Review the latest portfolio strategy commentary from Mike Gibbs, managing director of Equity Portfolio and Technical Strategy.
After dropping ~12% over just 7 days surrounding the hot May inflation report (taking the S&P 500 -24% from its highs), the index has attempted to bounce from oversold levels. And we note that oversold levels can allow for modest bear market bounces. Ultimately, inflation remains top-of-mind for investors- its stickiness at high levels is weighing on consumer disposable income and corporate margins, along with complicating the Fed’s situation as it attempts to bring inflation under control within a slowing economic backdrop. Unless the narrative changes in regard to Russia backing off or China ending lockdowns, it will be difficult for equities to sustainably move to the upside without better inflation data in our view.
With the path of least resistance lower for now, the economy slowing, inflation high, and the Fed in tightening mode, we expect the market trend to remain challenged over the coming weeks and months. That said, we do believe equities are likely to be higher than current prices over the next 12 months given our expectation for inflation to moderate. Accordingly, we recommend using the downdrafts as opportunity to accumulate high quality, favored stocks for the longer-term.
A positive on the inflation front over the past week has been the breakdown in Copper, along with broad weakness across the commodity complex. There has been a strong correlation between Copper prices and inflation expectations, so the technical breakdown in Copper may be foreshadowing a decline in inflation expectations ahead. Increasing odds of recession are likely contributing to the decline in Copper, so this does not indicate that we are “out of the woods yet” on economic weakness and market challenges. However, it is a move in the right direction that supports our view of moderating inflation in the economic outlook- and positive equity market returns over the next 12 months.
To show how the market is so intertwined, lower inflation expectations are likely to ease the upward trend in bond yields. Whereas bond yields have typically peaked before inflation over the past 30 years, we believe the market will be more reactive to inflation in the current environment due to multiple unforseen hiccups in inflation’s trajectory over the past year (i.e. Delta variant, Omicron variant, Russia/Ukraine war, China lockdowns). If inflation is at a peak and can show convincing improvement, bond yields are also likely to be at or near a peak. And there has been a strong inverse correlation between bond yields and S&P 500 P/E multiples this year. So a stall or decline in bond yields is likely to correspond with a pause or bounce in valuations. The longer these trends can persist and prove durable, the more conviction investors can have on the outlook and apply higher multiples to stocks.
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