A record slowdown in inflation, debt ceiling melodrama, and more.
Our Top Market Takeaways for May 12, 2023.
Market update
Swirl
There was both bad and good news this week, and stocks and bonds reflected the swirl.
On one hand, questions over the future of regional banks remain, and debt ceiling frustration wears on. On the other, inflation shows meaningful signs of abating, with the Federal Reserve narrowing in on pausing its hiking cycle, and corporate earnings have overall been far better than feared.
To break it all down, today we share five dynamics moving the needle in markets—and what it means.
1. Headline inflation has decelerated for 10 straight months—a first in over 100 years.
Evidence of cooling inflation keeps on growing. This week’s read on Consumer Price Inflation (CPI) came in bang on estimates—with both headline and core (ex-food and energy) prices increasing 0.4% on the month in April. That brought the year-over-year gauges to 4.9% for headline, 5.5% for core—still well above what policymakers are comfortable with, but a lot of progress from the highs of 9.1% and 6.6%.
It’s also worth noting that just six months ago, almost 80% of the goods and services in consumers’ price basket were running at a dangerously fast clip north of 6%. Today, that’s down to roughly 40%, while the percentage of components below a 3% pace continues to grow:
Inflation has been consistently cooling beneath the surface
The chart describes the percentage share of U.S. CPI items within year-over-year growth ranges of <3%, between 3–6%, and >6%. For the shade of <3%, the first data point came in at 78.3% in January 2019. Then it went down until it bottomed at 8.7% in February 2022. Then it went back up and peaked at the most recent data point at 39.1% in April 2023. For the shade of between 3–6%, the first data point came in at 21.7% in January 2019. Then it went up until it reached a peak at 47.8% in November 2021. Then it slowly dropped until the most recent data point at 17.4% in April 2023. For the shade of >6%, the first data point came in at 0% in January 2019. Then it went up all the way and plateaued at 78.3% in August 2022. Then it fell until the most recent data point at 43.5% in April 2023.
What’s more, at 5.00–5.25%, the Fed’s policy rate is now officially higher than inflation—yet another sign that this policy is restrictive. All this together (decelerating inflation, tight credit conditions and easing growth) should give the Fed the ammo it needs to pause at its June 14 meeting. Yet, a month is a long time in markets these days—and central bankers will also get another jobs report and CPI print before they get to that meeting.
2. Amid debt ceiling melodrama, markets are pricing more credit risk in the United States than some emerging markets.
The clock is winding down for policymakers to hammer out a deal. Treasury Secretary Yellen has signaled the X-date (the date of potential default) could be as soon as June 1. With bipartisan compromise still out of reach, the cost of credit default swaps, which offer insurance against the probability of the government defaulting on its debt, has soared to record highs, and is now comparable to emerging markets and even junk-rated countries. Treasury bill yields that mature around the X-date have also soared compared to those dated just a few weeks earlier or later.
U.S. credit risk trumps that of emerging markets
The chart describes U.S. credit risk versus emerging markets using 1-year credit default swaps (CDS) in basis points. For the U.S. line, the first data point came in at 16 in May 2022. Then it trended upward until it peaked at the most recent data point at 74 in May 2023. For the Brazil line, the first data point came in at 83.7 in May 2022. Then it climbed to 139.2 in July 2022. Later it dropped to bottom at 81.9 on September 12, 2022. Then it went back up to peak at 130.4 on September 30, 2022. Then it went on a downward path until the most recent data point at 55.9 in May 2023. For the Greece line, the first data point came in at 31.5 in April 2022. Then it went up and reached at high point at 69.5 in September 2022. Then it went down to the most recent data point at 42.7 in May 2023. For the Mexico line, the first data point came in at 51.9 in May 2022. Then it fluctuated and went up to 91.6 in July 2022. Before going down to a low at 52 in August 2022. Then it climbed to a high point again at 96.9 in September 2022. The series ended lower at the most recent data point at 31.6 in May 2023.
Given the high stakes, we continue to believe Congress will get the job done—most likely by suspending the ceiling until this fall when budget negotiations also kick off. Nonetheless, crashing through the X-date is still a risk, and even a scenario where the government keeps up its interest payments (but halts all other discretionary spending) to technically avoid default would still have adverse economic and market implications.
3. But even with all the uncertainty, 2022’s pain is drifting away—stocks are now higher over the last 12 months.
U.S., Europe and even Chinese stocks are in the green over the last year. Up until April, the S&P 500 had a negative year-over-year return for 12 months in a row—that’s only happened eight other times since 1950.
