Peak Inflation? Let’s Hope So

Stocks bounced at the open (Dow +500 pts; SPX +2.6%; Nasdaq +4%) this morning, providing some relief for investors. The VIX fear gauge sank below 30 and, perhaps signaling slightly better sentiment. The leading sectors—tech, consumer discretionary—are up over 3% in early trading. In addition, the energy sector is up 3% on higher oil prices. Oil hasn’t regained its Ukraine shock high of $125/barrel, but has bounced between $100 and $110. Other commodities like copper and agricultural goods are also moving higher. The bond market trade is decidedly risk-on today. That is, safe-haven Treasuries are selling off but riskier junk bonds are catching a bid.

I should probably point out the fact that the bond market is really in the driver’s seat, not the stock market. That’s because the Fed is using higher interest rates as a primary weapon to combat inflation. And we know that bonds are extremely sensitive to changes in interest rates. So when you see junk bonds rallying, it means economic recession fears are waning. We monitor a number of bond market indicators, including junk bond “spreads,” which measure how well low-quality bonds are holding up vs. high-quality bonds. The answer: we’re seeing some stress, but not nearly as much as in prior growth scare events in 2008, 2011, 2015, 2020.

We may be at peak inflation. The Consumer Price Index (CPI) was up 8.3% in April from a year ago. That’s a huge number, but slightly less than March’s 8.5% rate. Core CPI—excluding the famously volatile food & energy categories—decelerated to 6.2% growth from 6.5% in March. In addition, we learned today that price inflation for both imports and exports decelerated in April. Again, inflation is the highest it has been in decades, but seems to be slowing. This is exactly what investors need to see because lower inflation puts less pressure on the Federal Reserve to raise interest rates.

The University of Michigan’s monthly survey of consumer sentiment, on the other hand, isn’t encouraging. While off recent lows, the index for future expectations is down around levels we last saw in 2011 (coincidentally during another economic growth scare and bear market). This survey attempts to predict consumer spending for the near future, and seems to suggest that higher inflation is now beginning to discourage would-be buyers of durable goods like autos, appliances and furniture. Next week’s retail sales report from the Census Bureau may provide some clarity.

One big reason for this stock & bond market correction is that asset prices surged to unrealistic levels last year. Now we’re seeing a massive valuation reset. I’ve mentioned previously that one way of valuing the stock market is the price-to-earnings ratio on the S&P 500 Index. That is, how much does an investor have to pay for a dollar of profits provided by the largest 500 companies in America. That ratio was hovering around 22 at the beginning of the year, and has now fallen to 17. So stocks are cheaper, but we probably have further to go. When asked about the correct ratio (or multiple) on the stock market, Morgan Stanley’s Mike Wilson says 15-16 is reasonable. So “we’ve [already] done a lot of good work. We’re closer to the end than the beginning.” He believes this is a “cyclical bear market [that] will be done this year at some point.”