The Credit Strategist Blog
The CPI rose 8.65% in May from a year ago on top of a 5% year-over-year gain in May of 2021. This demonstrates the cumulative effects of rising prices which are often lost in media reports but certainly not lost on consumers. Excluding food and energy, core CPI was up 6%. These are the highest numbers in 40 years and every spending category was higher. This is about as bad a report as could be imagined and if we calculated inflation like we did 40 years ago, the numbers would be much worse. The only silver lining is hope that we are closer to seeing these numbers peaking but we are a long way from reaching the Fed’s 2% inflation target.
As I’ve written many times, this did not happen overnight. The causes of runaway prices are the following: (1) green energy policies; (2) higher wage policies; (3) weak antitrust policies; (4) profligate monetary and fiscal policies; and (5) supply chain logjams. The Fed only has control over half of item (4); the other items on this list are beyond its control. It contributed disproportionately to the problem because of the outsized influence on the economy of monetary policy and its unprecedented, untested and egregious efforts to prop up demand through ZIRP and QE. These policies, which should only be used in emergencies, became business as usual for the Fed and distorted markets and the economy and created an unsustainable situation including the current inflation.
It’s pretty clear what happens now. The Fed is going to raise rates by at least 150 basis points through September, most likely with 50 basis point moves in June (next week), July and September. After today’s inflation print, any thought of taking its foot off the gas pedal with a 25 basis point move in September is gone. It could conceivably hike rates faster during this sequence (i.e. opt for one or more 75 basis point hikes) to try to demonstrate control over the inflation narrative (a dubious endeavor as Mohammed El-Erian suggested this morning on CNBC) but will definitely raise rates by at least 150 basis points over the next four months. Powell & Co. also started QT this month and will ramp that up to $95 billion per month by August. This balance sheet shrinkage will add additional tightening pressure to markets and the economy that will intensify over time.
I believe these tightening moves will lead the S&P 500 to drop to at least 3400 by August (timing is always difficult to call) which would be roughly 14.5x forward earnings of $235. That earnings estimate needs to be lowered because the economy is going to slow down and we are going to experience an earnings recession. Investors should do their own earnings estimates and not rely on corporations and Wall Street to lower their numbers in a timely manner. In reality, 3400 represents a higher multiple than 14.5x right now and once you back out all the bogus non-GAAP earnings adjustments represents something closer to 18x which is hardly cheap in the current environment.
The question is what happens after that. Forecasting a few months out is difficult enough especially in an environment as complex as this; beyond that is a guessing game befitting the Oracle of Delphi. Markets are extremely fragile today because they are highly leveraged, short-term oriented (obsessed) and liquidity-constrained. We have yet to see liquidity constraints cause any accidents but as markets take another leg down (a drop to 3400 is a ~15% drop from today’s open though we are already down 2.7% as I write this to 3909) this could become an issue. Investors are likely to experience a lot of pain before coming out the other side of this current market sell-off which involves both the popping of a historic stock market bubble and related inflation bubble. The steamroller is right in front of you and Jay Powell is in the driver’s seat. Don’t lie down and let it run over you.