Growth vs. Inflation: A Trade Off

The month of May began tumultuously with the S&P 500 and S&P TSX Indices, at one point, down by ~-8.5% and -5.8%, respectively. The markets recovered most of the losses during the last week and ended almost flat for the month which allowed investors a much-needed respite. The bond markets witnessed similar movement with 10-year bond yields that initially moved over 3% on both sides of the border early but shed about 20-25 basis points in the second half to finish the month at 2.75%-2.80%.

Market jitters increased after the US Fed chair, Jerome Powell, stated in an interview with the Wall Street Journal that the Fed would continue to push through the interest rate hikes until there is convincing evidence that inflation will move down towards the targeted 2%. These remarks undid investors’ hopes that the Central Bank could ease the pressure after the US inflation report indicated that the US inflation has probably peaked. The inflation numbers for the 12-month period ending April 2022 stood at 8.3%, lower than 8.5% in March but above the expected 8.1%. Canada witnessed inflation numbers for April 2022 increase to +6.8% from +6.7% in March 2022.

The pivot in equity markets came after the sell-off in the S&P 500 index exacerbated to briefly push it into bear market territory (technically defined as a peak-to-trough decline of >20%). Bear markets in absence of a recession are rare and are short-lived. Given that the incoming economic data is indicating an overall strong but somewhat moderating economic activity, the market participants saw the sell-off as overdone. The PMI (Purchasing Manager’s Index) numbers for manufacturing and services activity in the US have declined from their highs, but at +55.4 and +57.1 for the month of April (See Chart), they remain well above the threshold of 50 (a number above 50 indicates the activity is expected to expand and below 50 indicates the activity is expected to contract).

Chart 1: PMIs have declined but remain at healthy levels as compared to history

Source: Bloomberg

In addition, the Federal Open Market Committee (FOMC) minutes released later during the month indicated the Federal Reserve members agreed that front-loading the hikes (i.e., larger hikes at the start of the cycle) would leave the bank in a favorable position to re-evaluate and readjust, if needed, later this year. This also raised market hopes that the federal Reserve is wary of the impact of policy tightening and is likely to take a cautious approach as long as the inflation trajectory remains on track.

Thus far in the cycle, the markets seem to have discounted the inflation headwinds and the policy path, in other words - the valuation multiples have contracted. As the central banks continue tightening the financial conditions, the market narrative is now beginning to focus on the impact on the real economy and, in turn, company earnings. In other words, the inflation worry is gradually giving way to growth worry as the impact of tighter financial conditions begins to take hold.

A drop in the earnings would be the second shoe to drop and strengthen the protracted bear market narrative. We think some dialing down of earnings expectations is likely as inflation eats through the companies’ margins and falling demand forces companies to reduce prices. However, unless the fall in earnings expectations is significant, this would be consistent with the narrative of moderating economic activity and align with the Fed’s objective of a softish landing, in our opinion. Rather than be in the bear camp so early in the cycle, we like to view growth and inflation as a trade-off decision, i.e., some demand destruction and not demand decimation could be enough to bring down the inflation.

We acknowledge the war in Ukraine, potential impact of unwinding ultra-loose monetary policy during the pandemic, and the zero covid goal of China; the world’s manufacturing factory, has muddied the outlook for the Fed to navigate successfully and thus increased the likelihood of a policy error. The Fed might well continue to tighten the financial conditions and put the economy into a recession, however, that seems more likely to be a 2023 scenario, in our view. In the interim, moderating inflation put together with moderating economic activity thereby giving the Fed a reason to potentially go slow on the hike path could give tailwinds to the risk assets.