The Factory Daily Letter

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Peak inflation

What has this historically meant for risk assets?

Rising inflation is the main culprit for the equity market weakness we have seen this year. It triggered the surge in bond yields which compressed equity valuations, and prompted the Fed to change its well-telegraphed forward guidance, while higher prices and restrictive monetary policy started to weigh on growth projections as the ISM peaked and the yield curve momentarily inverted – raising the spectre of recession.

So what might we expect to happen as and when inflation peaks?

Data released last week showed that the Personal Consumption Expenditures (PCE) Price Index (the Fed’s preferred price measure) rose by 0.2% (headline) and 0.3% (core) in April. Headline slowed to 6.3% YoY (vs the record high 6.6% in March) while core fell from 5.2% to 4.9% in an encouraging sign that inflation may have peaked.  Most of the decline was driven however driven by goods, while services prices continued to rise slightly.

Economists have also been expecting inflation to slow over the coming months. The survey that gathers the outlooks of more than 50 Bloomberg economists suggests that consumer inflation (CPI) should cool over the coming quarters: average expectations for Q2 and Q3 remain quite high (at 7.9% and 7.2% respectively) compared to the current reading of 8.3%, but the (negative) trend is currently expected to accelerate with CPI expected to reach 5.9% in Q4 2022 and 4.3% in Q1 2023:

Source: FactSet; Pictet Trading Strategy; as of 1/6/2022.

Market-implied inflation (using the 10-year break even rate) has also started to cool recently and is now just 8 basis points above where it was at the end of last year:

 

Source: FactSet; Pictet Trading Strategy; as of 1/6/2022.

Of course inflation is likely to remain elevated in the near term; the big unknown is the first derivative (i.e the rate of change in inflation) and several drivers continue to aggravate and/or contradict each other. On the one hand, for instance, the paring back of strict Covid measures in China (combined with more stimulus to support growth); upward pressure on commodity prices due to the ongoing war in Ukraine (and restrictions imposed by the EU on oil imports); and ongoing upward wage pressure thanks to the ongoing imbalance between supply and demand might all be considered inflationary. On the other hand, tighter and more restrictive policy from the Fed (with quantitative tightening starting in June); slowing economic growth off the post-Covid rebound; moderating base effects from last year and easing semiconductor supply chains should be deflationary.

While peaking inflation is unlikely to be enough on its own to restore the positive trend in equities, it is nonetheless a necessary precondition

We have been looking at typical behavior patterns across key asset classes across historical peaks in US inflation data, using the annual growth rate of the US CPI index. The chart below is of median market performance leading up to and after peak inflation.

Our first observation is that peaking CPI has often coincided with market bottom (such as in 1957, 1966, 1970 1974 and 1984). Of the 14 occurrences, the market continued fall past peak inflation in only two instances: 2001 and in 2008:

Source: FactSet; Pictet Trading Strategy; as of 1/6/2022.

In the table below we present the inflation and market performance statistics that feed the chart above. From a historical perspective, we notice weak market performance in the two months leading up to the peak in inflation (0.05% and -2.34%, median returns), which is followed by a recovery phase during which average historical performance gains traction and with more positive returns than negative ones. In the 60, 90 and 180 days following the peak in inflation, more than 60% of the time the returns are positive, a statistic that reaches 73% a year after peak inflation, and average performance is positive (+0.69%, +1.58% and +5.7% respectively).

Looking back to 2000, there are only two distinct outliers: 2001 and 2008 were both equity bear markets during which corporate earnings were under pressure and economic recession saw bottom lines contract. In both cases, peak inflation was followed by a significant equity market decline. However, today’s economy is expanding (albeit at a slower pace than a few months ago) while corporate earnings have shown resilience in Q1 reporting. Stocks have been suffering contracting valuations due to rising yields (which was not the case in 2000 and 2008).

Thus if that the US passed peak inflation in March, the likely scenario on this basis is that a short-term rebound in equities could be on the cards.

