The Implications of Red Hot Inflation

Mott Capital Management |

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CPI data came in much hotter than expected, killing the idea of peak inflation. It also should kill any hopes the bulls have that the Fed will pause in September or anytime soon, for that matter. Ultimately this will put pressure on the Fed to tighten even more and downward pressure on the S&P 500 index, potentially sending it to around 3,300 in the coming months. On top of inflation rates remaining north of 8%, the consumer continues to fall behind, with real wages and weekly earnings dropping by 3.9%, the lowest reading in the cycle. More importantly, this was the lowest reading since the series has had data going back to 2007. The high inflation rates and weak wage growth has resulted in the University of Michigan's consumer confidence falling to its lowest level ever, going back to 1978. The reading came in at 50.2. The odds of recession increased dramatically following the CPI report because the odds of a GDP price index reading north of 8% for the second quarter have increased considerably. The GDP price index and the CPI track each other very closely, and unless GDP nominal growth is going to be north of 8%, then the odds for a negative second-quarter real GDP report seem very probable. The bond market is, of course, repricing across the curve right now, and that's sending equity markets sharply lower. Treasury yields are seeing the most significant gains at the front of the curve as markets price in more rate hikes, with the two-year now trading at about 3%. The Fed Fund futures curve has moved sharply and is now showing peak rates of 3.6%, from 3.36% just yesterday and 3.2% just a week ago. That is a massive repricing in the Fed fund futures and an indication that the market believes an even more aggressive Fed is coming. The higher rates in the US is resulting in spreads widening with yields globally and sending the dollar sharply higher, with the dollar index now trading over 104. The stronger dollar is just another headache for the S&P 500 on top of rising rates, which centers around falling PEs and lower earnings estimates. A strong dollar will work to put downward pressure on corporate revenue and earnings. For example, Microsoft (MSFT) just recently warned the strong dollar would negatively influence its quarterly results. Plus, a Fed that continues to work to tighten financial conditions in an attempt to slow the economy is going to weigh heavily on earnings prospects for the S&P 500. The multiple on the S&P 500 will have to contract to a below-average PE ratio on a historical metric. Currently, the S&P 500 is trading at a fair valuation of 16.5 based on its historical average since 2000 of 16.6. But the problem is that the market needs to anticipate where earnings are going, and as of right now, earnings estimates for the S&P 500 are too high, assuming a recession is coming and growth slows. A reset to around 14 seems reasonable, given that was the bottom of the range for 2018 and 2020. Assuming earnings of $236.63 and a PE ratio of 14, the value of the S&P 500 would be around 3,300. That doesn't mean that we go straight down to 3,300. It probably means we grind lower over the coming weeks and months.