US CPI report: Things are looking bad, but don’t panic just yet

Tom Lauricella: I’m Tom Lauricella, Markets Editor-in-Chief at Morningstar. I’m here today to talk to Dave Sekera, our Chief US Strategist, about the market’s reaction to the latest CPI report. Dave, we had a CPI report that really scared both the bond and stock markets. What was in today’s inflation report?

David Sekera: Yes you are right. We are seeing a very large sell off in the markets today. Inflation, as measured by the annualized CPI, increased by 8.3% in August. While that’s a slight drop from July’s 8.5% gain, it really came as a surprise to the markets. The consensus even expected inflation to fall to 8.1%.

Well, I think the most worrying aspect was that most of the inflation was actually in core inflation, and this suggests that inflation is now spreading to other categories.

TL: We had a pretty clear reaction in both the bond and equity markets. What do you think of the scope of the move we saw?

DS: Well I think this market move is really emblematic of why we cautioned investors not to expect volatility over the next few months. Now we’ve recently found that the headwinds we encountered earlier in the year have eased, but of course nothing is moving in a straight line.

When economic and inflation metrics come out, any time we see days like today when those metrics suggest inflation isn’t slowing down as expected or the economy might not be as strong as we expected, we would certainly see downside moves . Then, on the other hand, if we see one of those metrics showing that inflation is slowing down and that the economy is still doing fine on those days, I would expect some pretty clear bullish momentum. I think today’s move is more an indication that traders are reacting to CPI than that it’s necessarily investors who are long-term fundamental investors who are making really big moves in their portfolios.

TL: Well, our economist Preston Caldwell, in response to the CPI report, said we shouldn’t panic about this one report. Is that the same message you would give to long-term investors, are you not responding to this report?

DS: Well, as you mentioned, Preston came out and made some comments after the CPI report. At this point we stick to our base case. We still expect inflation to trend downward over the next few months. In fact, this moderation should continue into next year. Our base case is inflation averaging 2.1% in 2023.

TL: What are some of the factors that will help lower inflation? At the moment, it looks like inflation is pretty sticky. People might be hoping for a little bit more progress at this point, but what are some of the things people can look at and say, “Inflation won’t be that bad as far as the eye can see.”

DS: Well, in the commodity markets we’ve already seen a number of commodities actually starting to roll off the highs we’ve seen over the past few months, especially considering the price of oil, which has been falling. I think over the next few months you’re going to see some of these energy-related prices fall, which should then filter through to the rest of the market.

I know Preston also hinted that most of the inflation we’ve seen over the past year has really been concentrated in a few different categories. He also noted that some of the bottlenecks we’ve seen and some of the shortages we’ve seen pushed prices higher in the first half of this year. We expect these bottlenecks to ease over the next few months. Certainly, some of these supply chain problems are already being resolved.

TL: While the message here is not to overreact to this one particular report, we must ask what will happen if inflation stays higher than we expect in the coming months? What could this mean for the markets?

DS: The big concern is that if inflation stays hot for longer, many companies will struggle to pass their own cost increases on to their consumers. Of course, that means we’d see tighter operating margins, which of course should lower company valuations. One thing we’ve been emphasizing to investors for a while is to focus on the undervalued companies that we believe have large economic moats.

Those companies that have these long-term sustainable competitive advantages are, in our opinion, best placed to pass their own cost increases on to their customers. Therefore, they will be able to keep their margins and then of course best keep their valuations.

TL: We’re going to go a little more into some of the opportunities for investors, but I just want to get back to the economic outlook a little bit. Especially if inflation stays hotter than expected, or even at this current pace if the Fed is raising interest rates, many investors are still concerned about the outlook for economic growth and the potential for a recession.

That’s probably also part of what’s spooking the markets here. What’s here to take away? At Morningstar, what do we think is most likely when it comes to economic growth and recession?

DS: I know our economic outlook for this year is that we expect full year 2022 GDP to be 1.8%. Well, of course we had some negative prints on GDP in Q1 and Q2, so alright. To get to our base case for this year, we have to expect GDP to be around 3% on an annualized basis for the rest of the year.

Well, as you know, it takes some time for the Fed to start tightening monetary policy before that tightening actually reaches the real economy. We expect GDP to slow next year. Our current expectation is that GDP will fall to 1.2% in 2023. Well, I think the interesting thing to think about in 2023 is that if inflation eases this year and it falls to its 2% target, at the same time GDP would fall to that 1% range , I believe that would actually give the Fed enough leeway to start turning around monetary policy, and by the end of 2023 it would actually be able to start easing monetary policy then.

TL: I have it. With that in mind, and if we’re telling people not to overreact to this one report, where is the opportunity out there for investors, long-term investors who might be trying to make money?

DS: Based on today’s movement, and according to the compilation of intrinsic valuations for the approximately 700 companies we trade on US exchanges, we believe the US stock market is fairly valued at a discount of approximately 15%. I think that actually gives investors a good margin of safety to invest in today’s markets. Well, having said that we certainly expect volatility in the near term.

I think investors investing money today will surely have the inner strength to weather the ups and downs that we are going to see in the market today. Breaking down our valuations even further, we find the best undervaluations we see by category in the value and growth areas. In contrast, the mixed and core stocks are much closer to fair value. In this case, I think a barbell portfolio would be well positioned for investors today, overweight value, overweight growth, and then underweight core or blended categories.

If I then look at our sector coverage I would see that while the cyclical sectors have obviously been the hardest hit by the downturn so far this year, that is where we are actually seeing the most value today, with as many of those stocks sold out. In contrast, many of these defensive categories that have held up relatively well are, in our view, generally fairly valued and in some cases are beginning to be overvalued today.

TL: I have it. All right David. Thanks for your time.

DS: Good. Thank you Tom

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