In recent weeks, a hope trade was beginning to take hold in markets. It posited that inflation would be peaking soon, allowing the Fed to back off its most hawkish/aggressive policy path. This, in turn, would drive stabilization and relief in risk assets like equities.

Friday’s red-hot inflation print dashed what, in our opinion, were misplaced hopes for an inflation peak and a dovish pivot. The inflation data solidified that we are likely in for a cruel summer of trading in equities, with the potential for further downside for indices and the likelihood of continued elevated volatility.

Before we can dive into the rationale of this call, we must be abundantly clear that we are not sharing this outlook to scare long-term, tax-conscious investors away from risk assets. On the contrary, we want to lay out a realistic path of how things can progress in the coming months so that we can be prepared to take advantage of volatility and more compelling valuations.

We do not see broad equity indices as cheap yet, and we think ultimate lows for this correction could still be in front of us. Nevertheless, pockets of opportunity are beginning to emerge, and as the cruel summer of trading progresses, we may find that these pockets will become larger sets of opportunity for long-term investors.

CPI: Sticky and Broad Keeps the Fed Hawkish

The Consumer Price Index (CPI) release for May showed that Headline inflation has yet to peak in the U.S. and even accelerated from April into May. Core inflation moderated on a year-over-year basis but did not slow down month-over-month. Headline inflation includes food and energy prices, while Core excludes these two categories because they are more volatile, be they ever so essential.

The debate around whether inflation has peaked or not misses the point that even a near-term peak in the CPI will likely not be enough to get the Fed to pivot to a more dovish or accommodative stance.

This is because inflation is now sticky and broad.

Inflation is broad because most of the components in the CPI are now elevated. What started in 2021 as a handful of pandemic-related price spikes has now spread to the broad economy. Now nearly 80% of the components in the CPI are above 4%. The Fed watches another measure of inflation breadth, the trimmed-mean CPI, which is at its highest level on record going back to the early 1980s. And thus, one or two items rolling over and causing a near-term peak are unlikely to be enough for the Fed to call the “all clear” on inflation.

Inflation is sticky because the slowest moving parts of inflation are now rising at the fastest pace in 30 years. Once these components become elevated, they tend to stay elevated for far longer than the more volatile, flexible components of the CPI.

The Fed fears broad and sticky inflation because it risks becoming entrenched in the economy and the psyche of consumers. This is why the Fed monitors long-run inflation expectations to see if they remain “anchored” close to the Fed’s own target of 2%.

For now, despite the swirl of near-term inflation data, long-run inflation expectations remain relatively anchored. Still, the Fed knows that the longer this high inflation remains broad and sticky, the greater the risk of an unmooring of these expectations (market based 5y5y forward inflation expectations is 2.39%, while the survey-based University of Michigan expectations of inflation over 5-10 years spiked to 3.3% last month).

Hikes: Bigger and Faster

Yet for this discussion of why a peak in YoY inflation is less relevant for Fed policy in the near term, we did not actually see the peak in May. Instead, the acceleration seen in May’s CPI print quickly shifted expectations towards bigger and faster rate hikes in 2022.

Though Chair Powell had ruled out the possibility of 75 bps hikes at the May FOMC meeting, the market is now pricing in about a 30% chance of 75 bps in both June and July. The market also priced in a 50 bps hike in September, instead of the 25 bps suggested by some Fed governors that argued for a “pause” in tightening after the summer hikes.

In totality, this acceleration in hiking raised the policy rate that the market expects the Fed to reach by the end of 2022 to ~3.25%. The Fed’s median forecast based on the March dot plot for 2022 is just 1.875%. This coming week’s FOMC meeting will likely show a rapid revision higher of this rate path.

Interest rates across the maturity curve priced in this bigger and faster rate hike path with higher yields. Importantly, we saw short term rates move up more than long term rates, causing the yield curve to flatten (meaning the difference between the long term, 10 Year, and the short term, 2 Year, fell).

The 2s10s curve is now just 9 bps, or nearing negative territory that would be an inversion (5s30s did invert on Friday). This captures brewing growth fears in the market. In a simple way, if the 2 Year is above the 10 Year, it can indicate that the market fears that the Fed will become too tight for the underlying economy (shorter term inversions like the 3 Month-10 Year is the market saying the Fed is already too tight).

It Has to Get Worse Before It Gets Better

One key argument we have been making about today’s markets and economy is that it has to get worse (much weaker data) before it gets better (a shift to accommodative policy).

We see little ability for the Fed to become supportive of markets in the near term, given both elevated inflation and a labor market that is still, by historical standards, incredibly tight.

Eventually, the Fed will shift to accommodation, but this shift will come after both financial markets and the economy are disrupted and slowed enough to justify a pivot to support. Pricing in a bullish pivot to support before we have even begun to see distinct weakness or stress in the economy and the market is jumping the gun.

