CPI report Friday strikes fear that the Fed will have to hike the economy into a recession.
On Friday June 10th, CPI figures came out and broke the recent narrative of “peak inflation” occurred in March. Under the hood there wasn’t a whole lot of good to look at:
- Headline inflation came in at 8.6%, edging out the 8.5% figure in March. Energy was the culprit in March following Russia’s invasion of Ukraine and accounted for 82% of the month over month change.
- However, the Fed’s fears of inflation expectations becoming embedded in prices broadly seems to be taking hold. One way to measure this is the “trimmed mean” inflation figure which takes out the high and low outliers and recalculates. This figure has been tracked since 1984 and is reaching new highs.
- The other more heavily watched area will be housing. This figure is important because a) it is the largest single component to the CPI basket and b) it is presumably an area of the market the Fed has more influence through monetary policy unlike food or energy. However, May figures do not show cooling quite yet.
Source: Bureau of Labor Statistics
Why does the market care so much about inflation?
- Inflation has backed the Fed into a corner and is forcing them to do something they would otherwise not want to do, hike into a slowing economy and weak market.
- It seems fair to say markets are addicted to accommodative monetary policy. Cheap cost of capital and quantitative easing have been a great backdrop for risk assets. In our 2022 Outlook we talked about how accommodation and higher returns have recently moved in lockstep with one another.
Source: 20222 Outlook, Navigating Moderation
- So naturally the inverse, tightening monetary policy and quantitative tightening can be painful as the addict wanes off their addiction. How painful and how long is what markets are trying to assess. The higher and more resilient inflation is the more aggressive the Fed will have to be to tame inflation and market prices and economic activity may be the collateral damage.
- The CPI print Friday clearly changed the market’s view of what is necessary to overcome inflation and is now pricing in two additional rates hikes between now and year end. It has also opened the door to even more aggressive thinking with small odds on up to 13 more rate hikes in 2022.
Views of what the Fed needs to do to beat inflation have shifted materially
Source: CME FedWatch Tool
What if the Fed does hike the economy into a recession?
- It is important to note that recessions are a normal part of markets and often help build the foundation for future opportunity.
- That said, recession led pullbacks do tend to be more sever and last longer. The data below shows pull backs of 10% or more since 1950 and those overlapping with a recession.
- It is interesting to note, the corrections and recessions of the late 70’s and early 80’s are largely attributed to a Fed increasing interest rates to cool inflation. All of those pullbacks were shallower than the average bear market drawdown.
- While we have no predictive power of calling the bottom of a pullback, most investors have come to think of recessions and markets more in the neighborhood of the GFC or the tech bubble in which markets were down 50% or more. There is no formula that says a recession has to create such a sever market pull back as those in recent history.
1. The CME FedWatch Tool now shows futures pricing implying a 26% chance of a 0.75 percentage point hike on Wednesday, up from just 3% a week ago. Anything less than 0.50 percentage point is off the table.
- By the end of 2022, Fed Funds futures are pricing in a target range of 3.50% to 3.75%. That implies an additional 0.75 percentage point of rate increases between now and the end of the year versus what the market was expecting a week ago. And it's a long, long way from the current target range of 0.75% to 1.00%.
2. Treasury yields jumped today, pricing in those higher expected benchmark rates.
- The 2-year Treasury yield rose 0.23 percentage point, to 3.28%—its highest yield since 2007. It most directly reflects the near-term path of interest rates.
- The 10-year Treasury yield rose 0.22 percentage point, to 3.37%. That's its highest yield since 2011.
Source: Treasury.gov, CNBC.com
1. Since 1929, the S&P 500 has experienced more than two dozen bear markets. This year’s declines have marked a quicker-than-average descent into bear territory, at 111 trading days since the index’s Jan. 3 record high, according to Dow Jones Market Data. Among the past 10 bear markets, only the 1987, 2009, and 2020 versions took fewer trading days to achieve a 20% drop.
2. The bad news on Monday was that history shows the pain isn’t over yet. The S&P 500’s average bear market peak-to-trough decline has been almost 36%, and the index has taken a median of 52 trading days to bottom out after entering a bear market. That would mean another 10 weeks or so of continued declines, putting the bottom in roughly late August. The key word is roughly.
3. The good news is that the slightly longer-term S&P 500 returns after a first bear market close are actually quite positive.
- In bear markets since 1950, the index has been higher 75% of the time three months later, by an average of 6.4%.
- A year after falling into a bear market, the S&P 500 has been positive 75% of the time, and climbed 17% on average.
There are numerous reasons why a bearish investor might say this time is different.
- Inflation may be more entrenched than expected, hurting consumers’ buying power and confidence and eating into corporate profit margins.
- The Federal Reserve may respond with more and larger interest-rate hikes, which could push the economy into a recession and extend the bear market.
- The war in Ukraine could escalate further, raising all kinds of terrifying worst-case scenarios.
But history shows that bear markets don’t last forever, and that the worst tends to be behind investors once that official definition is reached.
The New York Times (“What Happens When Stock Markets Become Bears”) had an interesting graphic which shows the longer-term trend of the market is positive, though bear markets can certainly be painful.
And, finally, as was previously shared from a Hartford Funds piece…..
- Half of the S&P 500 Index’s strongest days in the last 20 years occurred during a bear market.
- Another 34% of the market’s best days took place in the first two months of a bull market—before it was clear a bull market had begun.
- In other words, the best way to weather a downturn could be to stay invested since it’s difficult to time the market’s recovery. (Source: Hartford Funds, Ned Davis Research, 12/21. Time period referenced is 12/16/01– 12/15/21.)
Index Benchmarks presented within this report may not reflect factors relevant for your portfolio or your unique risks, goals or investment objectives. Past performance of an index is not an indication or guarantee of future results. It is not possible to invest directly in an index. The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. The S&P 500® Index, or the Standard & Poor's 500® Index, is a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies. GFC is an acronym for Global Financial Crisis. CME FedWatch Tool, is a tool created by the CME Group (Chicago Mercantile Exchange Group) to act as a barometer for the market’s expectation of potential changes to the fed funds target rate while assessing potential Fed movements around Federal Open Market Committee (FOMC) meetings.