Market Musings 110323: Focus on the Fed and Employment
Market Musings 110323:
Focus on the Fed and Employment
Watch next week’s US CPI report closely on March 14
Summary
Historically peak US inflation has led to higher stock prices over the last 14 inflation cycles since 1945.
The S&P 500 index has risen around 12% following a peak in US inflation over the following 18 months.
This time around US CPI inflation peaked in June 2022, at 9.1%. As of January 2023, it has fallen to 6.4%. Cleveland Fed nowcast model predicts 6.2% overall CPI for February 23
According to the Cleveland Fed, the 1-year expected inflation rate has fallen sharply from 4% to just 2.6% as of February.
Since June 2022, the S&P 500 index has only risen about 1%, to date. Should we follow this historical inflation cycle average, we should see another 10% rise in the S&P over the next 9 to 10 months.
Watch the US 2-year bond yield for clues. This bond yield peaked at 5.1% last week. But at the end of the week, this yield had already fallen back to 4.6%.
Preference within stocks for Europe, UK and emerging market stocks rather than the US.
This week’s podcast:
Our investment strategy for March 2023
Is inflation rebounding, and if so, does this challenge our view of lower inflation throughout 2023?
Why are short-term Euro government bonds a good investment today?
Are stock markets about to fall again after rebounding since October?
Why should investors add alternative asset exposure to their portfolios?
Which asset classes that lost value in 2021 and 2022 have potential to rebound this year?
Will peak inflation continue to drive stocks higher?
Historically peak US inflation has led to higher stock prices over the last 14 inflation cycles since 1945.
Over the last 14 inflation cycles since 1945,
The S&P 500 index has risen 12% over 18 months from the peak in inflation
Source: Bloomberg, Stifel
The S&P 500 index has risen around 12% following a peak in US inflation over the following 18 months.
This time around US CPI inflation peaked in June 2022, at 9.1%. As of January 2023, it has fallen to 6.4%.
US headline inflation has fallen to 6.4% in January from 9.1% in mid-2002
Source: tradingeconomics.com
Today, one year US inflation swaps are under 3%, suggesting a much lower inflation rate in one year's time. According to the latest household survey from the Cleveland Fed, the 1-year expected inflation rate has fallen sharply from 4% to just 2.6% as of February.
1-year expected US inflation at 2.6%
Source: St Louis Fed
However, since June 2022, the S&P 500 index has only risen about 1%, to date, suggesting that if we had to follow the historical average of the last inflation cycles, we should see at least another 10% rise in the S&P over the next nine to 10 months.
S&P 500 index has hardly rallied since the end of June 2022
Source: tradingview.com
The key here will be a fall in expected Federal Reserve interest rates reflected for instance, in the two year US Treasury bond yield.
Now this 2Y US Treasury bond yield peaked at 5.1%. But at the end of this last week, this yield had already fallen back to 4.6%.
Huge volatility in the US 2-year Treasury bond yield this year
Source: tradingview.com
Remember, this two year bond yield was only just about 4% in early February, if we see the two year yield continuing to fall along with inflation, this could be good news for stocks.
So what do we look for here?
First of all, we look for easing growth and labour market growth and this seems to be happening.
Temporary help is falling - this leads overall employment by c. 6 months
Source: tradingview.com
Secondly, we expect falling inflation rates both in Europe and in the US. This is already occurring, so we want to see a persistent trend of lower inflation rates develop from here.
Eurozone inflation uncomfortably high, but falling
Source: tradingview.com
Thirdly, we expect lower two year bond yields, which would reflect the calming of pressures on the US Federal Reserve to raise rates much beyond 5%. The market is currently pricing a peak Fed Funds interest rate at 5.25% by the middle of this year.
And lastly, we expect easier financial conditions to result which will then drive stocks higher. The OFR financial stress index is a good way to look at these financial conditions - a lower reading means lower stress, thus better for stocks.
OFR Financial Stress Index has trended lower since October 22, helping stocks
Source: Office of Financial Research
I still have a preference within stocks for Europe, UK and emerging market stocks rather than the US.
Euro and UK stocks have largely beaten US stocks since mid-October 2022
Source: tradingview.com
Have a great week ahead
Edmund
Disclaimer
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4 comments
A lot of people expect a water drought this summer in Europe.If so that will put up food prices and may affect inflation forecasts
Edmund. Thank you for a very interesting article, well backed up by data. Please could you give us your assessment of how much, or how little, the Silicon Valley Bank is likely to upset the markets?
I think the question you should be asking is how much of the recent fall in yields is down to expectations of falling rates and how much to fears of a systemic crisis owing to the SVB implosion. My sense is that it is the latter and therefore that the inferences of the article are premature.
BnB. Thank you for your reply. People ask the questions that they want answering. I am very capable of asking the questions that I would like answering, and of course you were free to do the same. Nevertheless, I do tend to come to the same conclusion as you do in that overall market conditions will determine whether I invest in anything at the moment.