Despite the Fed enacting the most aggressive interest rate hikes since the '80s, inflation continues at 40-year highs.
In September, the Consumer Price Index (CPI) rose a greater-than-expected 8.2% from the prior year, and 0.4% from the prior month, but this was down slightly from 8.3% in August and 9.1% in June (which marked the highest inflation in 40 years). The “core” measure of inflation, which excludes food and energy prices, rose 6.6%, accelerating from August and representing the largest increase since 1982. This was not welcome news, as the Fed had hoped more restrictive policy would have had a greater impact.
Instead, inflation remains well north of the Fed’s 2% target. The Fed’s preferred inflation measure, the personal consumption expenditures price index (PCE), is also running well ahead of its long-term target, rising 6.2% in August.
A strong labor market gives the Fed cover to continue tightening policy. In response to inflation that has consistently run ahead of its expectations, the Fed has increased the Federal Funds rate by 0.75% at each of its last three meetings, bringing its target range to 3.00%-3.25%. The upside surprise in the September CPI data resulted in another 0.75% increase at the Fed’s early November meeting and moved market expectations for a December increase from 0.50% to 0.75%. This would leave the target rate at 4.50%-4.75% at year-end from nearly 0% at the start of the year.
Given the magnitude of rate increases this year, history would suggest recession over the next year or so is likely. How severe a recession remains the key question, though strong consumer balance sheets should help cushion the impact. It is worth noting typically in recessions equities bottom well before GDP does.
Looking across asset classes there haven’t been a whole lot of places to hide during the market’s downturn. The increase in interest rates has hurt both bonds and stocks, with a traditional 60/40 portfolio comprised of the S&P 500 and 10-year Treasuries down over 20% year to date. This would register as the second worst performance in history.
The major stock indices are each in bear market territory driven by multiple contraction as earnings have remained resilient. The multiple the market is willing to pay for earnings is inversely correlated with interest rates. The yield on the 10-year Treasury is up to approximately 4.0% from 1.5% entering the year. Multiple contraction has driven market declines, as the forward P/E multiple for the S&P 500 has fallen from approximately 21.5x at the start of the year to closer to 15.5x. For context, this is below the 10-year average forward P/E of about 17.0x.
Meanwhile the overall earnings outlook remains relatively upbeat. For 2022 consensus estimates for the S&P 500 reflect 7% EPS growth with another 7%-8% earnings growth in 2023.
For individual companies, pricing power will be tested and those companies able to pass along the cost increases they are experiencing will fare far better than those that cannot. Owning growing, free cash flow generating companies with strong balance sheets and reasonable valuations -- like any of the three companies recommended in the November 2022 issue of the Investor Advisory Service stock newsletter -- is a sensible way to navigate this challenging environment.
In the November 2022 issue of the Investor Advisory Service, our analysts selected a major software developer with a growing subscription business, a robotic surgical device maker in the defensive healthcare sector, and a real estate company in the communications industry.
[Note: This commentary originally appeared in the issue of Investor Advisory Service published in late October. To receive this information in a more timely matter and receive two or three stock picks each and every month, we invite you to subscribe today with this special offer.]
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