Weekly Investment Update (09/16/2022)

August Inflation Print Driven by Shelter, Food, and Autos Locks in a 75bp FOMC Rate Hike Next Week and Drives ongoing Market Volatility; Forward Return Probabilities Skew Positively

As numerous Fed officials noted recently, their job raising interest rates is not done, and interest rate futures markets agree. Tuesday’s inflation report for August showed that shelter-related prices and auto-related prices composed the bulk of the monthly move higher. Food prices also remain sticky as one would expect given the lagged passthrough from higher commodity input prices. With the higher-than-expected monthly inflation print, interest rate futures markets moved to price in a 75-basis-point rate hike for the September 21 FOMC meeting and priced in a terminal rate between 4.25% and 4.50% over the next year.

As seen in Tuesday’s volatile price action, equity markets remain extremely sensitive to incoming inflation data and following what had been a large rally from the June low. The 4.4 percentage point drop in the S&P 500 was a four-standard-deviation event when looking over the past 50 years. We note that the months of June and September have shown the worst equity performance during midterm election years since 1900. Despite the historically negative performance during the month of September during midterm election years, equity markets have historically rallied into year-end during these years. We also note that after reaching a negative four-standard-deviation daily move, the S&P 500 produced a median return of 11.8% over the next six months with nearly an 80% probability of positive returns over the past 50 years.

If we fast-forward between one and three quarters, we are very likely to be in a macro backdrop comprised of lower inflation and slower economic growth with a Fed that has finished hiking interest rates. The pricing-in of this backdrop in the near term should be beneficial to positioning within equity portfolios. The combination of higher real interest rates and higher mortgage rates — the 10-year TIPS yield is up 100 basis points over the past year and the 30-year average mortgage rate stands above 6.1% — should continue to slow aggregate demand. This combination is likely to result in a leveling of Fed-induced financial conditions tightening over the coming months, which should support equity and fixed income markets.

Regional Manufacturing Surveys Show Softening Prices While Retail Sales Soften

Thursday’s Empire Manufacturing and Philadelphia Fed Business Outlook survey data showed softer prices paid and received. Prices paid fell to the lowest level in nearly two years in both surveys while prices received fell to the lowest level in nearly 18 months. This is encouraging news for the goods side of the economy and could help offset some of the stickiness in shelter-related inflation and wages over time.

August retail sales showed some slowing in nominal sales growth. Over the last three months, retail sales excluding gasoline, building materials, and autos rose at a 6.0% annualized pace. This likely leaves little, if any, room for gains in real terms as the CPI for goods excluding food, energy, and used cars rose 6.4% on the same basis. This slowing is to be expected as a result of the Fed’s goal of tightening financial conditions in a continued effort to slow aggregate demand.

We note that U.S. household balance sheets, in aggregate, stand $3.3 trillion above the level that pre-COVID growth trend would imply. As such, household savings remain quite elevated and should provide a buffer against a deeper consumption slowdown in the U.S. This is one of the drivers that continues to support service sector prices, which are likely to take longer to fall relative to goods prices. That said, the backdrop is much more negative for the bottom-quintile wage earners, where inflation has been especially problematic. This helps inform our stock selection, particularly with regard to consumer-oriented companies.

Risks Rise Globally, Bessemer Portfolios Remain Overweight the U.S.

While the U.S. continues to face a challenging macroeconomic environment, global financial conditions have tightened, and risks have risen. Leading indicators of economic activity have been contracting in China and Europe. One example of this is manufacturing PMI readings falling below 50 for both countries. The energy crisis in Europe is pushing inflation higher, and meanwhile, the ECB has just embarked on its tightening cycle, leaving much room for policy uncertainty. The weakened euro has exacerbated the energy crisis as imports become more expensive.

Economic conditions in China remain challenged under COVID-zero policies and a property crisis; growth forecasts have been downgraded to 3.5%, which would put GDP at its second-weakest annual reading in more than 40 years, and a reading far below policymakers’ stated target of around 5.5%. The property collapse in China continues to weigh on the economy, with home prices falling for the 12th consecutive month and residential property sales declining 30% year-over-year in August. Export growth for China slowed from 18% to 7.1% on an annual basis in August, and imports only rose 0.3% from the prior year due to weaker domestic demand. While the August data for retail sales and industrial production came in stronger than expectations, both industry and consumption remain weak. Meanwhile, policy uncertainty within China is pushing foreign businesses out of the country; 87% of U.S. executives said they are planning to move their business out of China, or already have. This could signal further pressure on Chinese trade, the capital account, and its domestic economy.

Relative to global data, economic data has held up in the U.S. Initial jobless claims continued to fall on a weekly basis, signifying ongoing strength in the labor market. Manufacturing PMI data remains in expansionary territory. Regional Fed surveys show an uptick in capital expenditure expectations for the next six months. Service data shows robust consumer spending amid inflationary pressures. Bessemer portfolios remain overweight the U.S., and underweight China and Europe, in part due to the more significant headwinds that the latter regions are facing.