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WEEKLY INVESTMENT PERSPECTIVE

While blistering summer heat is being felt across the U.S., financial markets are feeling the heat from another upside surprise on inflation. Equity markets tumbled lower last week and are sliding back into bear market territory in this week’s early trading following the May inflation report released on Friday with consumer price growth hitting a fresh 40-year high accompanied by a report of record lows in consumer sentiment from the University of Michigan. The reports highlight the challenge ahead for the Federal Reserve and the economy as red-hot inflation increases the pressure on the central bank for more aggressive tightening of monetary policy while the rapid slide in consumer sentiment already suggests cooling demand ahead without additional pressure. Continued disruptions from the war in Ukraine and China’s zero-Covid policy have kicked supply chain recovery down the road, so the Fed’s recourse is to further cool demand to bring supply and demand into equilibrium. In that backdrop, the potential is rising for a policy error that hits the brakes on the economy too hard leading to a downturn in growth.

Financial markets are responding as the S&P 500 has fallen over 21% from its high after losing 5.0% last week and 3.9% on Monday, while the Dow Jones has drawn down over 17% from its highs. The tech-heavy Nasdaq, which lost 5.6% last week and 4.7% on Monday, continued to see greater selling pressure and is now down over 30% from its high set in November. However, equity market losses so far this year pale in comparison to cryptocurrency markets, with Bitcoin futures down almost 20% on Monday alone. Meanwhile, bonds have also sold off with interest rates surging on inflation fears. The 10-year U.S. Treasury yield has broken above 3.25% and is now trading at its highest level going back to 2011 at around 3.34%, which is just above the 2-year Treasury yield of 3.33%.

May’s CPI report showed headline price growth accelerating to 8.6% year-over-year, while core goods and service prices grew at a 6.0% year-over-year pace. Price pressures are broad-based as higher food and energy costs (among other commodities) from supply disruption feed into most end markets. Faster than expected price increases in core services have been the largest driver of the recent surprises, as travel and transportation demand showed little sign of slowing down with airfares surging (up roughly 25% from pre-pandemic levels). Core goods prices, where cooling price growth has been central to expectations for moderating inflation overall, also showed a notable increase in May. Recent reports from major retailers have indicated notable overbuilding of inventories that is expected to put downward pressure on prices of select goods as the excess inventories are marked down, but this has yet to be seen in broad inflation reports.

Rate hike expectations have lifted much higher in response, increasing the anticipation for this week’s Federal Reserve meeting that will wrap up on Wednesday. Prior to Friday’s inflation report, members of the Federal Reserve were broadly guiding toward a high likelihood of 0.50% increases at the June and July meetings and then reassessing the pace of hikes at the September meeting. Following the inflation report, the market is pricing in higher odds of a 0.75% hike at one of the upcoming meetings, with the CME FedWatch tool showing nearly 30% odds of a 0.75% hike this week. According to Bloomberg, markets reflect expectations for a federal funds rate between 3.25% and 3.5% by year end, eventually hitting as high as 4.0% a year from now. That compares to May month end, when markets pointed to a 2.5% to 2.75% policy rate by year end and just surpassing 3.0% in a year. That is a powerful shift in expectations, which aligns with the recent volatility.

While rate-sensitive markets like housing are slowing significantly, the U.S. consumer has remained quite resilient with the support of pandemic savings to maintain spending despite wage growth not quite keeping pace with inflation broadly. Current estimates of excess pandemic savings remain in the $1.5 trillion to $2 trillion range, but this varies by income bracket and can only allow real consumption to tread water for so long. Our investment team will track and keep you apprised of the progress of supply chain recovery, which is crucial to reining in inflation without further shocking demand, while continuing to monitor the health of credit markets and the corporate earnings outlook.

At First Merchants Private Wealth Advisors, our investment philosophy always emphasizes a focus on the highest quality and financially sound companies and institutions with the knowledge that economic storms will come and speculative investment fads will fade as capital is pulled from places that it is not being efficiently and effectively deployed. We believe this high-quality focus is a necessity in these times of turbulence and uncertainty and that many of the businesses that we invest in on our clients’ behalf will come out stronger on the other side while other less financially stable businesses lose ground. Investors with a solid, well thought investment plan may understandably be nervous with these bouts of volatility but can remain confident that they are structured to weather the storm. However, please feel free to speak one of our team of advisors if you want to discuss your investment plan.

 

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