Prices Are High - What's Priced In?
The bumpy ride for financial markets continued last week, with U.S. inflation remaining front and center ahead of the Canadian reading this week. A multidecade jump in consumer prices was a reminder that inflation is a key driver and risk for the year ahead, impacting central bank policy, consumer spending, bond yields and sector leadership. With prices high, yields rising, and valuation concerns, we examine what's expected and likely priced in by the markets, along with implications for portfolio positioning.
Price pressures continue to build but are possibly peaking in the coming months
- All eyes were justifiably on U.S. inflation last week, with the released data revealing the fastest price increases in decades. The consumer price index (CPI) rose 7% in December from a year ago, the fastest pace since 1982 and the eighth straight month in which inflation exceeded 5%. Excluding the volatile categories of food and energy, inflation rose 5.5%, the most since 1991. The Canadian CPI scheduled to be released on Wednesday is expected to rise 4.8%, the fastest pace in 30 years1.
- Like last year, goods inflation played a large part in the jump in U.S. prices. For example, prices of used cars and trucks soared 37%, and furniture prices rose 14% from a year ago. While pandemic-related supply-and-demand imbalances continue to drive prices for durable goods higher, services inflation is also strengthening but to a lesser extent, rising 3.7% in December1.
- As supply chains normalize, energy prices level off, and year-ago comparisons become tougher, we expect inflation pressures to peak in the coming months and start moderating more meaningfully in the second half of the year. However, uncertainty around the timing is high because the omicron variant is worsening the labor and material shortages, at least temporarily. Even with prices for goods likely cooling off once bottlenecks begin to ease, services inflation is likely to stay strong, supported by home-price and rent increases and rising wages, which is why we expect overall inflation to stay above the Fed’s 2% target through 2022.
- What's priced in? While eye-popping, the December consumer price gains were no worse than feared and, likely because of that, stocks rose and bond yields fell the day of the release. After having surprised to the upside for most of the past year, the CPI has now been in line with consensus expectations for two months in a row in the U.S. and Canada. There are certainly upside inflation risks, but because investors have already recalibrated their expectations higher, we think that markets can stay resilient in the face of high prices in the near term.
The graph shows the surging U.S. inflation for goods and the rising inflation for services. While both are at multi-year highs, prices for services have risen more modestly.
Curbing inflation is now a priority for central banks
- In the first two weeks of this year the Fed has made another hawkish pivot, with policy now clearly shifting to combat inflation. Fearing that price pressures might become entrenched, a number of Fed officials are now calling for policy rates to rise as early as March. As a reminder, it was not that long ago (March 2021 meeting) that policymakers were projecting no interest-rate hikes through 2023. This pivot brings the Fed closer to the BoC which has already indicated since last year that it plans to raise rates by the April meeting, if not earlier.
- In our view, last week's U.S. inflation reading, together with the recent drop in the unemployment rate below 4% in the U.S. and return to prepandemic employment levels in Canada, solidify expectations for an earlier start to interest-rate hikes in North America. The upcoming start to the Fed's and BoC's tightening cycles, the sixth over the last 40 years, is a milestone that reflects not only the unexpected inflation overshoot, but also the strength of the economic expansion and labor market. The pivot from emergency support to dialing back the accommodation, then to tightening, is another datapoint signaling that the cycle is progressing further into the midcycle phase. Equity markets might no longer be in the highly rewarding early-expansion phase, but they are not in the late-cycle phase either, in our view.
- What's priced in? Bond markets are currently pricing in about a 90% probability that the Fed hikes rates four times this year and a 100% chance that the BoC hikes six times2. While it is possible, we think that it will be hard for central banks to tighten more aggressively than what the market is currently pricing in. Possibly, the retreat in the 10-year government bond yields after last Wednesday's U.S. inflation data confirms that a lot of the central bank repricing has already happened1.
The graphs shows that the bond market is expecting four interest-rate hikes in the U.S. by the end of the year and six in Canada.
Rising bond yields challenge lofty valuations. Earnings to the rescue?
- After three back-to-back years of above-average returns, U.S. stock valuations are high relative to their own history, while Canadian equities are more in line with their historical average. The speed at which bond yields have climbed in response to higher inflation and shifting central bank policy has forced investors to rethink their portfolio allocations. One of the most notable recent developments is the rotation away from pricey growth-style investments towards the more reasonably priced value investments. Because technology stocks carry an outsized weight in major indexes, valuation concerns have triggered a pullback in U.S. large-cap stocks and some volatility in Canadian stocks.
