For markets, inflation fears are joined by recession risks

“Sell in May and go away,” runs the old market adage, referring to stocks’ tendency to underperform from May to October. The third week of May 2022 may come to be seen as a bigger tipping point. Sharp falls in US and other markets last week were the moment when a sell-off that had started in the most speculative assets and technology stocks and spread to more profitable and established tech names became much more broad-based. That reflected a shift in investor sentiment. Worries about inflation have been joined by worries about recession — one that central banks may cause or worsen in their efforts to cool economies.

The catalyst, surprisingly, was earnings from two of the biggest big-box retailers, Walmart and Target. Both said sales were up but profits fell because of increasing costs and tightening margins. Both experienced double-digit share price falls more akin to moves seen in profitless growth stocks than dependable sellers of consumer goods. The market sell-off spread to other consumer staple stocks.

Apparent signs that even these powerful retailers were struggling to pass on cost pressures made investors fret that the record-high corporate profit margins and buoyant US consumer spending that have underpinned market returns in recent years were coming to an abrupt end. That took concerns into new territory. Previously, the withdrawal of liquidity after years of cheap money had mostly blown the froth off the most speculative assets, notably cryptocurrencies. The prospect of higher interest rates had chiefly hit tech and growth stocks whose valuations rely on bigger profits in the distant future.

Growing anxiety about the impact of the Federal Reserve’s response to inflation is coinciding with problems elsewhere. Lockdowns prompted by China’s zero-Covid policy are both crimping domestic growth and gumming up international supply chains. European consumers are being squeezed by soaring energy costs thanks to Russia’s war in Ukraine.

This leaves markets at a delicate point, and some money managers fear that if they go into a steeper slide, structural issues could magnify price falls. A new generation of portfolio managers has limited experience of managing bear markets. Trading conditions are clunkier, in part because banks have been constrained by capital adequacy rules from warehousing securities intraday and smoothing big movements as they used to before the 2008 financial crisis. Funds that have made bad speculative investments may be forced into firesales of higher-quality assets.

Such doomsday scenarios may not come to pass. Closer examination of Walmart and Target’s earnings reveals they ran up unusually large inventories — in Target’s case of big-ticket items such as furniture and TVs that consumers were buying in the pandemic but less so now — and had to cut prices to clear them. If what we are seeing is a sign that a late pandemic shift — the skewing of US demand towards goods and away from services — is unwinding, that could help to curb inflation by removing a force that had turbocharged goods prices. Falls in asset prices to date will also have wealth effects that might yet make it easier for the Fed to achieve its objectives without raising rates as far as it might otherwise have expected.

With US inflation above 8 per cent and Treasuries — unusually — also selling off in recent weeks, there are few safe places for investors. Commodities and energy stocks may be safer than some, though investors may have to hold their noses over ESG concerns. But amid such uncertainties, another market adage that proved a successful strategy in recent corrections — “buy the dip” — does not seem a safe bet.