Review the latest portfolio strategy commentary from Mike Gibbs, managing director of Equity Portfolio and Technical Strategy.
Inflation remains the primary driver of equity markets currently, and last week’s hot CPI report resulted in a sharp -9% selloff over just four days- pushing the S&P 500 to new lows (and bear market territory). The longer inflation stays at stubbornly high levels, the more problematic it becomes for the economy and the Fed (as it attempts to bring inflation under control). Supply challenges, contributed greatly by the Russia/Ukraine war and China’s zero-tolerance Covid policy, have made it hard for supply to improve toward demand. The Fed cannot help supply, but it can negatively impact demand through tighter monetary policy. The Committee elected to raise the fed funds rate by 75bps yesterday, taking its target range to 1.5-1.75% (matching consensus expectations). And in its commentary has attempted to gain more credibility- being hawkish but not too much, and tight but also flexible based on the data ahead. Ultimately, the trajectory of inflation moving forward will remain a significant influence on equity market trends. Unless the narrative changes in regard to Russia backing off or China ending lock-downs, it will be difficult for equities to sustainably move to the upside without better inflation data in our view.
Given our base case economic outlook of positive (albeit slower) economic growth and moderating inflation, we believe that equities will be higher than current prices over the next 12 months. However, the path of least resistance remains lower for equities in the shorter-term, and we do not expect inflation to rapidly improve overnight- leaving the Fed in tightening mode. Our favored area of potential downside continues to be the 3400-3600 area, as we see plenty of fundamental and technical justification for this level. The S&P 500 is currently trading at a 17.3x P/E, which is much cheaper than multiples witnessed in the post-Covid era and very reasonable historically. We note that severe draw-downs in the 2015/16 US manufacturing recession, 2018 trade war, and 2020 Covid shutdown found lows in the 14-16x P/E range. At 16x, the S&P 500 would trade at 3458 (interestingly, very near the pre-Covid peak) and would be -43% multiple compression (in line with that seen in the dotcom bubble and credit crisis). Additionally, 3648 represents the average -24% non-recessionary bear market decline historically. Technically, the S&P 500 200-week moving average has been a good level of support over the past decade in major market weakness- and is currently 3500.
Inflation remains the main variable to watch for market movements, and we expect investors to remain reactive to the data. If inflation can begin to improve, sharp upward pressure on bond yields is likely to abate- in turn, removing downward pressure on equity valuations. Once the dust settles on the current bear market, we believe that long-term investors will find compelling risk/reward from current valuations- it’s more a matter of timing in the shorter-term (weeks-months). With this in mind, we recommend using the downdrafts as opportunity to accumulate high quality stocks with a long-term perspective.
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