Source: FactSet; Pictet Trading Strategy; as of 1/6/2022.

In the chart below we set current market behavior against the median historical S&P500 performance around peak CPI. It illustrates how so far (leading up to the peak) the market has been following the historical median trajectory closely, it having continued to suffer losses as has so often been the case historically (albeit to a larger extent - see table above). While inflation is currently expected to remain ‘sticky’ for the reasons explained above, the historical pattern suggests that the selling pressure could start to ease should we see further evidence that CPI has peaked:

Source: FactSet; Pictet Trading Strategy; as of 1/6/2022.

A similar trend following peaks in US inflation is evident in European equities, as illustrated by the median performance of the DAX index in such instances on data going back to 1966 (we used the German benchmark as a proxy as it is an older market that includes more US inflation peaks). On a median basis the index has historically risen about 11.7% over the 240 trading days that follow the peak in US CPI. The proportion of positive returns over that period is also in line with that of the US (75% positive occurrences):

Source: FactSet; Pictet Trading Strategy; as of 1/6/2022.

The historical data show a significant move in emerging market equities over the five months that follow peak US CPI, after which they fall closer in step with their more developed peers. Indeed, since 1990, the MSCI Emerging Market Index has tended to reach a bottom 20 days after US peak inflation, whereupon it rebounds sharply, up nearly 19% over the next five months. However, it has historically tended to decline over the sixth month, falling in slightly below the median performance of European and US equity markets (median performance of 7.6%):

Source: FactSet; Pictet Trading Strategy; as of 1/6/2022.

Commodities have historically fallen following peak US inflation

As illustrated in the chart below (that shows the median behavior of the Bloomberg Commodity Index around peak US CPI), global commodity prices tend to fall significantly after inflation peaks, the index currently looking at a median performance of -9.5% 240 trading days after inflation started to decline (with only 16.7% instances of positive returns).

Source: Bloomberg Finance L.P; Pictet Trading Strategy; as of 1/6/2022.

Other than in 2005, peaking US CPI has always corresponded to a local top in the commodity index as shown below:   

Source: Bloomberg Finance L.P; Pictet Trading Strategy; as of 1/6/2022.

US Treasury yields tend to fall as inflationary pressures ease

The historical behavior of 10- and 2-year US Treasury yields around peaks in US inflation shows us that the yield on the US 10-year has tended to edge slightly higher in the first six months that follow peak CPI. However, it tends to be significantly lower after a year (with a median drop of 28 basis points):

Source: FactSet; Pictet Trading Strategy; as of 1/6/2022.

However, at the front end of the curve, the yield on the 2-year Treasury note has historically fallen faster as peak inflation has passed, as reflected in the average changes. In the 180 days that follow the peak, yields have historically fallen by a median 18 basis points, and are sharply lower after a year (-60 bps).

Overall, the US yield curve has on average started to steepen after a peak in inflation as short-term yields have fallen further and faster than the longer-term.

 

Source: FactSet; Pictet Trading Strategy; as of 1/6/2022.

So far, the 2-year yield has been tracking the historical trend: a rapid rise as CPI peaks (while momentum starts to fade thereafter):

Source: FactSet; Pictet Trading Strategy; as of 1/6/2022.

Fed fund rates have historically been steady or coming down when inflation has peaked: the Fed having been in a hawkish rate-hiking cycle in its attempts to curb it. 1980 is an example of when hawkish policy helped trigger a recession: many times such policy has damaged the economy and ultimately forced the Fed to stop its hiking process.

Under our central scenario, we expect the Fed to have to pause its hiking cycle after the summer as its effects on inflation and economic growth could start to become apparent (see more in our letter Great expectations of an expeditious Fed”.

Source: FactSet; Pictet Trading Strategy; as of 1/6/2022.

