Persistent Inflation Sends Stocks Near Bear Market Levels

While headline consumer inflation (CPI) improved to 8.3% yoy in August, the improvement was not as strong as expected. More importantly, the tricky part of the inflation data, as discussed last week, presented a significant challenge. The Atlanta Fed’s sticky inflation gauge rose to 6.1% year over year, a new high for this cycle. This deadly combination sent stocks back down to near bear market levels.

As expected, the headline improvement was helped by some moderation in the pace of commodity price increases, particularly energy.

Unfortunately, some of the areas of inflation related to the reopening of the economy after lockdown have been less helpful this month. Although three of the five were below the CPI composite, all five had larger year-over-year price changes than the previous month.

As noted last week, the continued decline in headline inflation is a necessary but not a sufficient condition for the Fed to deviate from its expected aggressive rate hike path. Rent is an example of sticky inflation that continues to weigh on the inflation story. In view of the resilience of the labor market to interest rate increases, there is unlikely to be any relaxation on the wage front anytime soon.

The 1-year Fed Funds futures rate is a key variable in recession probability and government bond yields. Amid persistently high inflation, expectations for the Fed Funds Rate reached a new high of 4.26% in a year, beating the 4.06% in mid-June, when equities bottomed and Treasury yields peaked . Markets are pricing in a rate hike of at least 75 basis points (0.75%) at Wednesday’s session, with 50 basis points in November and at least another 25 in December. In addition, 2-year Treasury yields hit a new cycle high, while 10-year Treasury yields are very close to June highs. The Federal Reserve’s need for a more aggressive rate-hike cycle to combat the persistent threat of inflation reduces the chances of avoiding a recession.

Cyclical stocks, which are more economically sensitive, had started to outperform underlyings, but the trend turned sharply lower after the inflation report. This move reflects the higher probabilities of a recession priced into equities.

Value stocks have been relative beneficiaries of higher yields and outperformed again last week. Additionally, Growth-at-Reasonable-Price (GARP) stocks with strong balance sheets look attractive, combining lower valuations with opportunities for long-term earnings growth.

The value space also has attractive relative valuations that are selling at very reasonable levels compared to growth stocks given history.

The path for stocks appears to remain choppy as the market grapples with the rising odds of an economic downturn caused by the Fed raising interest rates to fight inflation. Investors should have an appropriate asset allocation and focus on high quality, attractively valued companies to weather the looming recession and thrive thereafter. On a more positive note, future stock returns have typically been strong after falling 20% ​​from highs, and stocks are now close to a level.