Rising inflation and the increase in interest rates that followed were major causes of the 2022 bear market. The subsequent market recovery has several contributing factors including a recession that never happened and resilient corporate profits. However, moderating inflation and the likelihood of an end to this Fed tightening cycle were hugely important to the rally since the October 12th, 2022, S&P 500 bottom.
Realized and expected inflation have dropped dramatically since the middle of last year. Year-over-year inflation peaked at a little over nine percent in June of 2022 and now stands at around 3.7% according to the Bureau of Labor Statistics. This is still above the post-GFC trend, but the level has clearly moderated. Actual inflation is likely lower because the BLS rent numbers historically lag housing costs. The CPI Owners’ Equivalent Rent Index year-over-year reading was 7.3% in August which is significantly higher than real-time private indicators. Current rent increases are probably less than government reports although they were likely more than reported for 2021 and part of 2022.
Another crucial point is that inflation expectations are falling based on multiple sources. Consumers, small businesses, and various surveys show that consumers and businesses alike expect the inflation rate to come down. Most indicators are still above pre-COVID levels, but they are trending down and approaching post-GFC levels.
NPP wants to be clear that when we discuss inflation we are talking about rates of change and not price levels. Price levels in aggregate are still significantly above where they were before this bout of inflation started. Moreover, the impact of higher inflation has varied for income levels. Lower-income households have been more affected by rising food, energy and shelter costs than have upper-income households. Recent wage gains have finally allowed consumers to start catching up to the past few years’ cost-of-living increases. Real wages are not back to pre-COVID levels, but they are getting closer. Rising real wages should help consumers who have been struggling the past two years.
From a corporate perspective, inflation has helped certain companies while hurting others. Large companies with strong balance sheets were able to issue long-term bonds at low coupons. The cash on their balance sheets is earning materially more than it was before rates rose and frequently more than their fixed-rate debt is costing them. Additionally, price increases have contributed to a nominal profit boom. On the other hand, overleveraged companies will have to worry when their bonds come due. The higher interest expense will have a material effect on their profitability.
Despite declining inflation, long-term rates have been edging up. This may seem counterintuitive, but it is not irrational. As inflation has fallen, so has investors’ probability of a recession. Instead, strong job creation and good economic growth have pointed toward rosier future expectations of GDP. In other words, interest rates have edged up because future growth expectations have risen as the economy remains solid despite the Federal Reserve’s tight monetary policy.
We think the easy part of disinflation has occurred. However, it is not obvious what the new trend is. NPP does not expect the inflation levels of the 1970s to return. However, we do not think it will get back to the sub-two percent level that occurred after the GFC until COVID. Instead, we expect price increases to be modestly above what occurred in the recent past. A modest pickup in inflation is not a terrible setup for bonds. Despite the higher inflation rates, bond investors are getting paid more than inflation and should take advantage of current yields. Stock investors should do okay too, although investors will need to be a bit selective and avoid companies with significant short-term, fixed-rate debt. If the new intermediate inflation trend settles in around three percent or less without a severe recession, the prospective investing environment seems favorable. Bond investors would do better than they have the past fifteen years. Stock investors could expect solid, if not double-digit returns. In sum, investors may learn to like the new backdrop if inflation stays contained.