The stated target inflation rate of the Federal Reserve is a 2% year-over-year inflation level as measured by core CPI (consumer price index, excluding food and energy prices), though it should be noted that 3% is seen as a the top end of an acceptable range. In determining whether the inflation villain is vanquished, and the Fed can cease tightening monetary policy (tighter policy is typically a negative for stock prices eventually), it is helpful to review the data. As can be seen in the below chart, great progress has been made in tamping down headline inflation (which includes food and energy) from almost double-digit levels in 2022 to ~4% in the most recent reports.
Market Outlook: The Fake Death of Inflation?
Everyone has seen the movie where the villain, believed by the protagonists to have been finally defeated, suddenly rises again to great audience shock. A method classically utilized in many slasher horror films, just when the “good guys” think they are safe, is the exact moment when the monster reappears to knock off yet another beloved main character. In show business, this is known as the "Fake Death" scene; a storytelling technique used to add suspense and surprise to a narrative.
For investors, high inflation levels have been the villain of the market story for over a year now. While there appears to be some evidence that the inflation fiend is vanquished, or at least trending towards defeat; is it really? Or, will there be just enough improvement to convince intrepid investors to lower their guard only for the inflation monster to rise and claim yet more victims?
Although the focus is on inflation as a key data point, the primary action that has impacted the market is the response from the Federal Reserve in terms of rate hikes. These rate hikes have been implemented to counteract levels of inflation that reached their highest point in 40 years. As of late July, the target rate (5.25 – 5.50%) is set at a level that hasn’t been seen since 2001. This interest rate benchmark sets the reference level for all types of debt like home mortgages, business loans, consumer credit, auto loans, etc.
While the progress shown above is undeniably good, it must be pointed out that a significant source of that improvement is due to declining energy prices (grey bars). Energy markets have been largely influenced by the artificial impact of regular releases of millions of barrels from the U.S. federal government’s strategic petroleum reserve (SPR). As the SPR has already dropped below half its previous peak level, there are obvious questions regarding how long the government will continue these energy price suppressing releases, considering the need to maintain some supply for other possible future calamities, and if/when the SPR will become a net buyer again. That last idea represents the point where SPR activity becomes an upwards force on energy prices versus its current use to push them lower.
To demonstrate the impact of SPR releases, consider that energy prices have dropped sharply since the middle of last year despite global oil consumption being at record highs. The market demand for crude oil, despite all the green energy efforts, is still high and rising. This means that when SPR oil releases stop, or are forced to stop, this currently disinflationary data point could quickly become inflationary once again.
While still negative on year-over-year comparison, there is emergent evidence of a turn towards higher gasoline prices (see chart below), which supports the idea that the inflation villain may return to strike again. As energy price movements tend to flow through into every type of product (because of the transportation of goods, the need to power data centers, etc.), this is something to keep an eye on.
If we look to core inflation, which excludes food and energy prices and is said to be the Fed’s preferred inflation measure, not nearly as much progress has been made on these stickier price categories. While there is an obvious downtrend in this data, which may make it possible to cease hiking rates further, the still high level likely prevents rate cuts from being a real option in the near future. If interest rates remain at a 20-year high for an extended period of time, then many parts of the economy may be forced to redesign business models tailored to function in the low-rate environment of the last decade.
One of the main components of core CPI is rent and owners' equivalent rent (OER, the light blue section of the above chart), which is basically the cost of housing. One of the economic surprises this year has been the resilience of the housing market and home values, considering that mortgage rates have more than doubled off the 2021 lows. While there was some weakness early in 2023, home values have seen resurgence in recent months and that is not going to help inflation readings.
It is not all bad news that supports the idea of resurgent inflation. A true brightspot can be found in producer price index data (inflation for manufacturers) that is showing strong disinflationary pressures for goods prices (furniture, appliances, etc.). While goods prices alone cannot bring down inflation, it is a hopeful data point.
There is strong evidence that policymakers and investors shouldn’t become too complacent as high inflation’s death has yet to be confirmed. If it does once again head higher, that will put pressure on policymakers at the Fed to begin raising rates yet again, which would likely have a negative impact on most investable assets depending on how high the end rate ends up being and how fast it gets there.
Is Inflation Truly Dead?
