The Market Comes to Terms with “Higher for Longer”

The Fed may have avoided recession for now, but more economic pain may be necessary to bring inflation down to its long-term target.

After rising sharply in the first half of the year, the stock market has stalled in the month since we published our “Summer Investment Outlook” on July 28th. While it is normal for the market to take a bit of a breather during the dog days of summer, this year’s iteration has come with an incremental deterioration in investor sentiment. According to the AAII Investor Sentiment Survey, 49.0% of investors considered themselves bullish for the week ended August 2nd. Three weeks later, that figure had fallen to just 32.3%. Meanwhile, the percentage of surveyed investors considering themselves bearish rose from 21.3% to 35.9% over the same timeframe. Respondents reporting a neutral stance rose from 29.7% to 31.8%.

This shift has been variously attributed to a wide variety of factors, including signs of trouble in several overseas economies (most notably China), mounting headwinds to corporate earnings, banks grappling with fundamental pressures and regulatory scrutiny, labor disputes, increased scrutiny of equity valuations (and their return outlook vis-à-vis Treasuries), and more. However, despite the validity of all these concerns (several of which we may focus on in future articles), it remains clear that inflation – specifically, inflation that is persistently above the Federal Reserve’s 2% long-run target – still sits at the top of the hierarchy of investor worries.

The July CPI report published August 10th showed that the inflation gauge rose 3.2% from a year ago, slightly below expectations but above June’s 3% pace, marking a halt in 12 consecutive months of declines. Meanwhile, Core CPI, which excludes volatile food and energy prices, ran at a 12-month rate of 4.7%, the lowest since October 2021. With these figures well below the CPI’s staggering 9.1% peak in June of last year, it would be easy to conclude that the war on inflation is nearly won. The Fed surely deserves some degree of credit for the progress that has been made thus far without creating a recession, and consensus remains that a “soft landing” can be achieved. However, as we wrote last month, the “last mile” of getting core inflation back below 3% will likely prove the most difficult. The near-term inflation outlook bears this out: the Cleveland Fed currently sees CPI rising to a 3.8% annual rate for August, or a 0.8% monthly uptick, though annualized Core CPI is expected to come down slightly to about 4.5%.

There are a few reasons why disinflation may be stalling or even reversing. In our Summer Outlook, we highlighted the “stickiness” in rent/housing prices, where demand, which was constrained even before the pandemic, continues to outpace supply. Even as mortgage rates north of 7% (now the highest in more than 20 years) hurt demand somewhat, sellers locked in to lower-rate mortgages do not want to move. Indeed, almost all of July’s monthly inflation increase came from shelter costs, which rose 0.4% and were up 7.7% from last year. This represents a structural problem with the housing market that shows no signs of abating anytime soon, and which the Fed can do little about. Used car prices declined in July, but similar dynamics has plagued that input as well. Supply chain issues have abated, but not completely, and retailers continue to exercise their pricing power. Another issue is commodity prices, which haven’t been in the spotlight but have moved higher of late, and are also among the least subject to the Fed’s rate and balance sheet actions. Remember when egg prices went through the roof last year? That oft-cited example of inflation occurred because avian flu decimated supply, something that would have driven prices sharply higher whether the Fed Funds Rate was 5% or 15%.

Beyond the natural stickiness of some CPI inputs and the vagaries of commodity prices lies another, more technical reason why this late-inning phase of inflation reduction will be harder: “base effects”. A brief explanation: because inflation is most often measured on an annualized basis, the “headline” figures for measures like CPI are relative to the rate of inflation in the prior-year period. Put another way, part of why the inflation readings have looked so much better over the past several months is because they looked so bad in the corresponding months last year. Looking ahead, as we start to “anniversary” prior-year months in which inflation cooled, any incremental progress will only get more difficult to see and — for stock market and consumer sentiment alike — to feel. Whether we should measure inflation this way is a topic over which much ink has been spilled, but such conventions are notoriously slow to change once in place.

The good news is that the Ph.D. economists at the Fed know all the above. Unfortunately, that may also be the bad news, as far as the market is concerned. Knowing that above-target inflation should prove persistent, Fed Chair Jerome Powell and friends have been preaching a “higher for longer” mantra when it comes to interest rates for months now. Powell reiterated this in his speech last week in Jackson Hole, adding that the Fed is prepared to raise rates further if persistently above-trend growth puts further progress on inflation at risk. He also reaffirmed the Fed’s commitment to its 2% inflation target, saying that the Fed is committed to monetary policy that is restrictive enough to bring inflation down to that level over time, and that this is expected to require a period of below-trend economic growth as well as some softening in the labor market.  With bond yields returning to levels last seen before the financial crisis, it seems investors may finally be internalizing the Fed’s messaging. In the first two weeks of August, the market repriced the fed funds rate expectation for year-end 2024 nearly 40 basis points higher, according to CME’s FedWatch tool.

Still, it’s worth noting that the market has consistently underestimated the amount and pace of rate hikes throughout this entire hiking cycle. While the current consensus is that the Fed won’t raise rates significantly above where they are now, the prospect of rates remaining at or near their current level for longer than previously anticipated is what has market worried. The endless “bull vs. bear” debate has made a meaningful shift from being about how high rates will peak to how long they will remain elevated, and when and how the corresponding cooling effects on the economy will manifest. In some ways this debate is irrelevant — regardless of whether it raises rates higher or holds them higher for longer than previously anticipated (or both), the fact remains that the Fed has probably not yet inflicted enough economic pain to bring inflation down to its target. We’ll be keeping a close eye on the labor market and the health of the consumer, both of which have proven surprisingly resilient up to this point in this tightening cycle.

Ultimately, little of the above changes the approach we are taking with our clients’ investments. Given that we don’t know when rates will peak, or how long they will remain elevated, we continue to diversify the fixed income portions of portfolios across Treasuries with laddered short-to-intermediate maturities, along with high-quality corporate and municipal bonds. In terms of equities, should the market resume its rally, we remain well-positioned to take advantage of any increase in market breadth as sectors that have lagged this year catch up to mega-cap tech and artificial intelligence names. Should we enter a downturn, we’d expect our focus on high quality companies should allow portfolios to weather the storm.

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