Authored by :
Michael G. Dow, CAIA, CFA, CPA, Chief Investment Officer
Julien R. Frazzo, Director of Risk Management and Securities Research
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The Quick Facts
- Inflation is still hot, with the July Consumer Price Index (CPI) print at 8.5% but below the peak of 9.1% in June
- The weakest August performance in seven years for U.S. equities
- Federal Reserve Chair Powell committed to beating inflation
- Yield curve further inverts
- The U.S. Dollar trades at two-decade high
What began as a strong month for the major averages ended on a weak note. The S&P 500 finished August down 4.1%, while the Nasdaq posted a monthly loss of 4.5%. The moves put the S&P 6.3% above its mid-June intraday low. The Nasdaq is now 7.4% above its low. The summer rally peak came two weeks ago on Aug. 16, a full two months after the mid-June bottom.
Investors have been debating for weeks whether the economy was in a recession or heading toward one, and many thought an economic downturn would give the Federal Reserve (Fed) reason to ease up on its rate hiking plan. Fed Chair Jerome Powell reiterated during his speech in Jackson Hole, Wyoming in late August that the central bank was committed to curbing inflation and would continue to raise rates even in a recessionary environment. The question for the market now is whether margins will hold and allow for the earnings growth analysts expect, or could a recession mean actual earnings decline, on top of the multiple compression that has taken us into a bear market?
At the Jackson Hole 2022 Economic Policy Symposium, Powell committed to beating inflation, to “use our tools forcefully,” “for some time,” acknowledging that it would inflict “some pain,” which he said was one of the “unfortunate costs of reducing inflation.” Powell stated, “the historical record cautions strongly against prematurely loosening policy.” He also noted that “with inflation running far above two percent and the labor market extremely tight, estimates of longer-run neutral are not a place to stop or pause.” To sum up, the Fed’s policy stance needs to be restrictive enough, for long enough, to bring inflation back down to 2%.
On a total return basis, Energy and Utilities were the only two positive sectors in August, with a 2.7% and 0.5% return, respectively. Technology, Real Estate, and Health Care were all down more than 5% in August. Year-to-date, the Energy sector remains the clear winner with a 47.9% total return, followed by Utilities with 5.4%. The other nine sectors are all negative for the year with Communication Services, Consumer Discretionary, and Technology down 29.6%, 23.6%, and 21.9%, respectively.
The Russell 1000 Value was down 3.0% in August, outperforming the Russell 1000 Growth by 1.7% in August and 13.3% YTD. The outperformance of Value over Growth continues to be a major investment theme in an environment where long-dated cashflows get discounted at higher rates. The ESG segment of the market, as measured by the MSCI USA ESG Select Index, was down 4.3% in August, 0.2% more than the S&P 500. Over the last three years, the ESG index is up 46.5% and approximately 4.6% ahead of the S&P 500 on a total return basis. Outside of the U.S., the MSCI Emerging Markets Index posted a 0.4% gain in August and is now down 17.5% YTD, while the MSCI EAFE (Europe, Australasia, and the Far East) Index was down 4.7%, underperforming the U.S. Large Cap equity benchmark by 0.6%. After a period of underperformance earlier this year, U.S. equities, as measured by the S&P 500, are now outperforming both MSCI Emerging Markets and EAFE as of the end of August.
The yield on the benchmark U.S. 10-year Treasury now stands at 3.19%, below the June peak of 3.47%. The 30-year yield moved back above 3% at the beginning of August and now sits at 3.29%. Yield on the shorter-term 2-year Treasury recently touched 3.5% following Jerome Powell’s comments at Jackson Hole, which is the highest it has been since 2007. The yield curve remains inverted, with 2-year Treasury yielding 30bps more than 10-year maturities.
