Economy

Inflation was a big problem last year and inflation-fighting policies had a big, negative effect on stock and bond prices in 2022. Inflation will continue to be a front-and-center Issue for investors this year. 

Course Correction Needed was the title of the second section of my September newsletter. In that section, I wrote: “Until market participants sense a course correction in the inflation / interest rates / Fed policy dynamic, stocks are likely to struggle”.

I’m pleased to report that a course correction is under way. Inflation gauges are generally improving, longer-term interest rates made a meaningful adjustment, and the Federal Reserve has slowed its pace of short-term interest rate increases.

On February 2, the Fed brought its target for short-term interest rates up to 4.75%, an increase of 0.25 percentage points. This follows a 0.5 percentage point increase in December, and a series of 0.75 percentage point increases last fall and summer.

This indicates we may be approaching the end of the ‘Fed tightening cycle’ that I discussed in my October 2022 newsletter.

Improvements in inflation and a ‘go-slower’ Fed have given a very significant lift to stock and bond prices so far this year. Can this course correction persist in 2023?

The answer is yes, but likely will require the labor market to come off the boil.

The jobs market was hot in 2022. There were 4.5 million new jobs created last year, and millions of job openings remained unfilled.

This supply / demand gap in the labor market was a key factor that drove wages higher, which in turn contributed to inflation.

The hot labor market persisted in January. US employers added 517,000 jobs and the unemployment rate declined to 3.4% – the lowest since 1969. This is good for workers and good for economic growth. But for inflation? Not so much.

We should recognize the improvement in the financial markets in the early weeks of 2023 as a benefit for portfolios.

But we should also realize that the process of course correction is more likely to look like a winding mountain path, with sections of rocky trail and switchbacks, than a straight, paved road back to satisfactory investment results. 

RK

Inflation remains a front and center issue for many of us as we start the new year, including consumers, business owners, policy makers and investors. Inflation refers to a broad rise in the prices of goods and services across the economy over time.

For this first letter of 2023, I thought it would be helpful to dig into the inflation issue a bit deeper, and then share some recent good news on the subject.

Price stability is considered a hallmark of a healthy economy. Economists generally consider annual inflation in the range of two percentage points to be a desired inflation target.

There are positive effects of moderate, contained inflation. For instance, it can stimulate spending and spur demand and productivity. But inflation running significantly above target is considered a problem.

The main issue with too-high inflation – a feature of today’s economic environment – is that it is erosive. Inflation erodes the value of income, savings, and investments. It erodes purchasing power for consumers and businesses. In other words, elevated inflation means your dollar will not go as far tomorrow as it does today.

Statistical agencies measure inflation by first determining the current value of a ‘basket’ of various goods and services consumed by households, referred to as a price index, which can be tracked over time to give observers a sense of the path inflation is travelling.

Here’s a picture of how inflation has changed during the past 40 years, as measured by the Consumer Price Index, or CPI, which is calculated by the US Labor Department.

The grey line, labeled ‘Overall’ includes food and energy prices. Since food and energy are considered the most volatile items in the basket, they are excluded from the blue ‘Core’ measure.

Any way you slice it, inflation today is too high for comfort. The most recent CPI reading published in mid-December shows that consumer prices rose 7.1% in November from a year earlier. This is obviously quite far from the 2% target.

The good news is that inflation gauges are now headed in the right direction, and down meaningfully from the high point reached in June 2022 of 9.1%. I expect price indices to show further improvement in the early months of 2023.

Developments in the commodities markets are supportive of this expectation. The recent period of unseasonably warm weather in the northern hemisphere has had a dampening effect on oil and gas prices.

Also, China’s reopening is easing supply chains, which is likely to positively impact goods prices.

And last Friday, January 6th, the US Labor Department provided information that indicates wage growth, a key ingredient in demand for goods and services, seems to be slowing down, too. Wage growth eased to 4.6% from a near 6% annual growth rate at the beginning of 2022.

While a few months of data don’t seal the deal, inflation trends are encouraging.

If inflation continues to moderate, it will give the Federal Reserve, the country’s chief inflation fighter, some room to ease off the pace of interest rate hikes. This, in turn, would mean less pressure on the financial markets, and a backdrop more conducive to stock and bond price gains.

Case in point: following the release of the Labor Department data on Friday, stocks jumped by more than 2% and registered their best day since late November. The bond market got a lift, too, rising by 1% on Friday.

An improving inflation picture in 2023 will go a long way in helping to relieve anxiety associated with the financial markets that has carried over from 2022.

RK