Red-hot: U.S. inflation surges at blistering pace

On the latest edition of Market Week in Review, Head of Equity Portfolio Management for North America, Megan Roach, and Investment Strategy Analyst BeiChen Lin discussed January employment numbers from the U.S. and Canada. They also chatted about the latest U.S. inflation report as well as the performance of U.S. small cap equities in comparison to their large cap counterparts.

U.S. January employment rises, while omicron sparks job losses in Canada

Both the U.S. and Canada recently released nonfarm payroll data from January, Roach said, noting that there were some notable differences in the employment numbers between the two countries. In the U.S., nonfarm payroll additions totalled 467,000, she said - far and above consensus expectations for 150,000 job gains.

"Industry analysts had been anticipating a much lower number for January due to the surge in COVID-19 infections caused by the omicron variant, but the jobs report suggests the U.S. economy has been pretty resilient," she noted. Roach added that while the unemployment rate did tick up to 4.0% from a reading of 3.9% in December, it remains consistent with the U.S. Federal Reserve (Fed)'s target. All told, the January jobs report reinforces the central bank's case for embarking on a policy of monetary tightening soon, she stated.

Meanwhile, in Canada, 200,000 jobs were shed during January, with industries such as retail and hospitality hit particularly hard, Roach said. As a result, the country's unemployment rate rose to 6.5%, she noted. "This is probably reflective of the more stringent lockdown measures enacted by governments to slow the spread of the omicron variant - especially in places like Ontario and Quebec," Roach explained. Importantly, many of these restrictions are likely to be relaxed moving forward as COVID-19 cases decline, she said, which should allow for a pickup in the services sector.

"Ultimately, I don't expect January's disappointing numbers to soften the Bank of Canada (BoC)'s hawkish stance," Roach stated, noting that the BoC has signalled rate increases are likely to begin next month.

Markets price in steeper March rate hike as U.S. inflation reaches 40-year high

Turning to the latest developments on inflation, Roach said that pricing pressures continue to intensify in the U.S., with the government's consumer price index (CPI) rocketing 7.5% higher during January, on a year-over-year basis. "January's increase of 7.5% was the highest yearly increase in inflation in 40 years, topping both consensus expectations for a 7.3% rise and December's gain of 7%," she stated.

The trajectory for U.S. core inflation, which excludes the often-volatile categories of food and energy, was similar, Roach noted, with the core CPI climbing 6%, year-over-year - versus expectations for a 5.9% increase. In December, core inflation was up 5.5% on an annual basis, she added.

The red-hot inflation numbers, combined with January's strong jobs report and new data from the Atlanta Fed showing a significant uptick in wage growth, have really boosted market expectations for a Fed rate hike in March, Roach noted. "At the beginning of the year, market expectations for the Fed to start raising short-term interest rates at its 15-16 March meeting were around 60%. That probability has risen to virtually 100% in the past few days," she remarked. In addition, markets are now pricing in a 50-basis-point rate hike, rather than a 25-basis-point increase, at the next Fed meeting, she said.

3 factors that could trigger a turnaround for U.S. small cap stocks

Roach and Lin ended the segment with a look into the performance of U.S. large cap and small cap equities so far this year. "It's no secret that 2022 has kicked off with plenty of volatility and a generally negative return environment for equities," Roach said, noting that small cap stocks in particular have struggled to find their footing.

"Small caps have lagged large caps in the U.S., Europe and Japan since the year began - the asset class just hasn't been able to catch a break recently," she remarked. However, it's important to remember that U.S. small caps did fare very well in a year-long rally that began in the spring of 2020, Roach said, with the asset class at one point up nearly 100% from its 2020 March lows. However, small caps then proceeded to trade flat for the next six months, while U.S. large cap stocks continued advancing, she said.

The real struggles for the asset class began last November as the omicron wave gathered speed and the Fed pivoted sharply to a hawkish stance, Roach stated. In the three months since, U.S. small caps have declined by roughly 16%, she noted. However, small cap stocks did outperform their large cap counterparts in the U.S. during the week of 7 February, Roach observed.

So, could this mean brighter days may lie ahead for the asset class? "It's certainly too early to call a change in the tides," Roach remarked, "but this performance does suggest that perhaps the scariest parts of the omicron wave and the Fed's hawkish pivot have been digested by the market."

She said that in general, the performance of small cap stocks is positively correlated with above-trend growth, a pivot in consumer spending from goods to services and a resumption of capital-expenditure spending by companies. "At Russell Investments, we expect all three of these themes to continue through the remainder of 2022," Roach noted.

In addition, U.S. small cap stocks continue to trade at a 20% to 30% discount relative to their large cap counterparts, she said, while being more levered to economic and earnings growth. "Ultimately, I believe the combination of these factors could provide some footing for a turnaround in small caps after this year's rocky start," she concluded.

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Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.