Friday morning, stocks fell over -2.5% in response to an inflation report that surprised investors.*
While analysts and economists expected inflation to start to cool in May, by most measures, the prices of goods and services jumped past expectations. The Consumer Price Index (CPI), a key inflation index, was 8.6% higher than May of last year and increased from last month.
What does this mean for markets?
This most recent data point showing persistent inflation likely means the Federal Reserve will continue along its trajectory of three additional 0.5% interest rate hikes to cool red-hot inflation.
By year end, analysts expect short-term interest rates to be around 2.8% to 3%. So far this year, higher rates have led to a slowdown in economic growth, bond market turbulence, and an environment where dividend-paying stocks fare better than fast-growing stocks.
How does this affect our outlook?
We think the economy has moved into the mature phase of the expansion cycle, where markets can be quite bumpy, but money can be made over time.
In 2022, we think the U.S. economy will likely still grow 2% to 2.5%, closer to average growth, while inflation will likely start to cool to 5% to 7% as supply chains re-adjust and rate hikes cool demand.
In 2023, we think there’s about a one in three chance of a minor recession, defined as a 2% to 2.5% economic contraction over the course of a quarter.
It is also worth noting that the stock market and economy are not always in sync. The stock market has already “priced-in” about two-thirds of the average drop during recessions. During half of the past 12 recessions, stocks have generated positive returns.
In response to the shifts in the investment landscape, we have taken several steps, as suitable:
- Moved stock allocations to neutral as compared to target vs. overweighting
- Increased allocation to dividend-paying, defensive stocks vs. growth-oriented stocks
- Increased inflation hedges
- Positioned bonds defensively and added bond alternatives to cushion the impact of increasing interest rates
We also stand ready to execute our contrarian strategy of “buying low” when stocks overrun to the downside. Our next target is if the S&P 500 Index closes below a 3,900 support level. (Our last buy-low was on Feb. 24, 2022).
* Returns data are from FactSet. We use the S&P 500 index as a proxy for stocks. The S&P 500 is a market-weighted index that tracks 500 of the largest US listed-companies.