There has been a hopeful narrative circulating around stock markets as they rallied off recent lows.
That narrative involved peak inflation and peak Fed expectations. As measures of economic growth have begun to slow, investors allowed themselves to consider, ever so slightly, that just maybe inflation data would come off the boil. The Consumer Price Index (CPI) recently released disabused anyone of that notion. Peak inflation, and peak Fed as a result, will have to wait.
Total CPI rose 8.6% from a year ago.
The Core CPI that excludes food and energy prices rose 6.0% over the past year.1 While the Core CPI growth rate slowed for the second month, Total or Headline CPI reaccelerated. The longer food and energy prices remain this high, the more they will work their way into the broader Core CPI measure.
| CPI for All Urban Consumers: U.S. City Average Yearly Change | |
|---|---|
| All Items | 8.6% |
| Food at Home | 10.1% |
| Food Away from Home | 11.9% |
| Gasoline | 48.7% |
| Fuel Oil | 106.7% |
| Electricity | 12.0% |
| Utility Gas Service | 30.2% |
| New Vehicles | 12.6% |
| Used Vehicles | 16.1% |
| Apparel | 5.0% |
| Medical Care Commodities | 2.4% |
| Shelter | 5.5% |
| Transportation Services | 7.9% |
| Medical Care Service | 4.0% |
Source: Bureau of Labor Statistics
Source: FactSet
Items including energy, used vehicles, and apparel that experienced price declines during April, and lent evidence to the peak inflation narrative, reaccelerated in May.
After the Federal Reserve meeting on May 3-4 that resulted in a 0.50% increase to the Fed Funds interest rate, Chairman Powell was asked if the Committee might consider a 0.75% increase at future meetings. The Chairman confidently suggested that a 0.75% increase to Fed Funds was not something the Committee thought would be necessary. The CPI’s higher than expected print has revived the discussion in the markets of a 0.75% or even 1.00% increase to Fed Funds at an upcoming meeting. The Fed met again on June 14-15.
Stock markets reacted predictably poorly to the hotter inflation number. The S&P 500 Index declined -2.91% on Friday, June 10. The Russell 2000 Index of small cap stocks declined -2.73%, and the NASDAQ Composite fell -3.52% weighed down by its higher tech exposure. After a nice rebound in the S&P 500 since May 20, the index is retesting that low point again.
Source: FactSet
The decline in the S&P 500 so far this year hasn’t come at the hands of earnings.
Rather, the decline has been evident through valuations. The chart above shows earnings per share expectations for the S&P 500 Index (blue line) over the next 12 months and the PE ratio (red line) on those earnings expectations. The PE ratio has declined from just over 21.3 to 16.8 since January 1, 2022. That is a historically large contraction in valuation over a very short time period.
Notice the blue line representing earning per share expectations has not declined, and that is perplexing. In our May 17, 2022 Investment Insights, we wrote of our skepticism concerning profit margins and earnings. Since that date, some companies have lowered profit margin and earnings expectations, but the S&P 500 Index hasn’t yet seen a downward earnings revision at the index level. Why? Because other companies have raised profit margin and earnings expectations.
We did more digging into the data at the sector level.
Since December 31, 2021, earnings expectations for 2022 have fallen for Communication Services, Consumer Discretionary, and Consumer Staples companies. Earnings expectations have risen for Energy, Industrials, Technology, Materials, and Real Estate companies. Expectations have remained about the same for Financials, Health Care, and Utilities.1 When you combine this all together, earnings per share expectations at the index level are supported while the details of winners and losers by sector and company levels tell a very different story. We are still skeptical of current profit margin and earnings expectations, largely because of the headwinds we see for the consumer.
As if the CPI wasn’t enough bad news for a Friday, the University of Michigan Consumer Sentiment Survey didn’t help. The Index of Consumer Sentiment hit 50.2, a decline of 41.3% from a year ago. This level is comparable to levels reached in the middle of the 1980 recession and during The Great Recession of 2008/09. Consumers do not have a rosy outlook on the future. Current Economic Conditions are at 55.4, a -37.5% decline from a year ago, while the Index of Consumer Expectations sits at 46.8. This is a -44.0% decline from a year ago. This suggests consumers believe conditions will deteriorate versus the current situation before improving. Gas prices were mentioned by half of those surveyed followed by concerns over supply shortages.2
The consumer is under a great deal of pressure.
After stimulus fueled jumps to Real Disposable Personal Income in the second quarters of 2020 and 2021, that measure is now in its fourth quarter of decline. The Personal Savings rate climbed along with increases to income. Savings are likely serving as a buffer to spending cuts in the near term. How many of you know people traveling abroad this summer and taking beach vacations despite the cost of gasoline, scarce lodging availability, and high lodging and food prices? Much of this travel spending was booked during the late winter and early spring, before prices really took off. And the psychology of the pandemic is in play.
Source: FactSet
Chart Source: First Horizon Advisors
Data Source: Bureau of Labor Statistics
People were prevented from enjoying vacations and now seem intent on reversing that experience. But this cannot last forever.
With real incomes declining and the savings rate falling back to more normal levels, it should only be a matter of time before consumer spending follows suit.
This is particularly pronounced across the lower- and middle-income levels, where food and gasoline costs make up a higher percentage of spending. Certain big-box discount retailers are already noticing the hit to consumer spending. Earnings and profit margin expectations have been warned about by these companies more than once over the past few weeks. Spending has slowed and inventories are growing rapidly and unexpectedly.
The first half of 2022 experienced stock market declines based on contracting valuations. As we enter the second half, attention is turning to corporate earnings and how buoyant they can be, or not, in the face of persistently high inflation, higher interest rates, and growing pressure on consumer and business spending. Declining earnings expectations could put additional downward pressure on stock markets, as it would be difficult for valuations to expand in this environment to make up for lower earnings. If anything, the market is pressuring the Fed to be more aggressive in withdrawing monetary support than it has already committed to be. Until inflation subsides and the Fed can slow its pace of tightening, financial markets are likely to remain under pressure.
Tracy Bell, CFA
Director of Equity Strategies
Information presented is as of the close of business for the noted date, compiled from third-party sources and believed to be reliable. However, we do not warrant its accuracy or completeness. We use this information for illustrative purposes only and it does not represent the performance of any particular investment. This information does not constitute and should not be construed as investment advice or recommendations with respect to the securities or sectors listed.
S&P 500 Index is regarded as a gauge of large cap U.S. equities. The index includes 500 leading companies and captures approximately 80% of the available market capitalization. Russell 2000 Index is a small cap stock market index that makes up the smallest 2,000 stocks in the Russell 3000 Index. It was started by the Frank Russell Company in 1984. NASDAQ Composite is a stock index that includes almost all stocks listed on the Nasdaq stock exchange. Along with the Dow Jones Industrial Average and the S&P 500, it is one of the three most followed stock market indexes in the United States.
Presentation prepared by First Horizon Advisors – June 13, 2022.
Sources:
1 FactSet
2 University of Michigan Survey of Consumers
