The latest surprise in US inflation has had an immediate, negative impact on most markets – headline inflation in August was 8.3% compared to the 8.1% consensus forecast, while core was 0.6% versus market expectations calling for 0.35%. Investors had counted on slowing inflation. In many countries, it has actually accelerated (see Exhibit 1). Worryingly, part of the acceleration in core US CPI was driven by shelter, where price changes tend to be sticky.
Hope for a pause in central bank policy rate rises have now been dashed. The sell-off in risk assets over the last month had already been driven by higher policy rate expectations. The message from central banks had been clear that they were willing to do ‘whatever it takes’ to get inflation under control and that rates were going to be higher for longer than many in the markets expected.
After the latest US consumer price inflation (CPI) data, rate expectations have jumped even higher (see Exhibit 2), with the predictable negative impact on equities, particularly growth stocks. The peak forecast for US rates has now risen to nearly 4.5%, although the markets still expect the US Federal Reserve to pivot and begin cutting rates by the spring of 2023. We believe rates will remain high throughout 2023.
Rising discount rates are not the only risk to equities. In continental Europe, the poor performance of markets has been a function of rising rate expectations just as it has in the US. This is in spite of the fact that Europe’s equity indices are somewhat less sensitive to interest rates than those in the US given the greater value orientation of the market.
However, declining growth expectations have played a bigger role. In the US, purchasing manager indices (PMIs) continue to point to solid growth, with the latest manufacturing index from the Institute of Supply Management coming in at 53, while the services index was at 57.
Europe’s PMIs by contrast are already at sub-50 levels as the impact of the energy shock is becoming increasingly apparent – and this well before winter. Those services PMIs that were above the 50 threshold were boosted by a strong holiday travel season. A weak euro attracted a lot of US tourists. That impulse will likely fade with the end of the summer.
However, the US is not impervious to the worsening growth outlook. Earnings estimates (ex-commodities) for the current quarter have fallen sharply since June, down by over 7%. This leaves forecast year-on-year earnings growth at just 3.5%. That may turn out to be overoptimistic.
Recession and earnings growth?
Looking ahead to 2023, many economists and investors foresee a recession in the US. However, earnings growth forecasts have remained positive at 7.5%. In a recession, earnings typically decline by 20-30%.
Analysts’ forecasts are not necessarily out of line with investor sentiment, as opposed to simply being unrealistic. The bulls-to-bears ratio is currently near all-time lows, at one standard deviation below the long-run average. The 7.5% one-year earnings growth forecast, however, is also at the low end, even if not by as much. The long-run average estimate is 13.8%, so in fact the consensus is almost half that (see Exhibit 3).
Again, this is not to suggest that we believe those earnings growth forecasts will be realised. Growth in the US will need to slow significantly if inflation is to reach the Fed’s 2% objective. Corporate earnings will likely bear the brunt of the economic slowdown…