Persistent inflation sends stocks near bear market levels

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While the headline consumer inflation (CPI) reading improved to 8.3% year-over-year for August, the improvement was not as large as expected. More importantly, the sticky part of the inflation data remained a big challenge, as discussed last week. The Atlanta Fed’s rigid inflation measure hit 6.1% year-over-year, a new high for this cycle. This deadly combination once again sent stocks falling to near bear market levels.

As expected, the stock’s improvement was helped by a certain moderation in the rate of rise in commodity prices, in particular energy.

Unfortunately, some of the areas of inflation associated with the reopening of the economy after the lockdown have been less helpful this month. Although three of the five were below the headline CPI, all five saw higher year-on-year price changes than the previous month.

As noted last week, a continued decline in the headline inflation rate is a necessary but not sufficient condition for the Fed to deviate from its aggressive rate hike path. Rent is an example of persistent inflation that continues to plague the inflation story. Given the resilience of the labor market in the face of rate hikes, there will likely be no immediate relief on the wage front either.

The one-year federal funds forward rate is a crucial variable for recession probability and Treasury yields. In the wake of still-high levels of inflation, expectations for the one-year Fed Funds rate hit a new high of 4.26%, rising above 4.06% in mid-June when equities hit a low. trough and Treasury yields have peaked. Markets are pricing in a rate hike of at least 75 basis points (0.75%) at Wednesday’s meeting, with 50 basis points in November and at least another 25 in December. Additionally, 2-year Treasury yields have reached a new cycle high while 10-year Treasury yields are very close to June highs. The need for a more aggressive rate hike cycle from the Federal Reserve to combat the lingering threat of inflation reduces the chances of avoiding a recession.

Cyclical stocks, more sensitive to the economy, had started to outperform basic stocks, but the trend turned decidedly lower following the inflation report. This decision reflects the higher probabilities that the recession will be priced into equities.

Value stocks were relatively beneficiaries of higher returns and outperformed again last week. In addition, Growth at a Reasonable Price (GARP) stocks with good balance sheets look attractive, combining a lower valuation with opportunities for long-term earnings growth.

The value space also presents attractive relative valuations, selling at very reasonable levels against growth stocks when looking at history.

The trajectory for equities appears destined to remain choppy as the market grapples with the growing odds of an economic slowdown caused by the Fed’s rate hikes to fight inflation. Investors should have an appropriate asset allocation and focus on quality companies at attractive valuations to weather the impending recession and prosper thereafter. On a more positive note, future equity returns have generally been strong after a 20% decline from highs, and an equity level is near now.

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