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The CPI Report Looks Bad, but Don't Panic

Even as inflation gradually turns lower, wide swings in the markets are likely when the news disappoints.

Tom Lauricella: I'm Tom Lauricella, chief markets editor at Morningstar. I'm here today to talk about the market's reaction to the latest Consumer Price Index report with Dave Sekera, our chief U.S. strategist. Dave, we had a CPI report that has really spooked both the bond and stock markets. What was in that inflation report today?

Dave Sekera: Yeah, you're right. We are seeing very large selloff in the markets today. Inflation as measured by CPI on a year-over-year basis rose 8.3% in August. Now, that is down slightly from the 8.5% increase that we saw in July, but it really came as a surprise to the markets. The consensus expected inflation actually to fall to 8.1%.

Now, I think the most concerning aspect was that the greatest part of the inflation was actually in the core inflation reading, and that indicates that inflation is now beginning to spread into other categories.

Lauricella: We did have a pretty significant reaction in both the bond and stock markets. What do you make of the scope of the move that we've seen?

Sekera: Well, I think this market movement is really emblematic of why we've been cautioning investors to expect volatility over the next couple of months. Now, recently we have been noting that those headwinds we identified at the beginning of the year have begun to abate, but of course, nothing moves in a straight line.

As economic and inflationary metrics come out, anytime we see days like today where those metrics are indicating the inflation isn't moderating like what we expected, or the economy maybe isn't as strong as we expected, we certainly would see downside. Then on the other side, when we do see any of those metrics that do show inflation moderating and that the economy is still doing well, on days like that, I would expect to see some pretty significant upward momentum. I think today's move is really more indicative of traders reacting to the CPI than it is necessarily investors that are long-term fundamental investors really making big moves in their portfolios.

Lauricella: Now, our economist Preston Caldwell in response to the CPI report said, we shouldn't panic about this one report. Is that the same message that you would give long-term investors, don't overreact to this report?

Sekera: Well, as you mentioned, Preston did come out and made some commentary after the CPI report. At this point, we are holding to our base case. We do still expect that a trendwise basis that inflation will moderate over the next couple months. In fact, that moderation should last into next year. Our base case is for inflation to average 2.1% in 2023.

Lauricella: What are some of the factors that are going to help take inflation down? Right now, it's looking like inflation is pretty sticky. People are hoping for maybe a little bit more progress in this at this point, but what are some of the things that people can look to and say, "Inflation isn't going to be this bad going out as far as the eye can see."

Sekera: Well, in the commodity markets, we've already seen a number of commodities, actually start rolling over from their highs that we've seen over the past couple of months, specifically looking at the price of oil has been coming down. I think that in the next couple months you'll start seeing some of those energy-related prices coming down, which then should filter through the rest of the marketplace.

I know Preston has also indicated that most of the inflation that we've seen over the past year has really been concentrated in a couple of different categories. He's also noted just some of the bottlenecks that we've seen and some of the shortage that we've seen had pushed prices up in the first half of this year. We do expect that those shortages will start to ease over the next couple of months. Some of those supply chain issues are certainly starting to be resolved even now.

Lauricella: While the message here is don't overreact to this one particular report, we do have to ask ourselves this question of what if inflation does stay higher than we expect in the months to come? What might that mean for the markets?

Sekera: The big concern there is that if inflation stays hotter for longer that a lot of companies will have difficulty being able to pass through their own cost increases to their consumers. Of course, that a means that we'd see tighter operating margins, which of course should bring valuations of companies down. One thing that we've been highlighting for investors for quite a while now is really focusing on those undervalued companies that we think have wide economic moats.

Those companies that do have those long-term durable, competitive advantages are the ones that we think will be in the best position to be able to push through their own cost increases to their customers. Therefore, they'll be able to hold their margins and of course then be able to best hold their valuations as well.

Lauricella: We'll get into a little bit more some opportunities for investors, but I just want to go back a little bit to the economic outlook. Especially, if inflation does stay hotter than expected, or even at this current pace with the Fed raising interest rates, a lot of investors are still worried about the outlook for economic growth and the potential for a recession.

That's probably part of what's spooking the markets here as well. What's the takeaway here? What do we think at Morningstar that is most likely when it comes to economic growth and recession?

Sekera: I know our economic outlook for this year is that we expect 1.8% GDP for the full year of 2022. Now, of course, we did have some negative prints in GDP in the first and the second quarter, so that means in order to be able to get to our base case for this year, we have to see GDP about 3% over the remainder of the year on an average annualized basis.

Now, as you know, it does take time that when the Fed does start tightening monetary policy, before that tightening actually reaches the real economy. We do expect that GDP will slow going into next year. Our current expectation is GDP to fall to 1.2% in 2023. Now, I think the interesting thing to think about in 2023 is that if inflation does moderate this year and it does go down toward their 2% target and GDP is decreasing at the same point in time falling to that 1% area, that actually would give the Fed enough room I think to be able to start turning around monetary policy, and by the end of 2023, would actually be in position to then start easing monetary policy.

Lauricella: Got it. Against this backdrop and if we're saying to folks don't overreact to this one report, where are the opportunities out there for investors, long-term investors, who might be looking to put money to work?

Sekera: Based on today's move, according to the composite of the intrinsic valuations of the about 700 companies that we cover that trade in U.S. exchanges, we think the U.S. equity market's trading at about a 15% discount to are fair value. I think that actually gives investors a good margin of safety to be able to invest in today's markets. Now, having said that we do certainly expect to see volatility over the near term.

I do think that investors that are putting money to work today certainly are going to have the intestinal fortitude to be able to ride out these ups and downs that we're going to see in the marketplace today. When we break our valuations down even further, the best undervaluations we see by category are in the value and the growth areas. Whereas, the blend and core stocks are much closer to fair value. In that case, I think a barbell portfolio would be well-situated for investors today, overweight value, overweight growth, and then underweight the core or the blend categories.

Then, looking at our sector coverage I would note that the cyclical sectors, of course, those have been hit the hardest thus far in the downturn this year, but that's where we actually see most of the value today with as much as many of those stocks have sold off. Whereas, a lot of those defensive categories, which have held up relatively well, we think are generally fairly valued and in some cases starting to be overvalued today.

Lauricella: Got it. All right, Dave. Thanks very much for your time.

Sekera: All right. Well, thank you, Tom.