The signs of weakness and stress are starting to emerge, but they are not bad enough yet to get the Fed to act.

In markets, we have seen financial conditions tighten/rise (this implies lower equity valuations and wider credit spreads), but these financial conditions remain well below peak levels of stress that got the Fed to act in prior cycles (2016, 2018, 2020), and are historically still relatively easy, near 2019 levels.

U.S. equity valuations have fallen YTD, but at 17.1x for the S&P 500, the index valuation remains in line with long run average of 17x. Typically, valuations fall well below average during tightening cycles and/or recessions.

The tighter liquidity is starting to show itself in fundraising markets. According to BofA Global Research, high yield bond issuance is running nearly 90% lower than its 2021 peak. According to Renaissance Capital, the number of IPOs being priced YTD is down nearly 80% from 2021.

Early stage and lower quality companies that rely on incremental outside funding to keep the lights on are having to freeze hiring, lay off workers, and retrench growth plans for cash management. Even established Growth darlings are starting to realize that the growth and investment projections they made by extrapolating 2021’s policy-juiced pace of demand are far too optimistic.

The impact of higher rates is starting to cascade through consumer demand, first with the most interest rate sensitive parts of the economy. The Mortgage Brokers Association sees mortgage applications already down 40% from the 2021 peak, as today’s much higher rates meet elevated prices, ruining affordability for many potential buyers.

Consumers are getting pressured on all sides, not just by higher rates. Friday also saw the release of the University of Michigan Consumer Sentiment Index, showing a collapse in sentiment to new all-time lows, even below the Great Financial Crisis.

Consumers are feeling the pinch from an erosion in their purchasing power, where wage gains are not keeping pace with price increases (real wage growth has been negative since April of 2021). Further, the majority of consumers have spent down their excess savings balances and now are not receiving supplemental government support. As a result, they are turning to credit to buoy spending, with revolving credit card balances surging 13% in the last year, the fastest pace going back to the early 2000s.

Note this is all happening with a labor market that remains tight. As initial jobless claims begin to move higher off of record low levels and wage gains potentially slow, we could see the pinch on consumer spending become exacerbated.

This all translates to corporate earnings estimates that may be too optimistic given the slowing growth environment. Street estimates are for 10.5% S&P 500 EPS growth in 2022, and another 9.5% in 2023 and 2024. Though these estimates in 2022 are being held up by strong Energy EPS growth (+130%), overall, if growth continues to slow, we are likely to see revisions lower for this year and next.

In another “worse before it gets better” example, the earnings revision cycle lower is just getting started, meaning we have not reached the point where estimates are so low, dire and easily surmounted that a strong contrarian buy environment emerges (like in 2020 where estimates got cut too aggressively and analysts had to chase estimates higher).

So, we are seeing signs of slowing growth, weaker demand, and tighter liquidity in financial markets, but we have not yet reached the levels of weakness and stress that would justify a pivot by the Fed.

Defining Quality: The Three R’s

This leads to the ultimate question for investors: what we should do in response to this environment of high inflation, softening growth, tightening liquidity, and no near-term Fed support.

We continue to think investors should focus on quality. Quality has become quite the oversimplified buzzword this year and can easily be misunderstood. Thus, our approach to quality investing deserves a more exacting description.

We define quality with three R’s: resilient, resourceful, and reasonable.

Resilient because quality companies are those that have stable business models that can withstand economic volatility. We tend to favor companies that can generate strong cash flow through cycles, even in downturns, and, particularly in this environment, have pricing power that can sustain margins.

Resourceful because quality companies have strong balance sheets that can enable them to be opportunistic with M&A and share repurchases when valuations start to fall. Resourceful companies do not need to tap capital markets just to run the day-to-day business, meaning they do not have to raise debt when interest rates are high or issue equity when prices are low. Resourceful companies can sustain and even grow dividends during downturns.

Reasonable because we cannot pay any price for quality companies, mostly in a tightening liquidity environment when valuations are most at risk. We must be disciplined about valuations and are using volatility to find opportunity when quality names are getting indiscriminately discounted.

Conclusion: Get Used to It

Overall, we think we have to get used to this environment of weak, choppy, and volatile markets given economic and market data does not support the Fed becoming supportive of markets.

Getting used to this environment means being sharply conscious that many assets are in distinct downtrends. We need to be disciplined about not chasing relief rallies until we see signs that trends are improving and turning (and until valuations approach more compelling levels).

Getting used to this environment also means emphasizing the specific quality traits we described above. It means being ready, willing, and able when the proverbial baby is getting thrown out with the bath water to buy “crown jewel” names on sale.

As we described earlier, right now we see smaller pockets of opportunity that recent volatility has created, but as the summer of volatile trading continues and lows are retested or breached, we expect to see this opportunity set expand materially.

In the meantime, crank up the Bananarama, because it is likely to be a cruel, cruel summer.