The Inflation Problem is Easing, and the Fed’s Likely Going to Cut Rates
- The Federal Reserve recognized strong progress on inflation at its most recent policy meeting.
- Yields plummeted and equities rallied following the Fed’s announcement.
- Rate-cut expectations have risen substantially, including by the Fed.
- Over the next five years, we continue to favor U.S. equities, potentially supported by a virtuous productivity cycle.
Wednesday, Dec. 13, was important for two reasons:
- The Federal Reserve acknowledged that inflation is easing faster than expected, and Fed members will likely start cutting rates in the first half of 2024.
- The November producer price index (PPI) indicated that core inflation is back at the Fed’s target level.
Let’s start with the Fed meeting.
A Data-Dependent Fed Bows to the Data
Fed members kept policy interest rates unchanged in the 5.25-5.0% range, but the big story was they officially acknowledged that inflation is easing. In their updated “Summary of Economic Projections,” they revised their estimates of core inflation for 2023 down from 3.7% to 3.2%. The 2024 estimate was revised from 2.6% to 2.4%.
In light of softer-than-expected inflation, Fed members made two dovish moves:
- They removed the extra rate hike for 2023 originally penciled in. In other words, they don’t think rates are going any higher.
- They moved the 2024 rate estimate from 5.1% to 4.6%. The current rate is 5.4%, so the updated estimate implies the Fed will cut rates by around 0.8% (about three 0.25% cuts) in 2023.
Markets were off to the races after the Fed released its statement and economic projections. Bond yields fell, and equity markets rallied. Notably, Fed Chair Jerome Powell did not rain on the parade in his press conference. Instead, he reiterated the dovish outlook, noting progress on inflation, including in the categories the Fed focuses on. He once again emphasized that the risk of not doing enough to curb inflation was now balanced with the risk of holding rates too high for too long (and potentially breaking the economy in the process).
Inflation is Back at the Fed’s Target
Producer price index (PPI) data for November came in softer than expected, especially core PPI, which excludes the volatile food and energy components. The Fed’s preferred inflation metric is the personal consumption expenditures price index (PCE) and that takes several inputs from the PPI data, including for categories such as health insurance and airfares.
Core PCE typically runs lower than its counterpart, the core consumer price index (CPI). That’s even more true now because 40% of core CPI is comprised of rents, versus 17% in core PCE, and the official rental data is currently running at an annual inflation rate of 6%. This is outdated information as private market indices such as Apartment List show rents falling compared to last year.
The good news is the November CPI and PPI data indicate that core PCE was flat month over month in November. That means core inflation, using the Fed’s preferred metric, has run at an annual rate of 2.1% over the last three months and 2% over the last six months.
In other words, the inflation problem is over, at least for now. Even looking ahead, it’s likely that used car prices continue to fall and lagged data for rents catch up to reality, keeping downward pressure on core inflation.
The takeaway? The Fed is likely to cut interest rates, as its own projections suggest. And the first cut could come sooner rather than later.
A Big Day for Markets, and a Potentially Big Boost for the Economy
Unsurprisingly, markets responded well to Wednesday’s news, including the prospect of a rate cut as early as March, which investors estimate with a probability of almost 80%. Treasury yields headed even lower after Powell’s comments. The one-year Treasury yield fell 0.22% to 4.91%, and the two-year Treasury yield fell 0.3% to 4.43%. The recalibration was due to markets estimating about 1.16% worth of cuts in 2024, which is more than Fed officials’ estimate of 0.80%.
Equities rallied on the back of lower interest rates, with the S&P 500 Index rising 1.4% on Wednesday, leaving it less than 2% off its all-time high. Rate-sensitive sectors, such as utilities and real estate, outperformed. Even small-cap stocks, which have been weighed down by higher rates, saw huge gains, with the Russell 2000 Index rising 3.5%.
Lower interest rates can have significant positive effects on the economy, including on mortgage rates. Thirty-year mortgage rates are now estimated to be close to 6.8%, down from around 8% in mid-October.
Lower mortgage rates could unlock activity in the housing market, especially for existing home sales, where activity has ground to a near halt. Additional sales of homes can lead to more consumer spending, including for household appliances, furnishings, and other household goods. Lower rates could also boost auto sales, as loans for used and new vehicles become more affordable. Those are just a couple examples of direct, near-term boosts for the economy. In the medium term, a better outlook for inflation and interest rates could also result in a pickup in business investment.
In summary, the inflation tide has subsided quite decisively, which means a Fed pivot to interest-rate cuts is on the horizon, and that would be a very positive development for markets and the economy.
U.S. Stocks Likely the Best Investment Over the Next 5 Years
It was an important week for tactical market positioning, and several events have impacted our strategic outlook. At Carson Investment Research, we have moved our longer-term strategic asset allocations to their maximum equity overweight while continuing to favor U.S. equities. Stocks may gain 75-100% cumulatively over the next five years, which is 12-15% annualized. Here’s why.
