The tailwinds of change: Three-minute macro

Cooling CPI a tailwind for P/E multiples

We plotted the price-to-earnings (P/E) ratio of the S&P 500 Index against monthly inflation figures (as measured by year-over-year changes in the U.S. CPI) from 1965 to 1999, and our work suggests a negative relationship between the two: as inflation declines, P/E ratios have typically expanded (and vice versa).¹

The negative correlation (-0.72 to be exact) between inflation and P/E multiples is telling and makes sense: In periods of high inflation, investors are less willing to pay for each dollar of earnings as the purchasing power of that dollar is decreased. This is also in line with recent market action given the risk-on rally that has accompanied data suggesting softer inflation ahead. Furthermore, cooling inflation is needed for a pause in the tightening of monetary policy, another tailwind for risk assets, and a reason that multiples could expand. Interestingly, we found no significant relationship between inflation and multiples from 2000 to 2019, a period of tame inflation. This would suggest that while inflation is under control, it doesn’t have a significant effect on P/Es—in other words, when inflation is out of sight, it’s out of mind for investors.

Our view is that by the middle of 2023, inflation will have materially decelerated due to base effects, excess inventories in non-auto durable goods, and the alleviation of supply chain disruptions. There’s no shortage of headwinds to equities given a weakening growth backdrop: leading indicators in recessionary territory; erosion in earnings revisions (albeit at a slower rate than expected); unsustainably high margin levels; and a less-than-compelling equity risk premium. While these are just some of the reasons equities may be put under pressure over the next few months, softening of inflation could be a tailwind to equity valuations.

China reopening timeline

Optimism has soared in recent weeks on the raft of headlines indicating relaxation of various zero-COVID measures in Mainland China. Several cities have eased testing requirements for public spaces, there have been reductions in lockdowns within high-risk areas, and more local officials have appeared in public without masks. There are also reports of vaccination targets for the elderly reaching 90% by the end of January.

These are very encouraging signals, but uncertainties remain for investors. For example, high-risk areas that account for approximately half of GDP are still subject to lockdowns. Furthermore, we’re unsure if the vaccination rollout can proceed as planned and whether the lighter-touch approach will succeed in suppressing current outbreaks. If those measures aren’t effective, we’re unsure what measures will be adopted in response.

We’ve maintained a baseline forecast for a meaningful reopening occurring in China after the National People’s Conference in March 2023. Indeed, the market consensus of a 1H23 opening hasn’t changed despite recent developments. Key signposts to monitor in coming months will be vaccination and fatality rates, healthcare facility capacity, and government responses to the rise in cases. The most current read on China traffic volumes suggests transportation levels are at just ~30% of where they were before the pandemic. Overall, this supports our ongoing concerns about Chinese economic growth, with zero-COVID being just one of them. 

Excess savings aren’t excess for all

As recessionary probabilities rise for 2023, many bullish market participants quote excess savings as a cushion for consumers, but a deeper look suggests this may not be the case for all. In fact, bank balances per capita in the United States reveal that the bottom quintile of consumers is the only cohort that has less money in their accounts than before the pandemic: A person in the bottom quintile has an average of only a few hundred dollars in their bank account. In contrast, the top quintile has seen a rapid expansion of personal cash levels since 2019, up over 400%.

With the U.S. Federal Reserve (Fed) engaging in one of its most aggressive tightening cycles in history, we have growing concerns regarding the lower income cohorts’ ability to withstand any upcoming economic weakness. Monetary policy typically has an 18- to 24-month lag, and the reality is that we have yet to see the impacts of tightening hit the economy: Unemployment rates remain at decade lows and inflation has only moderately subsided. Necessities, including food and energy, have grown as a share of overall consumption expenditure, putting particular pressure on low-income households.

Despite the strain to the lower income cohorts, we don’t see accommodative fiscal or monetary policy providing much support in 2023. We’re likely to see a tightening of fiscal policy in the United States given a gridlocked government and growing fiscal deficit approaching the debt ceiling. Similarly, monetary policy will be very restrictive in the year ahead, but we would note one silver lining: As inflation comes off the boil, the Fed is likely to take a more balanced view of economic health and look at a breadth of indicators that would encompass a variety of income and demographic factors. 

1 We chose the timeframe from 1965 to 1999 because in this 35-year period, inflation averaged 5.0%. In contrast, in the 20-year period from 2000 to 2019, inflation averaged 2.2%, so we wanted to isolate a sufficiently long timeframe where inflation was not just higher, but also more dynamic.