U.S. equity markets tumbled today, Monday, June 13, continuing a sharp fall that started Friday following a hotter than expected inflation report showing prices rising at the highest rate since the early 1980s. In response, markets are recalibrating their expectations in anticipation of more aggressive interest rate hikes from the Federal Reserve (Fed), which is scrambling to quell inflation after being surprised by the speed and intensity of price increases. The market now expects the Fed to increase its target rate by up to 0.75 percent at Wednesday’s meeting instead of the traditional and more gradual pace of 0.25 percent per meeting. We expect additional higher rate increases to follow as the Fed attempts to slow demand enough to dampen price increases.
Markets currently expect the Fed to hike rates above 3 percent this year, getting closer to 4 percent in 2023, well above estimates when rates start to become restrictive. This should start slowing the economy and in turn, inflation. There already are signs of moderating economic activity as higher mortgage rates are starting to dampen housing activity and jobless unemployment claims are ticking up. Retail inventories are rising, a sign of possible downward pressure prices. The outlook for energy and food prices, however, remain tethered to geopolitical events in the near term, such as the war in Ukraine. Further energy price increases are possible through the summer. Also, supply chains remain vulnerable to continued lockdowns in China as the country seeks to control COVID outbreaks, which could further pressure inflation.
Our base case remains that the economy will slow meaningfully but avoid a recession, although the probability of a recession has risen. While inflation is eating into consumer budgets, household balance sheets are in good shape in aggregate, with low debt levels and high savings. The job market remains strong. Corporate balance sheets also are strong. Should the economy tip over into a recession, the drawdown likely will be moderate given the relatively strong state of the economy outside of inflation and a lack of large structure imbalances.
With the S&P 500 down more than 21 percent year-to-date following the market close, and NASDAQ down more than 30 percent, equity valuations appear more attractive, having fallen from lofty levels. Investors, however, can expect continued volatility ahead until there are tangible signs that inflation is sustainably slowing.
As always, investors should have a long-term investment horizon and consult with a financial advisor, especially in periods of high market volatility.