If the inflation monster is truly defeated, as the current trend is suggesting it might be, then the most recent rate hike in July may be the last of this cycle and it may be useful to consider how investment markets behave in similar environments. Looking at stock market history, as shown below, the S&P 500 has had a wide range of outcomes (+/- 30%) post the final hike with the average outcome being roughly flat 248 days later (which is roughly the number of trading days in a year). So, the presumed pausing event likely isn’t that meaningful for explaining potential future stock valuations.
Bonds on the other hand, as represented by the 10-year treasury, tend to have very strong performance after a pause. While the past is no guarantee of the future, owning bonds at or just before the Fed pauses has been quite fruitful for investors with decent mid-teens returns. This is a combination of both higher bond income, thanks to the higher interest rates paid, but also typical principal appreciation as a Fed pause suggests much less downside risk potential. Historically, bonds gain value as rates drop and lose value as they rise.
Another aspect of a pause to consider is that it is more often followed by rate cutting activity than a return to a hiking regime. Bond values tend to gain during periods of Fed rate cuts. After a pause occurs, the average time to cut is 10.5 months, with a range of 6 – 18 months. This would likely reflect a better environment for bonds than stocks as cutting activity most typically happens amidst recessionary economic environments as the Fed tries to lower borrowing costs to stimulate economic activity. Recessions tend to be bad for company profits and stock market valuations, but the lower rates tend to be a bond market positive.
The takeaway from the above should be that inflation is not a confirmed kill at this point. It is possible that it will revert higher in the coming months, and there is evidence suggesting rising odds of a resurgence. This occurrence would likely be negative for investment markets generally as it would undoubtedly stoke further Fed hiking activity. For bonds this risk is more muted as incremental hikes at this point are less meaningful than they were when rates were near zero in 2022. For stocks, higher rates could really start to bite, especially for companies that are reliant on cheap financing in their capital business models.
CWM has a menu of different investment strategies, all utilizing data as the foundation of making different stylistic investment decisions, your CWM team has provided some commentary on each below.
Risk Adjusted Models (RAM)
The primary goal of RAM is to, first, manage risk and then seek opportunity. These strategies are primarily geared towards clients with a regular distribution need or an inability to easily replace lost value during a market downturn. These strategies have been strongly risk-off throughout the 2022 market decline and continue to be so in 2023. The CWM team continues to seek primarily portfolio income opportunities as the current data environment continues to be a fragile one historically. Fragile market environments are those where sharp and swift declines are possible based on a history of similar conditions. Because of the remaining risk of inflation, steps have recently been taken to add market neutral positioning that will be agnostic to the gyrations of the stock market or the whims of the Federal Reserve Committee.
Tactical Allocation Models (TAM)
TAM strategies have risk management as a goal, but that is constrained by a client’s risk model selection. These models are primarily intended for client accounts that are still receiving regular contributions but are large enough to warrant risk management to protect principal. These strategies will allocate to stocks and income assets (like bonds) based on a client’s risk tolerance while data models will be utilized to construct suballocations within those macro categories. Said more plainly, the CWM team will seek to fulfill a client’s stock/income allocation selection as fully as possible, utilizing aggressive or defensive positioning within those categories to manage risk. The current stock portfolio in these models is mainly comprised of precious metals, large cap technology stocks, and international stocks along with some smaller positions. The income model remains invested in defensive income positions like government treasuries, corporate bonds, and some market neutral exposure.
Wealth Accumulation Models (WAM)
WAM strategies are CWM’s passive investing option for clients that either desire that style of asset management, accounts that are receiving meaningful new contributions, or accounts that are a relatively small portion of a client’s overall investment portfolio. These allocations are made up of a diversified set of assets and are designed to provide a positive rate of return as markets rise with some diversification into asset classes that have historically held their value or increased in value during market declines. Clients with WAM accounts need only continue to follow investment disciplines regardless of market activity, which can be easier said than done during market turmoil.
A key component of investment discipline is the responsibility of investors to continue to make portfolio contributions in line with their financial plans (assuming they are able). New contributions are particularly important in scary market environments, where often the best future return (buy low) opportunities exist.
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P.S. The world is full of news stories and datapoints worth analyzing, acting upon, or ignoring. Sometimes it’s important to take a step back and look at what’s truly important in your life and then make sure you are taking the time to enjoy the ride while it lasts…
Past performance does not guarantee future results. The return and principal value of investments will fluctuate as market conditions change. When sold, investments may be worth more or less than their original cost. No investment strategy can guarantee profit or protect against loss.
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