Inflation Expectations Dropping

Stocks opened lower this morning but quickly stabilized. It seems likely that yesterday’s pattern may repeat – morning drop, afternoon recovery. Since finding a new bottom on June 17th, the S&P 500 has pushed cautiously, if unevenly, higher. Commodities, on the other hand, are down this month. WTI crude is back under $100/barrel. Wheat has given up all of its price gain since Russia invaded Ukraine. Copper has fallen to a 1 ½ year low. Transportation costs are also falling. The Baltic Dry Index—measuring ocean freight prices—is down 35% since May 20th. The bond market is selling off today, bucking a three-week trend.

For the past couple of days tech stocks have rallied. And why not? Qualcomm (QCOM) and Broadcom (AVGO) trade at a bargain basement P/E ratios of 10-12 vs. the S&P 500 at 16. Alphabet’s (GOOGL) P/E is 16 vs. slow-growth General Mills (GIS) at 19. Which company has stronger long-term growth prospects? The cheaper one. At some point these hard-hit assets are attractively priced. Mohamed El-Erian, former Co-CEO of PIMCO, believes “genuine and sustainable value” is being created as asset prices fall. He says this valuation reset is necessary “because too much fiscal and monetary stimulus had artificially inflated stock & bond prices.” But now we’re reaching the point when bonds can again be used to actually earn some interest while providing some risk mitigation within diversified investment portfolios. Once we’re through this tough adjustment period, capital markets will be in a much more normal and sustainable place.

Bond yields and inflation expectations are beginning to nose over. Trading in the Treasury Inflation-Protected bond market now predicts 3.1% average inflation over the next two years. That’s down from 4.4% just three weeks ago. We’re seeing the same trend with long-term inflation expectations. This move suggests Fed policy is working to bring down inflation. We’re not sure, however, whether that policy’s by-product is a moderate economic slowdown or recession.

To most economists and investment strategists, recession is a foregone conclusion. Ritholtz Wealth CEO Josh Brown observes two main questions hotly debated among professional investors: 1) will we see recession this year or in 2023, and 2) will it be a severe or minor recession? Looking back into history, he says recessions caused by Fed tightening usually aren’t terrible. This event will likely be short and shallow because by the time the economy turns down, capital markets have already anticipated and priced-in the risk. So at this point, we should all be focused on our investment time horizon. “When do I need the money…and can I deal with the headlines and volatility long enough” to weather the storm?

What’s really odd about all this recession talk is that the job market remains exceedingly tight. Job openings in the US remain near record levels (11.3 million) according to the Labor Department. In fact, there are nearly 2 open positions for every unemployed person. Hiring held steady in May, as did layoffs, which are far below pre-Covid levels. About 4.3 million people quite their jobs during the month, confident that they could find better opportunity elsewhere. It seems likely, however, that the labor market will cool. After all, the Federal Reserve is intentionally trying to slow hiring activity. That’s why investors are eager to parse through the monthly Employment Situation Report, due out this Friday.