How Will Equity Markets Weather Inflation Fears?

Inflation is currently the number one driver of equity markets. Its stickiness at high levels is weighing on consumer disposable income and corporate margins, along with complicating the Federal Reserve’s (Fed) situation as it attempts to bring inflation under control within a slowing economic backdrop. We believe that inflation has likely peaked (on a year-over-year basis) and can moderate over the back half of 2022 and into 2023, as the supply/demand imbalance for goods and labor normalizes. But the stakes are high, and investors have grown impatient with consecutive hiccups in inflation’s trajectory – i.e., the COVID-19 delta variant last fall, the omicron variant, the Russia/Ukraine war, and China COVID lockdowns.

The longer high inflation persists, the higher the odds that the Fed will need to overtighten monetary policy – potentially to the point of economic contraction – in order to bring inflation down. The degree to which inflation is able to moderate over the coming months should have a significant influence on the path ahead for the Fed, resulting in a wide range of potential equity market outcomes over the next six to twelve months.

Finding the bottom

This elevated uncertainty is reflected in market volatility. At its recent lows, the S&P 500 had pulled back -23.6% from its early January highs. Whereas enormous stimulus through the pandemic fueled lofty valuation multiples, the Fed shrinking its balance sheet and swiftly hiking interest rates this year has resulted in valuations pulling back to more reasonable levels. Plenty of negative news is priced in at those valuations in our view, and the 39% P/E reduction is in line with that seen in bear markets historically. Investor sentiment has also gotten overly bearish, which often takes place near lows (contrarian indicator). However, numerous timing indicators we monitor, along with market internals in the relief rally, have not reached levels often consistent with durable lows. Unless Russia ceases aggression against Ukraine or China ends lockdowns, it will be difficult for equities to sustainably move to the upside without better inflation data in our view.