much upside for stocks here other than short-term trading rallies, while the current perfect storm of macro forces remain in control.

We're just going to have to wait for inflation to peak and for the Fed to complete its tightening of financial conditions, for the market to be able to refocus on the underlying fundamentals or find another positive catalyst to get this rally engaged.

In the meantime, we think the high volatility regime is going to continue to dominate the summer months, and things are going to stay pretty choppy out there.