The holiday-shortened week was a tough one for financial markets thanks to recent trends in inflation, which does not appear to be cooling as quickly as market participants had hoped. The January print of US PCE (personal consumption expenditures, the Fed’s preferred inflation gauge), was higher than expected and showed sequential increases across the board:
- Headline PCE Deflator: +0.6% m/m, +5.4% y/y
- Core PCE Deflator: +0.4% m/m, +4.7% y/y
In response, rates continued to rise across the curve, particularly in the front end as the yield curve inversion deepened. Futures markets are now pricing in 25bp rate hikes at each of the next three FOMC meetings (March, May, and June), with very low odds of any rate cuts happening before the end of the year. Rising rates in February have erased most of the gains enjoyed by bond investors during January, leaving fixed income close to flat on the year.
Equities were not spared the selling pressure either. The S&P 500 was down for the 3rd week in a row, while the more rate-sensitive Nasdaq underperformed on weakness in longer-duration technology stocks.
Other economic data released last week showed a resilient US economy. Initial jobless claims remain below 200k/week, S&P Global’s Composite PMI rebounded into expansion territory (as did several regional Fed surveys), new home sales rose for the 2nd straight month, and the University of Michigan’s consumer sentiment index rose slightly in the final February print, with a notable gain in the future expectations component.
Albion’s “Four Pillars”
Economy & Earnings
The US economy enjoyed a strong second half of 2022, but corporate operating margins have been gradually falling as labor and input cost pressures bite. Albion’s base case expectation is that the US economy will enter recession in 2023, putting downside pressure on earnings.
The S&P 500’s forward P/E of 18x is above the long run average. More predictive metrics like CAPE, Tobin’s Q, and the Buffett Indicator (Mkt Cap / GDP) suggest that compound annual returns over the next decade are likely to be in the single digits. Most or all of 2022’s P/E multiple compression was driven by rates, rather than an expansion of the equity risk premium.
Rates rose across the curve in 2022 in response to a dramatic pivot in monetary policy. Fed Fund Futures are pricing in a total of four 25bp hikes in 2023, with a “terminal” Fed Funds policy rate slightly above 5% for this cycle.
After reaching 40yr highs in spring of 2022, inflation moderated in the second half of the year. Headline inflation eased over the summer on falling energy prices, and core inflation followed suit in Q4. Goods inflation has fallen due to softening demand and excess inventory, while heavily lagged housing data is one factor keeping reported services inflation elevated, at least for now.