Jul 14, 2022
Jack Powell

US inflation surprised to the upside…….again

The last time US inflation was at 8.58% was in December 1981. Back then, the US Federal Reserve (the Fed) cash rate was at 13% vs today's cash rate of only 1.58%. Is the Fed "behind the curve" and needing to accelerate their interest rate increases? Yes, they now forecast much higher cash rates into the end of 2022 and 2023, as discussed over the page. It has also been the worst first half of to the year for 10-yr US Treasuries since 1788.

"Don't give me a low rate. Give me a true rate, and then I shall know how to keep my house in order." — Hjalmar Schacht, Reichsbank president, 1927

US inflation surprised to the upside…….again

At the June 2022 Federal Open Market Committee (FOMC) meeting, US inflation surprised to the upside (again) with a year-on-year (YoY) increase of 8.58%. It is now forecast to peak at 9% later in 2022.

The chart below shows that this upside surprise was due to food and energy inflation. Other parts of the US economy have been slowing, so even though Inflation surprised to the upside, core inflation (inflation excl. food and energy) has continued to decline.

US inflation and forecast – July 2022

Percentage-point contribution to annual change in CPI inflation
Source: Macrobond and Nordea - The Daily Shot

The last time US inflation was at 8.58% was in December 1981. Back then, the US Federal Reserve (the Fed) cash rate was at 13% vs today's cash rate of only 1.58%. Is the Fed "behind the curve" and needing to accelerate their interest rate increases? Yes, they now forecast much higher cash rates into the end of 2022 and 2023, as discussed over the page.

US Cash rate & Inflation (1954 – 2022)

US CPI YOY vrs Effective Federal Funds Rate
Source: Compound @ CharlieBilello

As US inflation continues to surprise to the upside, the Fed’s indicative cash rate forecasts have also climbed. As shown below, in September 2021, the Fed forecasted the US cash rates would be 0.25% by the end of 2022 and 1.00% by the end of 2023. Fast forward to their June 2022 FOMC meeting, and they are now forecasting the cash rate to peak at 3.40% in 2022 and 3.75% in 2023. This is an increase of 1,260% in the 2022 forecast cash rate in only eight months!!

US Fed June 2022 Dot Charts

The changing FOMC cash rates
Source: @TheTerminal, Bloomberg, The Daily Shot

The Fed dot chart above is also forecasting interest rates dropping into 2024. This assumes that Inflation has declined and the increasing chance that the US economy will go into recession in 2023.

Share markets are now pricing in higher interest rates

At the end of June, the markets have dropped -21% (S&P500), -30% (Nasdaq100), -13% (ASX200), -19% (NZX50) from their respective 2021 peaks. Below is a chart showing the worst US share market drawdowns since 1928. The current bear market is the bold blue line, and as shown, there is potential for further downside from these levels.

Worst US equity drawdowns (1928 – 2022)

Trading sessions
Source: Bloomberg and Saxo Group

Share analyst forecast – slow to price a recession

When considering what might be a suitable entry-level to buy into falling share markets, one of the indicators we consider is the Price to Earnings (P/E) ratio. This indicates the multiple that the share price is above the 12-month forecast earnings. The average P/E ratio for the S&P500 over the last 20 years is 15 times earnings. After the recent drop in share prices, the market is now trading at this level. This suggests that it may be a reasonable entry point. Not cheap but also not expensive.

If we used this as the only indicator, we might recommend the deployment of funds; however, the ratio has two parts to it. One is the price of shares, which is simply what the current share prices are trading at. The second part is the 12-month forward earnings. This is the less simple part of the ratio as it is determined by share analysts' forecasts for the company's earnings over the next 12 months.

The chart below shows that historically analysts have not been very accurate at forecasting a drop in earnings caused by a recession. During such times, analysts' forward earnings estimates have proven to be too optimistic. This is to be expected as recessions are inherently challenging to forecast.

Equity analyst earning downgrades usually miss recessions

Equity analyst earning downgrades usually miss recessions
Source: Bloomberg, The Pain Report

Currently, there is an increasing risk of a recession globally; hence the earnings forecast for the coming 12 months may be too optimistic. The chart below highlights that global Purchasing Managers Indices (PMIs) are declining, suggesting the global economy is slowing. The chart suggests we may see a drop in earnings per share (EPS). If we factor in falling earnings (below the analysts’ forecasts), then the P/E multiple might be closer to 18 times, which is not cheap.

S&P500 earnings expected to drop

'Diffusion index of global purchasing managers' index' against 'Global non-financials trailing earnings per share growth'
Source: Financial Times, A.S.R., S&P Global, Refinitiv Datasream

No diversification benefits

When designing investment portfolios, the standard practice is to invest in some shares and bonds. This is to reduce the risk of the portfolio's assets all dropping simultaneously.

Unprecedented levels of quantitative easing (QE) had pushed global interest rates/yields to historically low levels (record high bond prices) and shares to record high levels. When the QE ceased, interest rates started to revert to more normal levels, and as you would expect, both bond and share prices also normalised.

Since peak prices in November 2021, share and bond performance has become correlated for the first time since early 2000. The first quarter of 2022 shows a combined loss (shares + bonds) of almost 25%. This is the worst quarterly performance in modern history. During this correlated period, cash and short-dated bonds are kings.

Global Stocks and Bonds just had their worst quarter ever

Source: Bloomberg, The Daily Shot

The rise & fall of retail investors

In past corrections, the decline in share values has been exacerbated by retail investors capitulating and selling shares into a falling market. This behaviour has led to periods where shares traded at historically cheap valuations, such as in 2000 (the “Tech Wreck”) and 2008 (the Global Financial Crisis (GFC)). In the current decline, retail investors have held their positions and have continued to "buy the dip."

As shown in the chart below, retail investor sentiment is at levels last seen in the GFC, yet their portfolio allocation to shares remains historically high. This correction is unusual from others, given retail investors now have access to quality market information via Google, YouTube, and trading platforms like Robinhood in the US or Sharesies & Hatch closer to home.

We hope this will change retail investors' behaviour, but the psychological pain felt from losses will still be high at present. Retail investors have not capitulated to date, but there is already some serious blood on the street within their portfolios. We continue to watch the retail investors closely.

US Retail investors still holding shares

Sentiment vs Positioning - The Daily Shot
Source: All Start Charts Plus, The Daily Shot

Average retail investment now in loss

Estimated gains/losses among small options traders - The Daily Shot
Source: Sentiment Trade, The Daily Shot


We expect continued volatility into the end of 2022 and a possible global recession in 2023. However, we anticipate that interest rates are potentially already at or near their peak levels for this cycle.

Bond and share markets are now trading at more reasonable valuations versus history, though there are still some headwinds that we need to be mindful of. Share markets may be reasonably priced, but that does not mean they can't get cheaper.

No one rings the bell at the bottom of a bear market, but at PWA, we monitor these markets closely as we attempt to identify a time to start increasing the exposure to shares and bonds.


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