The average return over rolling five-year periods from 1923 through 2017 is about 11% (before inflation). However, in 49 out of the 96 five-year periods (51%), returns were higher than 12% annualized, i.e., greater than 75% overall through the power of compounding. In fact, returns were under 8% in only 31 periods (32%).
However, while the past is a reasonable guide for the future, we believe a few things tilt the odds further toward above-average returns.
The 2020s – America Rising
It may sound odd to suggest the 2020s will likely be the American decade, especially from the perspective of the stock market. U.S. stocks vastly outperformed international over the prior decade, and as this chart from J.P. Morgan illustrates, periods of outperformance tend to revert. But we’re going against the grain here.
Over the last year and a half, the U.S. economy has defied multiple forecasts of a recession and overcome an aggressive Federal Reserve tightening cycle amid the highest inflation in 40-plus years. Strong household balance sheets and solid income growth have led to a resilient economy.
The economy appears poised to grow around 2.5-3% in 2023 after adjusting for inflation, which would be above the 2010-2019 trend. That is remarkable, especially given the massive headwind of surging interest rates. No wonder the consensus has shifted away from recession calls, although several outlooks from across the industry still suggest poor growth in 2024. The U.S. has now raced ahead of other developed markets in economic growth since the pandemic. The U.S. economy is 7% larger in real terms, versus 3% or less for its developed peers.
At Carson, we continue to believe the economy will avoid a recession. But we take a different view on the drivers of economic growth, emphasizing the upside of productivity growth. That view makes us optimistic on the expansion continuing in 2024 and even beyond. There’s been a lot of buzz around generative artificial intelligence (AI) this year. Our view is the watershed moment for this technology is not about what it can do for us now, but rather the environment that allows generative AI and other transformative innovations to flourish. Creating a supportive environment for technology such as AI involves a reshoring shift to the U.S., which is boosting domestic investment. That is why we believe America will outperform its developed market peers.
Productivity growth can’t be created on demand, but environments can foster it. For example, by incentivizing investment, encouraging competition, and protecting property rights, the U.S. has created an environment that has given us generative AI, which can then seed additional productivity growth in the future.
2023 was the year of normalization. All the investment over the last couple of years, including labor, which is businesses’ largest investment, is bearing fruit and productivity is accelerating. Over the last two quarters, productivity growth rose at an annual pace of over 4.4% — the fastest two-quarter pace since the late 1990s outside of recessions and immediate post-recession periods.
In a previous blog, Sonu discussed why this is significant for the economy, inflation, and monetary policy. In sum, higher productivity can lead to strong wage growth with relatively low inflation. This can create a positive feedback loop between monetary policy and productivity. Strong productivity growth accompanied by low inflation could lead to more expansionary monetary policy. That could lead to greater investment and a tighter labor market with low unemployment and faster wage growth. This could in turn fuel further productivity growth and signal to the central bank that it can keep rates low.
That is essentially what happened in 1995. Former Fed Chair Alan Greenspan chose to reduce interest rates despite strong wage growth. He bet that productivity would increase due to technological breakthroughs and prior breakthroughs gaining traction, and he was right. Part of his success was due to expansionary policy leading to tight labor markets that boosted productivity further.
We could be in a similar situation now, with tight labor markets leading to productivity gains rather than inflation. Increased business investment could also push profits higher, boosting equity market returns above the historical average.
What’s the Risk?
By no means do we want to suggest that stocks will go up in a straight line. We’ll continue to see volatility, with pullbacks and corrections along the way. As Ryan likes to say, volatility is the toll we pay to invest. Expect to see pullbacks, corrections, severe corrections, and perhaps even a bear market in which stocks fall 20%.
But here’s some perspective: From Dec. 31, 2018, through Dec. 12, 2023 (just shy of five years), the S&P 500 has gained 102%. That period includes two bear markets, in 2020 and again in 2022. Yes, you’re reading that right — stocks have doubled over the last five years, amidst a worldwide pandemic, high inflation, an aggressive Fed, and surging interest rates.
One big risk that could upend our views is if the Fed keeps rates too tight for too long, which would lead to falling investment, more unemployment, slower wage growth, and ultimately weaker productivity growth.
That is why we seek to control risk in our portfolios. As recently stated, we also extended the maturity profile of our fixed-income holdings. While we are overweight stocks versus bonds, we think core bonds will increasingly return to their traditional role as a portfolio diversifier. At the same time, we’ve also chosen to diversify our diversifiers, with some allocation to managed futures, which is a hedge against inflation volatility.
The good news is the Powell-led Fed now views the risk of not doing enough to fight inflation as balanced against the risk of doing too much and potentially breaking the labor market. That’s a big deal, since it means policy could ease if inflation heads down in a sustainable way, which it could if productivity runs strong.
This newsletter was written and produced by CWM, LLC. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The views stated in this letter are not necessarily the opinion of any other named entity and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.
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