The US economy has tended to slow – and sometimes even contract – after inflationary pressures have eased

The table below shows how the US ISM manufacturing PMI index has evolved in the past around peaks in US inflation (since 1951). On average, instances of peak inflation have occurred when the activity gauge has been at 50.1 (however, note that if we focus our analysis only on recent data from 2000, the average reading is 53.1). More importantly, the average move in the ISM is negative (-1.1 over the first 30 days and roughly -3 points within the next 90 days). As a result, it has tended to fall into contraction territory over the 180 days that have followed, in a clear sign of challenging economic conditions, before bouncing back above 50 a year later.

However, a focus on more recent data shows that in most instances – except 2008 – the ISM has remained in expansion territory across instances of peak inflation.

Source: FactSet; Pictet Trading Strategy; as of 1/6/2022.

While this may seem contradictory, we think we could see a summer rally driven by cyclicals

A moderate rise in inflation is usually associated with a healthy economic cycle. Against such a backdrop, cyclical stocks tend to perform better than their defensive peers.

Indeed, as we illustrate in the graph below (the 180-day rolling correlation of the US cyclical performance with US inflation) the correlation tends to be mostly positive during periods of economic growth (cyclicals outperform) while it falls towards zero (and even into negative territory) during periods of economic turmoil.

However, more recently we have seen cyclicals clearly underperform their more defensive peers as inflation and yields have risen. Among the reasons for this are concerns associated with slowing economic activity which have sparked a flight-to-safety as inflationary pressures have also continued to grow on the back of supply concerns related to the Ukraine conflict.

Yet, and as we discussed recently, it is our view that the lion's share of recession risk might now be priced into the cyclical sectors (ex-energy). As a result, and against a backdrop of relatively resilient economic activity data in the US, any easing in inflationary pressures could now result in a rebound in US cyclical stocks.

Source: FactSet; Pictet Trading Strategy; as of 1/6/2022.

Predicting inflation remains a challenging task

Inflation remains a key factor that will certainly determine the path (and pace) of Fed policy and markets over the weeks to come. However, predicting the path of inflation is a notoriously difficult task, even for the most knowledgeable experts (many of whom initially described it as transitory…). Janet Yellen herself admitted her mistake on CNN Tuesday, saying that as the economy reopened, major shocks pushed up energy and food prices and supply bottlenecks hit the economy hard. New strains of Covid and China's zero-covid policy, combined with the war in Ukraine, add uncertainty to the process.

The latest PCE index reading for May has (that we discussed at the beginning of this letter) fuelled a slight shift in the inflation narrative suggesting that peak inflation may have been reached. However, with the price of oil still above $100 per barrel and expectations mounting around China’s (delayed) reopening process, there remains considerable uncertainty as to whether or not inflation has indeed peaked and, if so, how quickly it might slow.

Moreover, while the Fed's policy trajectory as priced by the market may have calmed a little, Fed's Waller recently indicated that he would support a continuation of 50 basis point rate rises over the coming meetings - highlighting the extent to which uncertainty prevails even among the Fed’s members.

Conflicting forces will continue to give conflicting signals in the coming weeks, and, in this context, many investors may prefer to stay on the sidelines until the situation becomes clearer. Nevertheless, if US inflation really has peaked, it would clearly constitute a significant step towards the restoration of a positive backdrop for equities.

In the short term, the technical signals also seem to suggest that the market has reached a local bottom, yet we think market participants will prefer to wait for further evidence that the Fed might choose to pause its hiking cycle at the end of the summer (to gauge the effects of hawkish policy) before they engage to support markets significantly higher. That said, if our scenario materializes, we think that a rally could take place during the summer, driven by oversold cyclicals.

A contrarian call in favour of oversold cyclicals

In the table below we present a screening of U.S. cyclical stocks (ex. energy and commodities) with an overall PTS score above 50 that appear to offer attractive upside potential (being those with an RSI below 60; and a distance to the 52-week high and a distance to the consensus price target above 10%):

Source: FactSet; Markit, Copyright © 2022 S&P Global Market Intelligence; Pictet Trading Strategy; as of 1/6/2022. *Criteria are explained in the endnotes. The target price presented in the chart is based upon chart analysis. This is not the product of an

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