While there’s never a guarantee of future returns (and we expect volatility in the months ahead), historically that’s boded well for stocks moving forward. In each of those eight other times, the S&P 500 was up an average of 18% a year later.
Global stocks have recouped their losses over the past year
The chart describes the 12-month trailing total return (local currency) for Europe stocks, U.S. stocks and China stocks. For European stocks, the first data point came in at 0% on May 22, 2022. It fluctuated up and down until a high point at 12.8% on May 3, 2023. Then it fell to the most recent data point at 11.2% on May 11, 2023. For U.S. stocks, the first data point came in at 0% on May 22, 2022. It went up first and reached 5.9% on June 7, 2022. Then it went down to -6.6% on June 16, 2022. Then it went up and peaked at 9.9% in August 2022. Before going down again and troughed at -8.2% in September 2022. Then it went steadily up and fluctuated until the most recent point at 6.8% in May 2023. For Chinese stocks, the first data point came in at 0% on May 22, 2022. Then it went up and peaked at 19.8% in June 2022. It then fell all the way and bottomed at -24.3% in November 2022. It then rose all the way and peaked again at 20.7% in February 2023. Then it went down and stabilized until the recent data point at 2.0% in May 2023.
All this jives with our view that stocks are forward-looking machines, selling off last year in anticipation of weaker growth to come and setting the stage for stronger markets this year.
4. Call it a comeback—earnings expectations are moving higher again.
Dare we say again that this earnings season has been impressive? S&P 500 companies are expected to round out Q1 with a -2.5% slowdown in earnings, up from estimates for over -7% heading into the quarter. Assuming the rest of this season’s reports keep pace (only roughly 8% of companies are left), it would mark the biggest turnaround we’ve seen since COVID times.
Even more impressive: A look under the hood shows that the median company has actually grown earnings by over 1%. And after over six months of adjusting for a weaker outlook, expectations for future earnings have turned a corner and are rising.
Earnings expectations in the U.S. are inflecting higher
The chart describes earnings expectations in the United States indexed at 100 = May 2021 using S&P 500 next-12-month EPS expectations. It started at 100 for May 2021 as the indexed level. It trended higher until it reached a peak at 122.6 in June 2022. Then it fell and troughed at 115.8 in February 2023. It ended a bit higher at 117.7 in May 2023
5. Treasury bills now offer the same yield as investment grade bonds.
Earlier this week, 1-month Treasury bill yields caught up to investment grade bond yields for the first time on record—both are yielding around 5.4%. But while a yield that high for lower risk cash and cash-like instruments may look good now, we don’t think those yields will last.
Short-term Treasury yields surpass the JULI Index for the first time on record
The chart describes the yield of U.S. Investment Grade Bond Index versus 1-month T-bill. For the U.S. Investment Grade Bond Index yield, it started at 3.65% in December 2017. It then went up to 4.72% in November 2018. It then declined to 2.65% on March 7, 2020. Before shooting up to a peak at 4.76% on March 20, 2020. Then it declined again and bottomed at 2.36% in August 2020. It went up on an upward ramp until it peaked at 6.28% in October 2022. It then faltered and fell to the most recent data point at 5.28% on May 11, 2023. For the 1-month T-bill yield, it started at 1.23% in December 2017. Then it went up until it peaked at 2.44% in April 2019. It went down from there and dropped dramatically to -0.10% in May 2020. Then it stayed near 0% until it came in at -0.02% in February 2022. Then it skyrocketed and ended at the last data point, which came in at 5.43% in May 2023.
With the Fed’s hiking cycle at or nearly at its end, reinvestment risk is real. When a recession hits, the Fed tends to cut rates by about 300 basis points (bps) in the following year. Today, markets are pricing in about 150 bps of cuts over the next 12 months, suggesting there’s more room for interest rates to fall from here.
That’s led investment grade and municipal bonds to meaningfully outperform rolling T-bills in environments like this in the past. Following the Fed’s last hike over the past seven cycles, U.S investment grade bonds have outperformed T-bills by roughly 14% on average (27% bond return versus 13% in T-bills). Finally, with inflation still around 5%, the real yield on T-bills is pretty much flat right now.
After the Fed’s final policy rate hike, bonds tend to reward
The chart shoes the average total return of municipal bonds, investment grade bonds and 3-month T–bills over the last seven Fed hiking cycles. The municipal bond return line was upward trending and reached an average total return of 32%. The investment grade bond return line was upward trending and reached an average return of 27%. The 3-month T-bill was also an upward sloping line, but only returned 13% on average in comparison.
Your J.P. Morgan team is here to discuss these insights in the context of your own portfolio.
All market and economic data as of May 2023 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.
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