Review the latest portfolio strategy commentary from Mike Gibbs, managing director of Equity Portfolio and Technical Strategy.
Wednesday’s much hotter-than expected CPI report was the latest upside surprise on inflation, pushing the year-over-year reading to 9.1% (41-year high). In fact, the month-over-month reading of 1.3% was one of the highest on record as well (largest since Sep 2005’s Hurricane Katrina-induced 1.4%). The ugly inflation report puts further pressure on the Fed for a heavier hike at its July 27th FOMC meeting. The market-implied odds of another 75bp hike are now 100%, and odds of a 100bp hike are up to 70%- which will take the fed funds rate up to ~2.5%. The Fed is unable to improve supply issues, but it can negatively impact demand toward supply. This is what is playing out to bring inflation under control, with high odds of economic contraction as it takes place.
That said, inflation is a lagging indicator and we expect it to moderate in the months ahead. Oil prices are trading at their lowest level since February today (and down 24% over the past month). The ag commodities (i.e. cotton, wheat, corn, soybeans) have also shown significant weakness since mid-June, which will trickle through the system and lower consumer price pressures. Moreover, many major retailers have noted over-supply. With supply improving and overall demand moderating (low disposable income and weak asset prices weigh on spending), inflation is very likely to moderate over the coming months in our view.
Equities have discounted a lot of negative news (down 24% from prior highs), but the predominant market trend still remains downward. The S&P 500 P/E multiple has contracted to a reasonable level (~17x) but may ultimately need to get to 14-16x as it did in the last several severe drawdowns (2020 Covid recession, 2018 trade war, 2016 US manufacturing recession). Q2 earnings season also began this week, and we believe forward guidance will need to be lowered (current estimates are too high in our view). The initial price reaction from the handful of companies reporting so far has been weak, supporting our continued downward bias for the short-term. We expect a retest or undercut of the lows at some point, and highlight the 3400-3600 area as our favored level of potential downside. At 16x trailing 12-month $217 earnings, the S&P 500 would trade at 3472. This P/E contraction would be in line with that seen during the dotcom bubble and credit crisis recessions. Technically, this level coincides with the 200-week average (3519) which has largely held as support over the past decade and is near pre-Covid prices.
Despite our cautious short-term stance, long-term investors should refrain from getting overly negative with the S&P 500 already down over 20% from its highs, and should turn their focus to bull market potential rather than what may be left on the downside of this bear market. Recessionary bear markets average -33% historically, but bull markets gain 152% on average. Don’t lose sight of the opportunity on the other side of the current weak trend.
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