Stocks remain under pressure, with concerns centered on stubbornly high inflation. The longer inflation stays high, the more interest rate hikes the Federal Reserve might need to pursue, which could increase the chance of recession and lower corporate profits.

We continue to advocate for an essentially neutral portfolio positioning with our favorable stance on the cyclical Energy and Material sectors offset with the defensive Health Care sector. Key indicators we follow closely continue to signal further economic growth ahead with little chance of a near-term recession. All of this is discussed below.

Inflation Remains Stubbornly High

The Consumer Price Index (CPI) shot up 1.0% in May, the second most since June 2008, and above the consensus of 0.7%. Food prices surged 1.2%, the biggest gain in over two years, and the second most since January 1990, led by higher grocery prices. Energy rebounded 3.9%, following a short-lived retreat in the month before. Core CPI, which excludes food and energy, rose a smaller 0.6%, but also exceeded the consensus of 0.5%. It was the biggest gain in nearly a year. Almost all core CPI components increased from the month before, as price pressures remained broad-based.

Along with the gradual rotation of consumer demand toward more services and fewer goods in the post-pandemic era, services inflation is likely to remain high. But the same shift in consumer demand, coupled with recent signs of some easing in supply chains and some large retailers leaning toward discounts to move excess seasonal inventory, suggest that core goods price inflation should continue to moderate. We, along with consensus estimates, continue to expect inflation to cool down in the second half of 2022. This stronger-than-expected inflation is forcing the Federal Reserve to pursue an aggressive path of interest rate hikes that increases the potential for a policy overshoot that results in recession. However, monetary policy acts with a significant lag of about a year and we believe a recession is more likely a 2023 or longer-dated possibility.

Key Indicators Continue to Signal Further Growth Ahead

None of the major recession indicators we closely follow are signaling an imminent recession. Despite concerns over the flattening yield curve, the 3-month bill/10-year note segment of the Treasury yield curve remains solidly upward sloping. Historically, this segment of the yield curve has demonstrated better recession-predictive value than the 2-10-year segment, which has flattened much more. The Leading Economic Index (LEI) is nowhere close to contracting on a year-over-year basis, and the target fed funds rate is well below the Federal Reserve’s estimate of the equilibrium fed funds rate, which suggests the economy can withstand further interest rate hikes.

Outside of low-end consumers, which are impacted the most by high food and energy prices, most consumers remain well positioned for further consumption and still have excess savings and pent-up demand. Banks are healthy and able to lend with defaults remaining low. Energy independence is also a critical difference during the current energy price spike, with many beneficiaries of high energy prices within the U.S. economy. These factors are critically different from the conditions heading into the 2008 recession.

Energy and Health Care Look Well Positioned

Looking at data from 1984-2022, Materials, Energy, and Health Care have all shown outperformance when inflation is above 3.5% and Treasury yields are rising— the environment we now find ourselves in. We also reiterate that owning stocks provides a key factor in maintaining purchasing power, independent of the inflation environment.

Energy and Health Care look relatively well positioned, even assuming a recessionary environment. Energy trades well below its 30-year average Price/Earnings (P/E) valuation multiple in absolute terms, and close to record lows relative to the S&P 500 Index. Even haircutting its earnings by the median of the past six recessions, the P/E ratio today would still rank below the 30-year average. While Health Care trades at a P/E close to its 30-year average, it has grown earnings during each of the last six recessions and looks more attractively valued today than other defensive sectors like Utilities and Consumer Staples.




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