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Appreciate the Appreciation!

Appreciate the Appreciation!


While we may experience occasional months of distortion on our disinflationary path towards the Fed’s 2% goal as we did in January, remain confident. The economic climate has changed, and companies can no longer stick price hikes to consumers without a fight. Supply chains have eased, shortages have abated, and inflation expectations have normalized. With core PCE inflation at 2.8% and inflation expectations low, it becomes harder to justify a 5.5% Fed Funds rate. Meanwhile, the economy keeps rolling and the rally keeps rallying. We cannot maintain this pace without the usual interruptions and sentiment has become complacent, but the backdrop of higher earnings, lower inflation, and a more accommodative Fed is constructive overall and worthy of… appreciation!

Inflation re-acceleration poses the most significant risk to our optimistic outlook for 2024. This places market moving weight on each CPI, PCE and PPI inflation release. This week, we received the January read on core PCE inflation, which is the Fed’s preferred inflation measure and the one they ascribe their 2% target to. The number came in high, as January numbers tend to do, but as expected, and still directionally lower:

Chart showing Personal Consumption Excluding Food & Energy

Markets took the measure in stride as rates remained subdued and stock prices rose further into record territory. Some commentators suggested that the hotter January monthly data indicated a break in trend and a risk to further stock market gains. We don’t think so.

Remember that inflation involves price negotiations between buyers and sellers. I specifically remember a post-COVID conversation I had with a close friend in a very large company. Global supply chains collapsed, economic shutdowns created systematic shortages and stimulus money flooded consumers with cash. My advice to him: “RAISE YOUR PRICES A LOT! You will never have another opportunity like this! A massive increase in demand paired with a massive decrease in supply gives you generational cover to increase your prices. Once things calm down you may have to lower them to protect market share, but your base prices will be much higher by that point.”

I was certainly not alone in providing this advice and they did raise prices a lot, because they could, and people expected it. That situation no longer exists:

Char showing 5-Year Breakeven Inflation Rate

This chart chronicles the 5-year breakeven inflation rate within markets. At 2.4%, we sit right at the pre-GFC crisis level and only slightly above the pre-COVID level. Markets largely believe inflation has passed. 

Chart showing Inflation Expectation - University of Michigan

This chart chronicles the Michigan Inflation Expectations index which recounts consumer inflation expectations over the upcoming year. At 3%, we sit right at the long-term average, down significantly from the post-COVID surge. Consumers largely believe inflation has passed.

The reason I share this perspective is that, while the Fed monitors the numbers and the markets react to every release, price takers no longer see inflation as a major concern and, as such, will not willingly accept price hikes.

Within the economy, pricing power has rebalanced from the sellers to the buyers. Marketplace psychology will help further guide inflation toward the Fed’s 2% target, absent some exogenous event that allows companies to capitalize on confusion.

The February inflation release falls on March 12th. This number could be hotter as well, considering seasonality distorts early-month readings as new-year price schedules post. Markets may react, but interest rates side with us as seen in the movement of the 10-Year Treasury yield, despite the potential January/February jump:

Chart showing 10-Year U.S. Treasury Yield

Lastly, if disinflation maintains course, rates remain subdued, earnings keep climbing, and the Fed continues signaling rate cuts, this rally should broaden well beyond the Magnificent 7. And so, it has:

Chart with Asset Class Total Returns

Note that, for the month of February, small cap stocks (Russell 2000) outperformed large cap stocks (S&P 500), industrials outperformed technology, and China outperformed the U.S. At this pace, markets would rise 50% this year. Unlikely. It may be time for a breather, but as long as the inflationary trend maintains course… this rally should also.

Have a great week!

Sources: FRED, Marketwatch, Bespoke

David S. Waddell

David S. Waddell

CEO, Chief Investment Strategist