1. Are we closer to the inflation peak?

• Despite the increase in realized inflation, the market still sees the Fed as credible in fighting inflation. The markets' estimate of what the 5-year forward 5-year equilibrium rates will be (see chart N°2), shows inflation expectations at 2.6%, which is only modestly above the Fed's 2% target, considering that CPI has historically outperformed the Fed's preferred PCE inflation measure by about 30 basis points.

Source: FYNSA Strategy; Bloomberg

• Underlying measures of inflation have also increased, but the basis for a deceleration is emerging, particularly in housing inflation (see graphs N°3 and N°4).

Source: JPMorgan

• This item of US inflation inflation is important to highlight because of the relative weight of shelter (housing) in overall inflation and services inflation. This category represents 1/3 of the total basket and 50% of services inflation. In this sense, the price trends in the sector described above seem auspicious and "tighter financial conditions" should do their job. (The 30-year mortgage rate rose from 3.25% at the end of 2021 to 5.57% now, much higher than the 30-year Treasury yield.)

Source: FYNSA Strategy; Bloomberg

• The rest, by the way, is played out in goods inflation. Here the pressures range from geopolitics to supply chains. Indeed, the shutdowns in China have only accentuated these supply chain risks. I would go further: the shutdowns in China in recent weeks explain much of the market stress due to the "stagflationary combination" they imply, but with the resurgences now "under control", it is to be expected that these pressures may begin to ease going forward.
• Underlying drivers of inflation, such as extended supplier lead times and the prices companies charge consumers, may be peaking. Thus, inflationary pressures appear to be easing, even before we consider the sharp tightening of US financial conditions. The "base effect" should do the rest.
• Ultimately, this will end up being a "delicate balance" between goods inflation that should continue to decelerate later in the second half and "stickier" services inflation.

2. If we are closer to the "inflation peak", it is fair to say that we should be near the bottom of the market.

Most of the equity adjustment so far this year is multiple compression. We believe the forces that pushed equity prices lower may begin to abate: the war in Ukraine no longer seems likely to escalate into a broader conflict; the number of new Covid cases in China has been cut in half; and global inflation may be bottoming out.

• With analysts' corporate earnings estimates rising, multiple compression has driven the 15% YTD decline for the S&P 500. The consensus P/U fwd multiple has declined 16%, from 21x in early 2022 to 17x today, closely tracking rising real interest rates (Chart No. 6). Over the past two months alone, 10-year real rates have risen from -1.0% to +0.3%, their first venture into positive territory since early 2020. Year-to-date, the S&P 500 earnings yield (inverse of P/U) has risen 90 bps (4.8% to 5.7%). nearly matching the 125 bps increase in real Treasury yields.
• Because the P/U multiple has moved with the risk-free rate, the "yield gap" between the EPS yield and the real Treasury yield, a proxy for the equity risk premium (ERP), is close to where it started the year. The current yield gap of 550 bps is close to its 10-year average (560 bps), although much wider than its 25-year average (440 bps) (Chart No. 7).

Source: FYNSA Strategy; Bloomberg

• Looking ahead, the trajectory of the stock market will depend on the outcome of the Fed's battle against inflation. In our base case scenario, GDP and corporate earnings continue to grow, albeit at a slower pace than in 2021. Financial conditions will continue to tighten, but the impact of higher rates on equity valuations should be at least partially offset by a narrowing yield gap.
• If the risk of recession increases, interest rates may fall, but not enough to prevent stock multiples and stock prices from continuing to fall. In a recession scenario, analysts would cut earnings forecasts. The average EPS decline during U.S. recessions since 1949 equals 13%. The real Treasury yield could also fall to -0.5%, 50 bps above its historical low. If the yield gap were to widen to 650 bps, near its 4Q 2018 high, the P/E would contract to 17x and the S&P 500 index could fall to 3600 (-10% as of today). Such a drop in the S&P 500 would represent a 24% peak-to-trough decline, matching the average decline during past recessions.
• Our best guess at the moment is that the U.S. economy will manage to avoid a recession, at least not an imminent one. The statement following the FOMC decision that raised the federal funds rate by 50 bps, in a widely expected move, emphasized that the Fed expects that a "soft landing" of the economy may be possible under the assumption that household spending and business investment "would remain strong" and that inflation would begin to decelerate in 2H22 (although it acknowledged that virus-related shutdowns in China "are likely to exacerbate supply chain disruptions" and that the committee is "very mindful of inflation risks"). Under those assumptions, prices much lower than 4,000 points for the S&P 500 would not be justified and we maintain our estimates of fair value levels closer to 4,600 points.

Source: FYNSA Strategy; Bloomberg

Finally, if we are closer to the "inflation peak", it is fair to say that we should be close to the bottom of the market. Therefore, for traditional investment timeframes (between 12 and 18 months), falling inflation and recession fears may cause stocks to recover a significant part of their losses.

Humberto Mora

Assistant Investment Manager Finance and Business Finance and Business Brokerage Firm