Wise Investors Should Pay Close Attention to Falling Inflation
What happened last week?
- The S&P 500 rose 2.24%%
- The Dow Jones gained 1.94%
- The Nasdaq advanced 2.37%
This week, investors will focus on November’s University of Michigan’s Consumer Sentiment survey, where attitudes about the future and current conditions may have bottomed. October Existing Home sales should point to signs of stabilization near the post 2010 lows.
3 Things to Know
Inflation’s Fall Is Good News
Inflation is a symptom of a sick world economy, one suffering from too much money chasing too few goods and services. That was true of the pandemic period, but it is ending. Inflation’s drop from an 8.7% pace globally in 2022 is just one sign of the world economy healing.
While supply shocks remain a risk, demand is moderating, and supply is recovering without a severe economic contraction. This is good news.
Ever since the Fed began its campaign of higher rates to control inflation, there has been a raging debate about the nature of that inflation.
Did the large fiscal and monetary responses to Covid create inflation that was self-reinforcing or transitory? And, if “COVID inflation” was embedded, would an upward wage-price spiral force policymakers to engineer a recession to drive up unemployment to push down prices?
We are now beginning to see the answer. The spike in inflation is coming down as fast as any supply-driven spike of the past.
Markets Are Responding Positively
Markets are responding quite positively to reported declines in inflation with the S&P 500 gaining 7.6% in the month to date.
The 10-year treasury yield has fallen 44 basis points over the same period. Investment grade US corporate yields with a 5-year maturity — near our weighted average duration — still yield about 5.85%.
This is nearly double the Fed’s expectation for its policy rate over the same period, making them an effective way to sustain yield and potential for price appreciation when the Fed again swerves.
We believe the Fed will see materially slower job growth during the year ahead. Job gains in 2022–23 exceeded GDP growth by the most since 1974. This is unsustainable and likely to reverse.
As US employment gains fade in the face of restrictive monetary policy and slowing inflation, we also believe the Fed will change course and seek to protect the labor market from an unwanted contraction.
Some call this a “soft landing” scenario, but we do not think in terms of a hard or soft landing. Recessions have already “rolled across” cyclical industries in 2023.
Demand for goods, trade and housing contracted in the past year and will begin 2024 at weak levels.
Discretionary services spending should then slow in 2024, keeping economic growth constrained. And if the Fed acts to protect jobs, as we expect, there is no reason newly lean industries will contract again.
This is why we expect S&P 500 EPS to grow more than 12% over the next two years, and our estimates are purposely conservative.
US Equities Stand to Gain in 2024
Though bonds are strong competition for equities, we added further to our equity allocation with an overweight to the S&P 400 and 600 Growth components on October 18th.
This was the first time our asset allocation to equities went “overweight” from neutral or underweight since June 2020.
If inflation falls while yields moderate even while corporate profits rise, we expect it to lead to substantial gains for US equities in the coming year.
Therefore, if yields decline in the coming year on slower employment growth while corporate profits rise, we will likely raise our equities weighting further.
Equity allocations would broaden globally if lower interest rates also led to declines for the US dollar.
See our weekly CIO Strategy Bulletin for more details