Late last year, we knew that 2022 would be a slower growth year as fiscal and monetary stimulus came to an end. We knew that inflation would be higher than trend and that it will remain so for quite some time. We also believed the Federal Reserve was behind the curve — but seeing the data, the Fed is much further behind, and as a result has been more aggressive with its tightening plans. No one could have anticipated the impacts of the war in Ukraine, however.
It's these three issues that have pressured the equity and bond markets this year, and we continue to believe these unknowns are reasons we will be in a trading range for the medium term.
The equity market is volatile, and the latest inflation data added fuel to the fire. This week's consumer price index rose an enormous 8.5% year on year and 1.2% vs. February. Rising gasoline prices accounted for over half the increase from February to March. The energy index rose 11% in March vs. February, while the food-at-home index rose 10% year on year, in the largest annual increase since March 1981.
The PPI was also hot at 11.2% year on year, and the hottest on record. Services inflation rose 8.7% year on year and goods increased 15.7% y/y. The services sector matters a lot more than goods because it affects consumption, income and inflation. Services spending is two-thirds of total consumption, four-fifths of employment and 60% of the CPI.
The Fed has made it crystal clear that it will raise rates quickly and shrink bond holdings more aggressively — by $95 billion a month starting in May. As Fed governors grow increasingly more hawkish, expectations are for bigger and more numerous rate increases this year, possibly totaling as much as 250 basis points. There is also speculation that the Fed will raise rates by 50 basis points at the next two meetings in May and June, respectively.
Though equities are the best hedge against inflation, at times like this, investors need to be highly selective about what they buy. Now is the time to pick solid companies, not take big sector bets. For my portfolio, I'm sticking to companies with strong fundamentals and free cash flow growth using our barbell approach, owning both value and growth.
Inflation Heats Up, but Economy Shows Resilience
Many are talking about "peak" inflation, and while we hope that is the case, we strongly believe inflation will remain elevated. The stickier parts of inflation are worrying. In the March nonfarm payroll report, hourly earnings surged 5.6% year on year. When compared with the latest CPI, it's clear that wage increases aren't keeping up with inflation; if inflation isn't reined in, it could affect consumer demand.
Home prices nationwide increased year over year by 20% in February 2022 compared with February 2021, according to S&P CoreLogic. Not only are the headline home prices a concern, they will affect rents as they follow home prices on average by 12 months. The Dallas Fed forecasts average rents will be up 6.9% by 2023 from the 4.5% levels reported from the BLS. Of course, we know rents in many areas of the country are much higher.
The Fed has stated that it will be data-dependent this year, and there are positive signs that indicate the economy is resilient enough to withstand rising rates. The March ISM survey, a leading indicator, highlighted healthy expansion across both services (58.3) and manufacturing industries (57.1). New orders in ISM services surged 4 points to 60.1 — which is a leading indicator.
Survey respondents shared commentary on continued business and demand strength with elevated backlogs, yet supply chains remain unstable and labor continues to push costs higher. Lastly, shipment of core capital goods increased at a 15.6% annualized rate in Q1, emphasizing demand-driven business activity and a focus on supply chains and inventory to help meet that demand.
