Forget inflation, Jefferies says to watch out for a ‘disinflation era’ like the early 1980s

Inflation was the most pressing concern of Americans in 2022 as prices for everything from gas to wheat soared to record highs. Year-over-year inflation, as measured by the consumer price index, hit a 40–year high of 9.1% in June, but then retreated rapidly—and Jefferies argues that the trend will continue over the next year.

“U.S. inflation has peaked,” Desh Peramunetilleke, the investment bank’s global head of microstrategy, wrote in a Thursday note. “Disinflation is a key assumption for our roadmap for 2023.”

Jefferies believes that Americans—and particularly American investors—shouldn’t be worried about inflation at all. Disinflation like what was seen in the early 1980s is the real threat, and it’s likely to come with falling corporate earnings and a U.S. recession by the second half of 2023.

The investment bank’s analysts laid out a few key similarities between the period that followed “The Great Inflation” of 1965 to 1982, and the rapid decline in the CPI today.

When Paul Volcker became the Federal Reserve’s 12th chair in August of 1979, he immediately embarked on a fight against the rampant inflation that plagued the economy the decade prior to his appointment, eventually raising interest rates to nearly 20%. Volcker’s rapid rate hikes slowed the economy so quickly that by January 1980, a recession began, and unemployment would go on to peak at 10.8% in December 1982.

Over the past year, the Fed’s current chairman, Jerome Powell, has raised interest rates more aggressively than anyone since Volcker—and he’s made it clear that he is willing to apply some economic “pain” in order to get inflation under control, just like his predecessor. Jefferies analysts say his actions are giving them déjà vu.

“The Volcker Fed’s disinflation era of 1980-83 has strong resemblance with the current cycle given the tolerance for higher rates even at the expense of rising unemployment and a recession. Also, the disinflation trend was helped by easing supply side (oil) pressures, just like now,” they wrote.

If the current economic era is comparable to the Volcker years, it could be a recipe for tough times for investors. During the disinflation of the Volcker Fed, the S&P 500’s trailing earnings per share dropped 19%. And that’s common during “significant disinflation periods” throughout U.S. history, according to Jefferies’ analysts.

Jefferies isn’t the only investment bank to warn of a broad decline in corporate earnings in recent weeks either. Morgan Stanley’s CIO Mike Wilson has repeatedly argued that corporate earnings estimates are too high and they’ll eventually fall, taking stocks with them.

“That’s another area investors are being a little bit complacent—costs are increasing faster than net revenues,” he told CNBC last week, describing the effects of fading inflation on S&P 500 companies. “The full-year [earnings] estimate has got to come down.”

Wilson sees the S&P 500 falling as low as 3,000, or more than 20%, in the first half of the year.

And Jefferies’ equity analysts echoed that view this week, saying that they expect the S&P 500 to “correct” in the first quarter due not only to falling earnings, but also the effect of higher interest rates on profit margins and growing recession risks.

But after a rough first half of the year, stocks could present “strong upside” by mid-2023, they added, recommending that investors look to “quality” names because of their historical outperformance during periods of falling inflation.

“Quality investing has delivered consistent rewards,” they wrote. “From a style perspective, focus on quality. Quality-growth sectors outperformed cyclicals during the 1980s disinflation period.”

Wall Street analysts and wealth managers like to group stocks into different investing categories—called “style factors”—with the goal of helping clients generate above average returns, manage risk, and diversify their portfolios. For example, analysts might say that they favor “growth” stocks—equities of companies that are expected to grow rapidly—over “value” stocks—equities that trade at a low price relative to their fundamentals and/or peers. And while Jefferies’ equity analysts said on Thursday that they prefer the “quality” style factor at the moment, defining “quality” is easier said than done.

“There is no fixed definition of quality, as it really depends on the investor’s perspective,” the analysts explained.

Typically, “quality” stocks are defined as companies that have steady, predictable cash flows and are profitable based on metrics like return on equity (ROE) and return on invested capital (ROIC). But Jefferies has developed its own framework for determining true “quality” that includes criteria like “robust balance sheets,” “consistent and high margins,” and predictable earnings.

Companies like Walmart, Home Depot, Visa, and Merck all made Jefferies’ “quality at a reasonable price” list that could outperform the overall market this year.

As far as sector positioning, the analysts recommended looking to “staples, utilities, communication services, and healthcare,” arguing that when CPI was falling between April of 1980 and February of 1983, these sectors “outperformed the most.”

This story was originally featured on Fortune.com

More from Fortune:
Air India slammed for ‘systemic failure’ after unruly male passenger flying business class urinated on a woman traveling from New York
Meghan Markle’s real sin that the British public can’t forgive–and Americans can’t understand
‘It just doesn’t work.’ The world’s best restaurant is shutting down as its owner calls the modern fine dining model ‘unsustainable’
Bob Iger just put his foot down and told Disney employees to come back into the office

Source: https://finance.yahoo.com/news/forget-inflation-jefferies-says-watch-175517331.html