Fed, Inflation, and Growth Risk
The U.S. stock market experienced a roller-coaster May, with the S&P 500 dipping more than 20% below its high but bouncing back in the final week of the month. The Dow and the S&P 500 ended the month little changed, while the Nasdaq lost about 1.9%.
High inflation, Fed tightening, and recession risks remain the most substantial headwinds for the equity markets. Headline CPI fell a bit from March’s peak but was a bit stronger than expected, rising 8.3% on a year-ago basis. Core CPI also pulled back less than expected to 6.2%. The encouraging news is that excluding COVID reopening categories such as airfares, the month-over-month core inflation was slightly below the prior three-month average. As widely expected, the FOMC raised the target fed funds rate by 50 basis points to 0.75% - 1% in its May meeting, marking its first 50-basis point rate hike since May 2000. The markets quickly priced in a series of steep rate hikes and are concerned that the Fed might possibly raise rates to levels that slow the economy.
What do we see as the risks with the Fed’s policy? First, as the Fed is behind the curve in the current tightening cycle, the asynchronously tight monetary policy might exacerbate the slowdown in the economy. Normally the Fed would adjust its policy rate in response to changes in inflation and the unemployment rate. However, over the past year, the Fed’s modified policy and their misinterpretation of the surging price increases as transitory has caused their policy to remain exceptionally accommodative, despite the fast decline of unemployment and surging inflation. The Fed now looks poised to hike the rates aggressively when inflation has peaked and the pace of drop in the unemployment rate is much slower, thus increasing the risk of overshooting and choking off economic growth.
Second, the Fed faces a more challenging situation in today’s inflation as it is primarily supply-driven. Unlike in most cases since the 1990s, when inflation was largely driven by excessive demand, supply constraints caused by the pandemic and the Ukraine war are among the key forces behind today’s inflation. When inflation is caused by supply factors, monetary policy is unable to directly resolve those disruptions. For example, a tighter monetary policy will do nothing to reduce uncertainty about the Ukraine war. The Fed is thus in a tough spot ‒ slowing growth with higher rates or living with persistently high inflation. The risk is that the Fed fails to manage the trade-off properly and pushes rates to such levels that damage economic growth.
We are closely monitoring the dynamics of interest rates, economic growth, and geopolitical risks. In the last week of May, the market seemed to pay more attention to signs of slowing growth. This may alleviate inflation pressure and ultimately lead to a less aggressive pace of rate hikes. There were some tentatively encouraging signs as the PCE deflator rose only 0.2% in April, compared to gains of 0.9% in March. Our base case view is that the monetary policy response already priced in by the market should be sufficient to curb inflation and that the global economy will avoid a recession over the short term. However, uncertainties remain, and our dynamic asset allocation views reflect the risks. We stayed neutral exposure to U.S. equity with an investment level of 64%. We are 48% invested in our flagship international strategy as we downgraded European equities on energy shocks and remain conservative with emerging-market assets.
By the Numbers (Year-to-Date)*
U.S. Equities (S&P 500 Index) | -12.9%
International Equities (MSCI ACWI ex-U.S.) | -10.7%
U.S. Bonds (Barclays U.S. Aggregate Bond Index) | -8.9%
Global Bonds (JP Morgan Global Aggregate Bond Index) | -11.1%
The NorthCoast Navigator is a market "barometer" displaying NorthCoast's current U.S. equity outlook. This aggregate metric is determined by multiple data points across four broad market-moving dimensions: Technical, Sentiment, Macroeconomic, and Valuation. The daily result determines equity exposure in our tactical strategies.
As of 5/31/2022. Data provided by Bloomberg, NorthCoast Asset Management.
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Neutral Indicators |
Positive Indicator |
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Valuation S&P was flat this month, with valuations for equity remaining negative. P/E: decreased marginally from 20.68 at the end of April to 20.65 at the end of May; Forward P/E: remained unchanged at 18.2 at the end of May. Inflation-adjusted valuation metrics continued to be negative with inflation rising.
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Sentiment The breadth of growth in the U.S. manufacturing sector seemed to have narrowed as the ISM manufacturing index fell for the second consecutive month, declining to 55.4 in April from 57.1 in March. The supplier deliveries index rose, indicating slower deliveries. The University of Michigan's consumer confidence slumped to 58.4, the lowest since 2011, as high gasoline prices, surging inflation, and a volatile stock market continued to weigh on the consumers. NAHB index dropped 8 points to 69 in May, pushed down by higher mortgage rates and poor affordability. |
Technical Technical indicators were neutral, with fear index signals remaining positive and momentum indicators in the negative territory. The S&P 500 was 7% below its 200-day moving average, 5% below the 100-day average, and 3% below the 50-day average. The VIX remained high for most of the month but dropped in the last week and settled at 26.2 at the end of May (compared with 33.4 at the end of April). Volatility continued to be high in May amid concerns over tighter Fed policy, persistently high inflation pressures, geopolitical risks, and COVID lockdowns in China.
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Macroeconomic The April employment report showed continued robustness in the labor market with healthy payroll gains of 428,000. Inflation remained elevated, with the headline and core CPI up 8.3% and 6.2% on a year-ago basis, respectively. Meanwhile, the Producer Price Index for final demand rose more than anticipated in April, increasing 0.5%. Retail sales continued to be healthy (up 0.9%), but the pace of growth was slowing. On the other hand, pending home sales fell back to their lowest level since the beginning of the pandemic.
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1 Source: Bloomberg, NorthCoast Asset Management. NorthCoast Asset Management is a d/b/a of, and investment advisory services are offered through, Connectus Wealth, LLC, an investment adviser registered with the United States Securities and Exchange Commission (SEC). Registration with the SEC or any state securities authority does not imply a certain level of skill or training. More information about Connectus can be found at www.connectuswealth.com. The information contained herein has been prepared by NorthCoast Asset Management (“NorthCoast”) on the basis of publicly available information, internally developed data and other third-party sources believed to be reliable. NorthCoast has not sought to independently verify information obtained from public and third-party sources and makes no representations or warranties as to accuracy, completeness, or reliability of such information. All opinions and views constitute judgments as of the date of writing without regard to the date on which the reader may receive or access the information and are subject to change at any time without notice and with no obligation to update. This material is for informational and illustrative purposes only and is intended solely for the information of those to whom it is distributed by NorthCoast. No part of this material may be reproduced or retransmitted in any manner without the prior written permission of NorthCoast. NorthCoast does not represent, warrant or guarantee that this information is suitable for any investment purpose, and it should not be used as a basis for investment decisions. © 2022 NorthCoast Asset Management. PAST PERFORMANCE DOES NOT GUARANTEE OR INDICATE FUTURE RESULTS. This material should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any securities or investment products or to adopt any investment strategy. The reader should not assume that any investments in companies, securities, sectors, strategies and/or markets identified or described herein were or will be profitable and no representation is made that any investor will or is likely to achieve results comparable to those shown or will make any profit or will be able to avoid incurring substantial losses. Performance differences for certain investors may occur due to various factors, including timing of investment. Investment return will fluctuate and may be volatile, especially over short time horizons. INVESTING ENTAILS RISKS, INCLUDING POSSIBLE LOSS OF SOME OR ALL OF AN INVESTMENT. The investment views and market opinions/analyses expressed herein may not reflect those of NorthCoast as a whole and different views may be expressed based on different investment styles, objectives, views, or philosophies. To the extent that these materials contain statements about the future, such statements are forward looking and subject to a number of risks and uncertainties. |