Service, please! Three-minute macro
Inflation continues to be stubborn, but now we’re focused more on the services component, which is causing the bulk of the pain. Meanwhile, with volatility pretty much everywhere, investors find themselves without many assets to turn to because of rising asset class correlations. Finally, we take a look at the potential of the Brazilian equity market, which looks cheap.
Service prices continue to weigh on inflation
The September CPI print in the United States ran a cold shower over any hopes of a rapid deceleration in prices. Beyond both the headline (+0.4% month over month (MoM)) and core measures (+0.6% MoM) coming in 0.2% above expectations, the acceleration in services inflation remains a key source of worry. Core services’ contribution to total inflation has steadily grown in 2022, adding 0.5% to the headline figure in September. Within services, we note shelter costs rising at their fastest pace since 1982 (6.6% year over year). This component was boosted principally by owners’ equivalent rent (OER), which reflects past increases in home prices and higher mortgage costs. Unfortunately, this series is slow moving: OER will likely accelerate until the end of the first quarter of 2023, when the effects of lower U.S. home prices in 2022 start reflecting in the index.
Taking a step back, while we anticipate that core inflation will continue to rise over the next few months, a larger (albeit less well-known) set of price data suggests that disinflationary pressure should be reflected in consumer prices in 2023—Producer Price Index final demand (even if it rose more than expected in September), Institute for Supply Management services prices, Purchasing Managers’ Index output prices, the Zillow rent index, and the Manheim used car prices index. Moreover, on the goods side, retailers in certain areas are sitting on an uncomfortably high level of inventories resulting from the bullwhip effect of the pandemic; therefore, large discounts related to inventory clearance aren’t out of the picture going into 2023.
Lesser-known price data suggests a slowdown
Selected measures of prices since 2019
Cross-asset correlations in new (and disturbing) territory
With markets continuing to trade in a tumultuous nature with elevated volatility levels and negative returns in most asset classes year to date, cross-asset correlations that have traditionally been relied on by investors are continuing to break down. Most notably, the correlation between equities and bonds (measured by the S&P 500 Index and Bloomberg U.S. Aggregate Bond Index 200-day rolling correlations) is at its highest in over 20 years. The current reading of 0.21 is miles away from the long-run average of
–0.29.
Market movements this year have been driven by reaction to unexpectedly aggressive monetary policy tightening. With each adjustment higher, most assets have rerated lower as higher peak policy rates are factored in. Conversely, when the underlying macroeconomic data has provided markets with a glimmer of hope that we might get a dovish pivot from central banks, bonds and equities have rallied together. Unfortunately for those seeking easy diversification, we expect this correlation pattern to continue as monetary policy uncertainty remains high.
Asset correlations aren't doing anyone any favours
Correlations, U.S. stocks and bonds since 2008
Election results bolster the case for Brazil
Brazil’s presidential election on October 1 resulted in a win (although not as convincingly as some expected) by leftist Luiz Inácio Lula da Silva against far-right Jair Bolsonaro. The tighter-than-expected results set the stage for the runoff round on October 30, but investors took comfort in this outcome: The closeness of the election may force Lula’s campaign into more of a centrist form; a centrist-tilted Lula government will likely bring clearer policy visibility and tax reform. We caution the risks around the fiscal framework but, overall, we see this development as market friendly.
We’ve been bullish on Brazilian equities. Even against the backdrop of a 40% outperformance against emerging-market equities year to date, the changing political dynamic incrementally supports our thesis. We view a Lula government as one that would improve sentiment around Brazilian assets for both foreign and domestic investors, which are trading at a discount by several measures. Brazilian equities are cheap relative to history: At 7.8x forward earnings, Brazil’s price-to-earnings ratio sits substantially below its long-run average. Brazilian assets have a policy uncertainty discount baked in that we expect to retreat after the runoff election round, which makes us comfortable with an overweight in Brazilian assets.
Brazilian equities look cheap on a historical basis
MSCI Brazil Index and its P/E ratio
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