Beyond the very near term, how does this inflation report change our outlook? In short, we’re not sure it does to any meaningful degree.
We’ve discussed our view that earnings expectations are too high for 2023. In part, revenues in 2022 were supported by corporate pricing power. If inflation and demand are moving lower (with wages somewhat sticky), the “selling less stuff but for higher prices” story may just turn into a “selling less stuff” story for many companies. This will be a headwind to earnings.
In our view there is a good chance that rate hikes slow from here as inflation continues to come down. Importantly, however, a slower pace of hikes doesn’t mean the destination has changed: +/- 5% is still the most probable terminal Fed Funds rate. The market has yet to price in the “higher for longer” mantra of the Fed. Current market expectations are for a couple of cuts in the second half of 2023 (chart below). In the event the Fed does cut as the market predicts, it won’t be because inflation has come down and everything else is rosy. It will be in response to challenging economic/market developments. A sustained level of higher rates will impact economic growth and earnings.
Bottom line: the market must finally internalize the idea that lower rates don’t necessary mean risk-on. For many years the Fed could cut rates in response to small slowdowns in growth or disruptions in the market – they wanted inflation to be higher, so why not! There was no governor on monetary policy. Today, inflation constrains the Fed’s ability to ease policy in response to deteriorating economic conditions – they want deteriorating economic conditions to ensure well-anchored inflation! This is the opposite of what everyone became used to post-2008. Maybe we’re back to “normal” cycle dynamics where rate cuts are usually quite bearish for risk assets.
As we’ve repeated many times, we don’t think the market needs to “crash”. Clearly some damage has already been done. But we do think that the highs seen in January 2022 may be elusive for some time.
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