The Daily Spark

The P/E ratio for the S&P500 is today about 30% above its historical average, see the first chart. And the Shiller Cyclically-Adjusted P/E ratio, which adjusts earnings for inflation, is about 50% above its historical average, see the second chart.

The problem for the stock market is inflation. As long as inflation is significantly above the Fed’s 2% target, the FOMC will remain hawkish and try to tighten financial conditions to slow down growth, which is negative for the equity market.

The consensus currently expects CPI and PCE inflation at the end of this year to be between 4% and 6%, which suggests that we will have to get into 2023 before we know that we are not in a new regime with permanently higher inflation.

The key question for all markets is the following: How will the Fed respond later this year when the unemployment rate begins to move higher if inflation is still around 5%, as the consensus expects? And if the Fed turns dovish later this year in response to rising unemployment, how will long rates and breakevens then respond? It will ultimately be a test whether the Fed will put more weight on rising unemployment or on too high inflation.

During the pandemic, the US economy lost 22 million jobs, and two years later, we have now re-created 21 million of those jobs, see the first chart below. The second and third charts show the sector distribution of the rebound in jobs. The level of employment in sectors within leisure and hospitality is still below pre-pandemic levels. In contrast, employment in industries such as air transportation, warehouses, and construction is now above pre-pandemic levels. The bottom line is that during the pandemic, we have seen a change in the composition of employment with solid growth in jobs in the goods sector and, more recently, strong growth in employment in the service sector. View our full employment report.

Our chartbook with daily and weekly indicators for the US economy is available here, and the bottom line is that there are basically no signs of the economy slowing down. The chart of the week is the weekly hotel data, and it shows that RevPAR and the occupancy rate continue to move higher, see chart below.

The first chart below shows that there are currently 11.5 million job openings and 6 million unemployed. The second chart shows that in leisure and hospitality there are more than two job openings per unemployed. The last graph shows that most job openings are in small firms with less than 250 employees. This data points to an overheated labor market with significant upward wage pressure. With this backdrop, the Fed will continue to push up short rates and long rates (via QT) to cool down labor demand, and it could take several quarters before the labor market cools enough for the Fed to turn less hawkish.

Fed Chair Powell said yesterday that the FOMC wants to tighten financial conditions. Investors must monitor to what degree this policy goal is achieved through wider credit spreads, lower equities, and/or higher interest rates.

This chart book looks at recent trends in credit markets, and the conclusion is that yield levels are rising, and IG spreads and HY spreads have widened. But with unemployment at 3.6% and inflation at 8.5%, there is still some way to go before the economy begins to cool down. The bottom line is that the Fed needs to continue to tighten financial conditions because of significantly elevated inflation levels, and some of this tightening will come in the form of wider credit spreads. As a result, the ongoing turbulence in markets is likely to continue until we begin to see inflation trend meaningfully lower.