The MSCI AC World Index pulled back 1.7% last week – its second consecutive week of losses. In the United States, the S&P 500 dropped 2.1% while the interest-rate sensitive NASDAQ tumbled 2.6%. European, Japanese, and Emerging Market stocks each lost 1.2%. The 10-year U.S. Treasury yield jumped another 13 basis-points to 2.82% as investors weighed an accelerated runoff of the Federal Reserve’s balance sheet.
U.S. inflation rose to 8.5% in March – its highest level since December 1981. This level was well above what the Federal Reserve considers to be consistent with price stability. However, there are some signs that we may be nearing peak inflation with used car prices falling and crude oil prices coming off their March highs.
By the end of 2022, U.S. inflation could fall within a range of 5.5% - 6.0%. This is unlikely to cause the Federal Reserve to reverse its decision to tighten monetary policy, but it would be welcome news if accurate. It may also mean that Treasury yields are nearing a peak.
The next Weekly Market Update will be released on May 2, 2022.
Has U.S. Inflation Peaked?
The Bureau of Labor Statistics reported that the consumer price index (or CPI) rose from 7.9% in February to 8.5% in March – the highest reading since December 1981 (see figure 1). Energy prices surged 32% year-on-year, food prices soared 8.8% year-on-year, and core prices, which exclude both energy and food prices, jumped 6.5% year-on-year. These prices were well above the level that Federal Reserve officials believe is consistent with price stability, which is why they feel the need to act with interest rate hikes and a drawdown of the balance sheet. However, there are some signs that we may be nearing peak inflation…or at least a plateau.
One of the more positive aspects of the inflation report was that used car prices fell 3.8%. Absent the drop in used car prices, Citi Research’s economists estimate that core inflation would have been 0.2% higher month-on-month. Combined with base effects, falling used car prices could cause core inflation to pull back on a year-on-year basis next month. Unlike volatile energy prices, it is important to note that the spike in used car prices is likely not going to repeat with wholesale prices suggesting a continued downward trend (see figure 2). Crude oil prices have also come off their highs with West Texas Intermediate averaging around $100 per barrel through mid-April (see figure 3). Food prices, on the other hand, are staying elevated and shelter prices continue to firm. Combined, food and energy prices make up about 20% of the CPI. These dynamics are likely to leave prices elevated for some time, but Citi Research’s economists think that consumer prices may fall to 8.2% year-on-year in April. By summer, investors could be looking at 7.5% year-on-year and by the end of the year, prices could fall within a range of 5.5% to 6.0% higher year-on-year.
Interestingly, Citi Research’s economists are largely in line with what consumers have been reporting as well with the University of Michigan’s one-year ahead inflation expectations coming in below expectations at 5.4% in the latest report (see figure 4). Core inflation; however, could still be sticky with rising home costs likely to keep the metric above 5% through year-end (see figure 5). While welcome, these potential declines are likely not enough to make the Federal Reserve reverse its decision to tightening monetary policy, but it appears to be trending in the right direction.
We are also encouraged to see Citi’s Inflation Surprise Index moderating while Citi’s Economic Surprise Index has been solidly in positive territory since mid-February (see figures 6 and 7). These metrics suggest that inflation prints are surprising by a smaller margin while economic data are beating expectations by a wider margin. This may not fully include the impact of the Russia Ukraine conflict, but the U.S. economy looks resilient thus far. For further information on potential economic scenarios, please our CIO Strategy Bulletin | Three Scenarios for the Economy and Markets.
What Does This Mean for Financial Markets?
We have written in detail about how expectations for an aggressive Fed tightening cycle has led to an inversion of the yield curve, but that U.S. stocks often still rise during tightening cycles. In fact, during the last seven Fed tightening cycles, U.S. stocks have risen every single time during the tightening cycle by an average of about 14.5% over a period of about two years (see figure 8).
|Fed Tightening Period||Fed Funds||S&P 500||NBER First Recession Month||Number of Months Recession Occurred After The Start of Tightening||Real GDP Drop (%)||Policy-Induced Recession?|
|Start||End||Type of Cycle||Start||End||Chg Change in FF (bps)||Start||End||% Chg Change|
|Jun-04||Jun-06||Fast||1.03||4.99||396||1132.76||1253.12||10.6%||Jan-08||43||-3.8%||Monetary Policy Not Primary Driver|
|Oct-15||Jan-19||Slow||0.12||2.40||228||2024.81||2607.39||28.8%||Mar-20||53||-10.1%||Monetary Policy Not Primary Driver|
When it comes to the fixed income market, the sharp ascent in Treasury yields may be starting to ease. As Citi Global Wealth’s Chief Investment Strategist Steven Wieting has pointed out recently, rates tend to peak around the time of yield curve inversion. This has been a consistent pattern over the last several decades (see figure 9). There is probably some risk in calling a peak for Treasury yields as investors have never experienced such an aggressive runoff of the Fed balance sheet, but the Fed’s hawkishness should be increasingly priced in by now. For a deeper dive on fixed income markets, please see our CIO Strategy Bulletin | A Brighter Future for Fixed Income?
What Should U.S. Investors Watch in the Week Ahead?
In the week ahead, investors will receive a slew of housing data for the month of March including the NAHB Housing Market Index, building permits, and existing home sales. With mortgage rates climbing to above 5.0%, investors will be watching for any signs of weakness in the housing market. Aside from that, first quarter 2022 earnings will kick off in earnest with S&P 500 earnings-per-share (EPS) expected to rise by about 5.8%. Excluding Financials, EPS are forecast to rise by 13.5%. We will be watching closely for any negative guidance related to the Russia Ukraine conflict and how inflation may be impacting margins. Overall, we expect S&P 500 EPS to climb by about 8% in 2022.
|Index||Weekly Chg change in percent||YTDyear to date change in percent||12 Months 12 month change in percent||Div. Yield division yield in percent|
|Instrument||Weekly Chgchange||YTDyear to date||12 Months12 month change||Level|
|10-Year Treasury Yield (%)||12.7 bps||131.7 bps||125 bps||2.83%|
|Index||Weekly Chg change in percent||YTD year to date in percent||12 Months||Div. Yield division yield in percent|
The Week Ahead
|4/18||10:00||NAHBnational association of home builders Housing Market Index||AprApril||77.0||79.0|
|4/19||8:30||Housing Starts||MarMarch||1740k thousand||1769k thousand|
|4/19||8:30||Building Permits||MarMarch||1820k thousand||1859k thousand|
|4/20||10:00||Existing Home Sales||MarMarch||5.78m million||6.02m million|
|4/21||8:30||Initial Jobless Claims||4/16/2022April 16, 2022||180k thousand||185k thousand|