In this week’s update, our new Chief Investment Officer, Ramesh Poola, Ph.D., CFA®, shares the latest news on inflation and touches on the recently passed Inflation Reduction Act (to be elaborated on next week).
Welcome to the RFA’s Weekly Market Update! Kids are back at school and excited for a new beginning of the school year, while parents feel a sigh of relief. It is that time of the year; change is in the air!
Change is present at RFA as well as I join you for the first time. I don’t pretend to lift weights, but as the new face of the Chief Investment Officer, I am excited to do the heavy lifting for your investment portfolios. I am highly committed to maintaining the rigor and discipline of the investment strategies you all have invested in at RFA. I constantly look for ways to add value to fulfilling your investment objectives.
I look forward to working with each of you, and if there is anything I can help you with, please let your Wealth Manager know.
Now, let me provide some insights on the markets and share what different factors have been driving them most recently. As you may know, stock markets are forward-looking and can shift from optimism to pessimism in a few days or weeks. On the other hand, bond markets are usually less speculative and need more evidence to change sentiments. However, the economic data, the Fed’s policies, and corporate earnings drive stock and bond markets daily. Let us review the highlights of these key drivers over the last few weeks.
Since the beginning of this year, inflation has been the biggest factor driving the Fed’s rate hikes and the market volatility. After peaking at 9.1% in June, the headline CPI cooled slightly to 8.5% in July. The core CPI, which excludes food and energy, rose by 0.3% month-over-month and was unchanged on a year-over-year basis at 5.9%. Markets have finally been able to breathe a sigh of relief. Does it mean we are turning the corner on inflation? What changed? We look beyond these headlines to find canaries in the coal mine.
The decline in energy prices was a key driver of the downward surprise in headline CPI. Energy prices fell by 4.6% in July after surging 7.5% in June. Gasoline prices were down 7.7%. The post-Covid demand spur seems to be cooling off, too, with airfares and hotel prices easing by 7.8% and 3.2%, respectively, and used car prices also falling by 0.4%. On the other hand, food and shelter inflation is still persistent. Food prices increased by 1.1% month-over-month. Over the past year, food prices have been up 10.9%, the highest since May 1979. The cost of shelter rose 0.5%, and the owner’s equivalent rent increased by 0.6% m/m. These numbers will be significant to watch, as food and shelter account for nearly 45% of the CPI and substantially impact inflation expectations.
The inflation moderation was also driven by the continued supply chain improvements and lower import prices—the core goods inflation excluding vehicles moderated to 3.7% annualized after rising 7.1% in June. The moderation in services inflation was an even more significant sign for the medium-term outlook.
The University of Michigan’s consumer sentiment index increased five index points above the all-time low reached in June.
The five-year breakeven inflation rate, commonly interpreted as the average annual inflation rate expected over five years, had fallen to 2.6% after peaking at 3.6% in March. This might be the market’s way of telling us it sees inflation getting under control in the near future.
The job market is very robust, while the growth has decelerated over the first half of this year. Much ink has been spread about the risk of recession. But we will not know whether we are in a recession until the National Bureau of Economic Research tells us officially. Meanwhile, the stock market seems to have priced some of the recession risks.
With 90% of the S&P 500 Index stocks reporting second-quarter earnings, corporate profits are growing at about 9% annually, a far cry from the 48% growth we witnessed in 2021. Companies beating revenue estimates have been larger than average, while earnings surprises have been below average. The increase in input costs and wages had pressured corporate profits. With the Fed continuing to tighten, earnings will remain the key player in the future direction of markets. Sectors with operating leverage such as materials, energy, consumer staples, or structural growth stories like technology and healthcare look more attractive after the first half sell-off.
The ink is barely dry since President Biden signed the 755-page “Inflation Reduction Act of 2022.” It included $433 billion of spending on the climate and energy programs, offset by $739 billion of new revenue raised through a 15% corporate minimum tax, prescription drug pricing reform, and increased IRS tax enforcement. But the name can be misleading. Inflation is a monetary phenomenon; the new law will not have a noticeable impact. Next week, Gabe Adams will go into more detail on the Inflation Reduction Act.
As we saw better inflation numbers in July, getting inflation from 9% down to the 5 – 6% range by sometime next year is highly likely. But getting back down near the Fed’s 2.0% target is hugely challenging. Rents have been increasing around the country and are a stickier part of CPI, making it very tough for the Fed to reach its stated goal. So, we expect the Fed to continue to hike rates for the rest of 2022, but they may not be as aggressive as we have seen in the last two hikes.
Our Investment Committee continues to look at these indicators, sector-specific risks, and the performance and outlook of the companies in our portfolios. Such market insights and data will guide us in proposing portfolio changes, and we will keep you well informed when we make strategic changes.
I hope you all have a wonderful weekend. Please join us next week for another market update. Until then, yours truly, Ramesh Poola!