The Road to Lower Inflation Takes a Detour

The rate of inflation is accelerating. That’s not how we hoped to start this week’s Insights.

Take a moment and review Figure 1. The 4-month moving average has broken out of its long-term downward trend (red-dashed lines). On a monthly basis, prices bottomed in June and began to gradually turn higher. The upward trajectory picked up in January.

But, what about the so-called calendar effect? Wasn’t the bump in January and February tied to the new year? Well, apparently not.

The Consumer Price Index rose 0.4% in March. It’s up 3.5% versus one year ago. In February, it was up 3.2%.

The core rate, which excludes food and energy, rose 0.4%. It’s up 3.8% year-over-year, the same as February—see Figure 2.

Inflation has slowed dramatically on an annual basis. That is important to acknowledge. But price hikes remain elevated. Using the year-over-year rates as our yardstick, progress toward price stability (defined by the Federal Reserve as 2% annually) has stalled.

Let’s review another metric. The 3-month annualized rate can be noisier and more volatile, but it can detect new trends faster than the year-over-year rate. Like the monthly core CPI, it has also turned higher, bottoming out at 2.64% in August and rising to 4.53% in March. It has risen in six of the last seven months.

What’s happening? U.S. BLS data highlight that the price of consumer goods, excluding food and energy, are declining—yes, that’s right, declining. Goods are in a slight deflationary trend (Figure 4). But services are much higher and are showing signs of accelerating.

At best, the road to lower inflation isn’t hitting bumps; it’s taken an unexpected detour. At worst, inflation is moving higher, and we’re repeating the mistakes of the 1960s and 1970s. Or will inflation get stuck in the current range, denying the Fed the ability to start cutting rates?

Following the runup in stocks, some volatility shouldn’t be discounted. The latest CPI report is forcing a shift in sentiment on rate cuts, which is creating short-term volatility.

No Matter How You Slice It and Dice it…

The latest employment numbers from the U.S. Bureau of Labor Statistics (BLS) point to a robust job market.

On Friday, the U.S. BLS reported that nonfarm payrolls rose 303,000 in March, well ahead of expectations. It’s not simply March; growth has been above 250,000 for four months running. Meanwhile, the unemployment rate fell to 3.8% in March from 3.9% in February.

So far, Fed rate hikes in 2022 and 2023 appear to have done little to dampen economic activity.

Despite numerous headlines of tech sector layoffs, not many laid-off workers are filing for unemployment benefits.

Though the population is much larger today, claims are hovering near a level not seen since the early 1970s.

What does this tell us? Most firms want to retain workers. If sales flounder, employers lay off staff, and first-time claims for benefits rise. That’s not happening today.

And it’s not simply upbeat job growth or low layoffs, job openings remain elevated, too, and have stabilized at an elevated level over the last eight months.

At last month’s press conference, Fed Chief Jay Powell said strong job growth wouldn’t discourage the Fed from cutting rates. Progress on inflation, or lack thereof, will better inform the timing of the Fed’s next move.

In a declining economy, job openings shrink as layoffs surge. Yet, we’re mindful that not all who seek a job quickly find a position. Overall, however, the labor market is solid.

Inflation Makes a Play, Investors Ignore

There was a brief pause as the new year began, but for all practical purposes, markets put on quite a show in the first quarter of 2024, with the Dow, the Nasdaq Composite, and the S&P 500 Index setting multiple records.

During the quarter, the broad-based S&P 500 Index notched 22 closing highs, and the Dow recorded 17, according to Dow Jones Newswires. The Nasdaq posted four new highs.

A recent story re-printed in Morningstar on March 25^th summed it up nicely.

“A record stock-market rally has caught many of Wall Street’s top strategists flat-footed. Now, they’re racing to catch up, updating their year-end S&P 500 targets…At least six Wall Street banks have lifted their S&P 500 targets over the past two months.”

We won’t offer an opinion on the market over the next few months. There are too many unknowns. While top market strategists are bright individuals and provide keen insights, they have tripped on their forecasts before.

Catalysts

As the year began, a key gauge from the CME Group suggested the Federal Reserve was gearing up to cut interest the fed funds rate by 1.50 – 1.75 percentage points this year, likely in a series of six or seven 25 basis-point (bp, 1 bp =0.01%) rate reductions.

Pushback from Fed officials, who are projecting three 25 bp rate cuts this year, and unexpectedly sticky inflation early in the year have forced investors to reduce rate-cut expectations by half. Notably, longer-term Treasury yields have edged up since early January.

But that hasn’t blunted the market’s advance.

That leads to an important catalyst. There are few signs that a profit-killing recession is on the horizon. Investors seem more smitten by rising earnings and steady economic growth right now.

Moreover, the enthusiasm for AI has yet to abate.

Still, reassurances from the Fed that recent sticky inflation had not yet changed its plan for three interest rate cuts this year have aided sentiment (Figure 1).

Notably, volatility has been minimal.

No matter how small, Figure 2 measures the pullback (drawdown) from each peak-to-trough in the S&P 500 since its bear market low in October 2022.

Since the S&P’s 10% correction in the second half of 2023, market volatility has been unusually low, as illustrated in Figure 2. The S&P 500 has gained 27.6% since that 10/27/2023 low.

It’s up 46.9% since the bear market bottomed in October 2022 (both returns exclude dividends reinvested; both through 3/28/2024).

A decline of at least 10% in any given year isn’t unusual. Since 1980, the average annual maximum drawdown for the S&P 500 Index has been 14%, according to S&P DJ Indices and LPL Research.

Maximum-annual drawdowns (peak-to-trough) have ranged from 2.5% in 1995 to 48% in 2008. In 21 instances since 1980, the pullback has been less than 10%.

Euphoria leads to complacency?

Robust market performance can lead to excessive risk-taking and complacency. The economic fundamentals are strong, and the Fed seems intent on reducing interest rates this year. Both have historically been favorable for stocks.

What could go wrong?

Market corrections rarely occur in a vacuum. Stocks don’t go on sale “just because.” Yet, long-term disciplined investors won’t discount the possibility of a decline.

What might create market volatility? Unexpectedly bad economic news could jar markets.

Fed officials believe the recent uptick in inflation is temporary and can be tied to the calendar, i.e., price hikes near the beginning of the year.

However, what if the recent sticky inflation numbers prove to be more than a temporary setback? Well, the Fed could delay rate cuts.

We are also mindful that an unwanted surprise could encourage short-term traders to take profits. A year ago, Silicon Valley Bank unexpectedly failed, temporarily forcing stocks lower.

When stocks appear priced for perfection, any disappointment can encourage some selling.

With all that said, as we enter the second quarter, economic conditions that created a fertile ground for bullish sentiment remain in place.

Investors who have maintained a well-diversified portfolio and adhered to a disciplined approach have participated in the market’s advance over the past year.