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Investment Strategy

March 06, 2023

Investment Strategy Brief: Inflation Catch-22

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Below is a transcript of this week’s video:

Despite some significant tightening from the Federal Reserve over the past year, inflation has not convincingly returned to its 2% target in the U.S. We reference the inflation surprise index, which tracks whether inflation prints are coming in ahead of or below consensus expectations from economists. With readings still above zero, economists at large have continued to underestimate inflation’s staying power. As a result, the market now believes that a fed funds rate of 5.5% will be needed to wrestle inflation under control. That’s up materially from a little less than 5% to start the year.

What sort of trajectory does this put the Fed on? Well, they’ve raised rates considerably above neutral already, which by itself should begin to have a contractionary effect on economic growth, as the effects of higher rates take time to cascade through the system. Fed funds futures are now pricing in rate hikes at each of the next three meetings, which is notably more aggressive than they expected just a month ago. But those additional rate hikes will likely narrow the path to a soft landing (that is, one that avoids recession) even further.

Investors and the media have been hyping up the potential for a soft landing scenario, where inflation comes back down to earth and the U.S. avoids recession. We look at the number of stories on Bloomberg that use the keywords “soft landing” in the title or body of the article. The observation here is that economic optimism always seems to peak before recessions, and by itself is not indicative of the actual direction of the economy. The last few times in history when the potential of a soft landing got this much excitement, a recession promptly followed anyway.

But there’s a bit of a catch-22 here. In either scenario, where the U.S. hits either a soft or hard landing, corporate earnings might be in for difficult times ahead.

Even if the U.S. avoids a recession, earnings could take a hit if disinflation reduces the pricing power of companies and costs remains sticky. Next-12-month earnings estimates for the S&P 500 have tracked inflation surprises closely in the postpandemic cycle, as many companies have benefited from robust revenue growth led by higher prices. If the U.S. achieves a soft landing, that means the Fed will have been successful in bringing inflation to heel. In such a scenario, profit margins could take a hit as companies find it increasingly difficult to pass on higher costs to consumers.

But when it comes down to it, it appears increasingly likely that the U.S. will not be able to avoid recession. That means a broad-based, cyclical downturn that sees corporate profits fall alongside demand may be in the cards. The average drawdown in earnings for the S&P 500 during recessions going back to the early 20th century is 15%. Applied today, that average haircut would result in $190 earnings per share for the index. This stands in contrast to the current bottoms-up consensus estimates, which aggregate analysts’ estimates for the individual companies in the index, at $223 per share for 2023. This implies that there is considerable downside to currently rosy earnings expectations. This is something that could be a catalyst for weaker equity markets ahead. The takeaway here is that in either scenario, soft or hard landing, corporate profits may come under pressure as pricing power recedes.

To summarize, stubborn inflation pressures are leading to ever higher expectations for tightening monetary policy in the U.S., with fed funds now expected to peak out near 5.5% by late summer. All else equal, each incremental step higher in rates narrows the path for a soft landing that avoids recession. This is setting up a bit of a catch-22 for corporate earnings since neither inflation scenario going forward is particularly good for profits. If the U.S. avoids recession because inflation has fallen enough for the Fed to let up on the gas, the reduced pricing power of companies and sticky costs could hit profits. On the flip side, in the more likely case that a recession is imminent, a 15% hit to earnings may be around the corner, which markets have not yet fully come to terms with.

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