- On a positive note, the valuation gap between equities and bonds remain fairly wide, continuing to support equities and reinforcing the "TINA mantra" (There Is No Alternative to stocks) for now. Even though yields are on the rise, they remain low. And as long as corporate earnings rise at a decent pace, the relative valuation gap can be sustained.
- What’s priced in? U.S. banks kicked off the earnings season last week. Results were generally solid, but the bar was high following the group's outperformance in recent weeks, and the sector pulled back. TSX and S&P 500 earnings are forecast to increase 35% and 21% respectively in the fourth quarter, marking the fourth straight quarter of earnings growth above 20%. For 2022, consensus expectations are for earnings growth to decelerate but still grow a healthy 8% for the TSX and 9% for the S&P 5001. We expect valuations to slightly decline, consistent with the historical experience during past central bank-tightening cycles. However, the current earnings estimates appear reasonable to us, with potential for upside if above-trend economic growth materializes as projected.
Source: FactSet. Past performance does not guarantee future results.
The graph shows the yield spread between the TSX earnings and the 10-year Canada government bond, which remains positive supporting stocks.
The investment puzzle: Putting the pieces together
Slowing but still robust economic growth, high inflation, and upcoming rate hikes complicate the investment landscape for the year ahead. We think that this backdrop translates into lower returns and more volatility, but still a continuation of the bull market.
- Even if the BoC hikes rates six times as priced in, we think that policy will be far from restrictive. A policy rate near 1.50% by year-end would be well below the about 6% - 7% expected nominal GDP growth (3% - 4% after inflation), below the BoC's 3.4% inflation forecast for 2022, and below the pre-pandemic policy rate1.
- Stocks have historically experienced some volatility around the first interest-rate hike but generally maintained their upward trajectory six months and a year out. While returns tend to moderate after tightening begins, equities haven't historically run into trouble until the tail end of the cycle when the yield curve inverts. Given our view that the upcoming 2022 Fed and BoC hikes won't choke off the economy, we would view any central bank-induced pullbacks or corrections as an opportunity to add quality investments at lower prices.
Source: FactSet, Edward Jones calculations. Market indexes are unmanaged and cannot be invested into directly and are not meant to depict an actual investment. Past performance does not guarantee future results.
The graph shows the S&P 500 performance before and after the first rate hike since 1986. The pace of gains tends to slow, but the upward trajectory in stocks has been sustained.
- Long-term bond yields have jumped over the past two weeks. As central banks tighten policy and the economic expansion continues, we think that yields will grind higher, with the 10-year Canada government bond yield likely reaching 2.0% before year-end. Rising yields will likely continue to challenge fixed-income returns, but we still expect bonds to play an important part, acting as a portfolio stabilizer during times of equity-market volatility. An appropriate allocation to domestic and international high-yield bonds might help enhance returns.
- Equity markets should be able to absorb higher bond yields, but valuation pressures on growth-style investments could cause some indigestion. We think that rising yields support the rotation toward value investments, especially in the first half of the year, as earnings from cyclical industries are expected to outpace earnings from growth sectors like technology.
- Overseas markets are trading at lower valuations, and, unlike U.S. markets, their sector composition is tilted towards value and cyclical sectors. If pandemic conditions improve and global rates rise, we think that overseas diversification will likely help returns. A potential headwind for U.S. equity performance when translated in Canadian dollars could be the softening in the U.S. dollar vs the loonie. Historically, the U.S. dollar has appreciated in the months leading up to the start of the Fed's hiking cycle but has tended to fall during the first six months after the first interest-rate hike.
Source: FactSet, Edward Jones calculations. Past performance does not guarantee future results.
The graph shows that the U.S. dollar has historically appreciated against other currencies heading into the first Fed rate hike, and has tended to fall six months after.
Angelo Kourkafas, CFA
Source: 1. FactSet
Weekly market stats
|S&P 500 Index||4,663||-0.3%||-2.2%|
|MSCI EAFE *||2,333.00||0.2%||0.1%|
|10-yr GoC Yield||1.77%||0.1%||0.3%|
Source: Factset 01/14/2022. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results. *Source: Morningstar 01/16/2022.
The Week Ahead
Economic data being released this week include CPI and Retail Sales.
Angelo Kourkafas is responsible for analyzing market conditions, assessing economic trends and developing portfolio strategies and recommendations that help investors work toward their long-term financial goals.
He is a contributor to Edward Jones Market Insights and has been featured in The Wall Street Journal, CNBC, FORTUNE magazine, Marketwatch, U.S. News & World Report, The Observer and the Financial Post.
Angelo graduated magna cum laude with a bachelor’s degree in business administration from Athens University of Economics and Business in Greece and received an MBA with concentrations in finance and investments from Minnesota State University.
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