Review the latest portfolio strategy commentary from Mike Gibbs, managing director of Equity Portfolio and Technical Strategy.
The S&P 500 is now down 19% from its highs, approaching the 20% “bear market” threshold, as high inflation continues to weigh on equities. In fact, the average S&P 500 stock is already in a bear market (24% off its highs), as is the Nasdaq Composite (-29% from highs) and the Small Cap index (-22% from highs). The S&P 500 is oversold enough for a short-term bounce but there is much to repair technically. And though the selloff feels extreme, we have not seen a capitulation in several technical indicators that would be consistent with durable lows historically. That said, the majority of stocks are trading at compelling valuation levels (i.e. prices have contracted signficantly despite strong earnings growth). While we expect market trends to remain challenged until more clarity is gained on inflation (given its elevated risks) and that equities may see further weakness, we would use the current down-draft as an opportunity to selectively accumulate favored stocks for the long-term.
High inflation remains the issue, and the ongoing Russia/Ukraine war along with China Covid lockdowns are the latest bouts of uncertainty impacting the potential timeline of inflation improvement. April core CPI was able to decline to 6.0% y/y from 6.2%, however the higher m/m increase of 0.6% m/m was disappointing- indicating stronger inflationary pressures than hoped. The more elevated m/m inflation numbers we get, the harder it becomes for the y/y reading to get to a more comfortable level. This, in turn, puts further pressure on the Fed to raise rates aggressively in order to get inflation under control- potentially to the point of economic contraction if necessary. We believe that inflation has likely peaked on a y/y basis, contributed in part by favorable base effects (as the calendar begins to lap last year’s high numbers). In addition, we are encouraged by a narrowing supply/demand imbalance as inventories rise, along with an improving labor market that can ease wage pressures. However, the degree and duration of Russian escalation, along with China’s zero-tolerance Covid policy, remain headwinds to the potential path of inflation improvement.
Inflation’s path ahead will ultimately be the primary driver of equity markets in our view. The market has been in a “high inflation and accelerating” regime, in which valuation multiples historically see the most pressure on average. However, we believe this is transitioning into a “high inflation but decelerating” regime, where valuation can stabilize or expand. This is important, as the pullack this year has been completely valuation-driven with earnings remaining strong. In fact, there has been a strong correlation between multiple compression and higher interest rates this year. A lot will depend on how quickly inflation can moderate. If inflation really starts to improve, Fed pressure will ease, market expectations for hikes will come down, interest rates are likely to at least stall their sharp ascent, and equities can begin to rebuild for renewed upside.
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