Inflation: Peak or Pause

by | May 19, 2022 | Inflation, Market Updates

Yesterday, the S&P 500 fell more than four percent to set a new 52-week low, breaking the 4,000 level.

Panic selling is raging this week spurred by disappointing reports from Wal-Mart (WMT) on Tuesday and Target (TGT). The implication is lower retailer profitability and the need to clear inventories by competing on price. The reports from these two retailers are signaling good news for the inflation outlook for the rest of the year and re-confirm our belief that Inflation is peaking.

Inflation headlines will likely continue to be unsettling.  Gasoline and groceries prices, are not likely to go down. Gasoline prices are up 48% from a year ago, and the cost of groceries is up 10% to mark the biggest increase in four decades.

There are, however, some rays of sun are peeking through the clouds of inflation. In the two years during the pandemic, consumers spent 65% of their money on goods and 35% on services. Spending returned to normal allocations of 65% on services and 35% on goods this year. This reversion to the mean is an essential component of combating Inflation. Monthly increases in prices paid for goods and services during the first four months of 2022 have decreased, which is a “great sign” as all data, except food, has been accumulated over the last 30 days. With steeply higher prices, consumers are becoming increasingly price-conscious in their buying.

Supply chain blockages, which has been one of the major causes of inflation, show signs of improving. A survey of shippers, for instance, across the country, showed that truck availability for transporting retail and industrial goods has improved significantly.

It is probably too early to think about smoothing out the job market, but a slowdown in hiring may start to show over the next quarter or two. Wage increases are only inflationary if they are not accompanied by higher productivity. So far, rapid wage increases have been paired with higher productivity, muting the inflationary effect of more generous wages. The Atlanta Fed wage tracker is running at 6% on a 3-month moving average for March, the highest rate in the series’ history.  So, the 0.9% annual increase in unit labor costs in the U.S. for the fourth quarter was in line with the past two decades.

Fed Chair Jerome Powell remains steadfast in using higher interest rates to curb inflation.  He said there is “broad support” for additional 0.50% increases in the next two meetings, which would bring Fed funds rates somewhere between 1.75% and 2.00% by the end of July.  The Fed also plans to shrink its balance sheet by about $1 trillion a year.

One indicator that has gotten very close to triggering is speculative ETF positioning (AKA, “Dumb Money” indicator). This indicator compares daily volume traded in short or inverse ETFs relative to the volume traded for levered long ETFs. When the percentage of short volume rises to 60%, it has consistently signaled a tradable bottom. We will continue to take advantage of heavily beaten stocks, while at the same time retain our defensive positioning.

Heading into May, our Sector Rotation Model moved into a defensive posture. Consumer Staples, Energy, Real Estate, and Utilities Sectors all have large active overweights. So far, the bet has worked out. Staples, Energy and Utilities have been the best performing Sectors for the month (Real Estate is toward the bottom of the pack). Tech, Health Care, Consumer Discretionary, and Financials are current underweights. Tech and Discretionary have been the biggest laggards during this month and entry points are becoming very attractive. 

Our asset allocation models have been underweight since the beginning of the year and currently are allocating under 40% to equities. Bonds occupy around 20% of the portfolio, with Real Assets in the 25% range, 9% in our global model, and 15% in cash in our U.S. only model. We have outperformed the benchmark across all of our ETF strategies and will look to increase equity exposure in the latter part of the year. 

We realize some headwinds are facing the markets – war in Ukraine, Chinese economic slowdown, high inflation – but we also realize that investors often make profits during market drops. We urge you to be patient and follow your long-range financial plans and goals. Investors, however, will undoubtedly experience increased volatility and some panic selling.

Warren Buffett, our best-known value buyer, has apparently found some stocks trading at attractive valuations. Berkshire Hathaway has spent more than $51 billion on stocks in the first quarter of this year, making his fund the biggest buyer of stocks in a single quarter over the past decade.

The U.S. economy should still produce a positive GDP and end 2022 with a growth of 2.55% to 3% on an annualized basis, which we have averaged during the last ten years. Historically, when the S&P has experienced a down year, the average return is – 1.0 percent from the end of October through the end of December. A recessionary environment is doubtful at these levels. We believe that companies will produce robust earnings and drive earnings higher, but it may be bumpy getting there.  

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