July’s headline CPI released on August 10 was flat m/m after rising 1.3% in June, supporting the peak inflation theme. Food costs increased again (+1.1% m/m and is now up 10.9% vs. Y/Y). This is the seventh increase in a row of 0.9% or more. Energy decreased by 4.6% after rising 7.5% in June. Less Food and Energy, core CPI rose 0.3% in July, a 10-month low, after climbing 0.7% in June, helped by an almost 8% fall in the cost of airline fares, but still increased 5.9% in the 12 months through July, matching the pace in June.
In Washington, Congress passed the Inflation Reduction Act (IRA), which funds clean energy and climate initiatives ($369 billion) and the Affordable Care Act Extension ($64 billion), as it added a 15% minimum tax on corporations (with exceptions), permitted Medicare to negotiate prescription drug prices, funded additional IRS enforcement, and added a 1% buyback tax. President Biden signed an executive order forgiving up to $20,000 in student loan debt per person for those with an income of less than $125,000 (impacting 43 million people), costing $329 billion. From a macro perspective, the good news is that the original Build Back Better legislation proposal to slash S&P 500 EPS by ~10% was reduced to ~2.5% with the IRA legislation, according to research estimates.
Oil prices declined 9.2% in August. WTI Crude traded as high as $123.70/bbl back in March, a 14-year high. YTD oil is up 19.1% but is off 27.2% since that March high. Gold declined in August by 3.1% and is down 16.5% from the March highs of $2,050. For 2022, gold is down 6.5% and not helping as an inflation hedge.
Persistent levels of high inflation in a rising rate environment continue to accelerate the U.S. dollar rally against other major currencies. The world’s reserve currency made a new two-decade high in August against a basket of major currencies, as measured by the U.S. Dollar Index. The U.S. Dollar Index was up 2.6% for the month and has gained 13.6% YTD. Bitcoin was up about 3% in mid-August before selling off to close out down 15.2% for the month. Ethereum was down 8.7% in August. Since its November all-time highs, Bitcoin is down over 70%. Bitcoin and Ethereum are now down 56.7% and 57.4% YTD, respectively.
Volatility picked up at month’s end following Chair Powell’s Jackson Hole commentary on August 26. The CBOE Volatility Index (or VIX), a popular measure of the stock market’s expectation of volatility based on S&P 500 index options, also known as the fear gauge, sank early mid-month to below 20 on better-than-feared earnings and economic data before closing out August near the monthly highs at 25.9.
Chart of the Month – Headline CPI and Components
The Consumer Price Index (CPI) measures the monthly change in prices paid by U.S. consumers. The Bureau of Labor Statistics (BLS) calculates the CPI as a weighted average of prices for a basket of goods and services representative of aggregate U.S. consumer spending. The CPI is the most widely used measure of inflation, closely followed by policymakers, financial markets, businesses, and consumers.
The BLS reports index weights for dozens of categories, subcategories, and specific items in the CPI’s basket of goods and services. The biggest category by far is Shelter, which accounts for nearly a third of the index. The single weightiest item, at about 22.3%, is “owner’s equivalent rent of primary residence” (OER) – essentially how much homeowners would have to pay if they were renting their homes. The next-biggest category, Food, accounts for just under 14% of the index. Groceries, or “food at home,” makes up a bit more than half of that category. Gasoline accounts for just 4% of the overall CPI, but prices for it have risen more than any other good or service in the CPI basket over the past year.
The U.S. CPI was flat month-on-month in July, slowing to 8.5% year-on-year. The core CPI (ex., Food & Energy) rose +0.3%, keeping the year-on-year number at 5.9%. We likely have peak inflation in place, though the core is still showing some stickiness. Persistent price pressures remained high, with OER increasing by 5.8% year-on-year and rent increasing by 6.3% year-on-year.
August 2022 CPI data is scheduled to be released on September 13, 2022, at 8:30 A.M. Eastern Time.
As of August 31, 2022. Source: Bloomberg, Beacon Pointe.
Quote of the Month
“By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”
– John Maynard Keynes
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