Inflation Falling

Inflation Falling

A year that began with losses ended the same way. After a strong November, December erased the prior month’s gains and sent stocks back to the cusp of a bear market. Economic data, which proved robust for most of 2022, showed some signs of softening. Analysts now predict the S&P 500 companies will see their fourth quarter earnings decline 3%. While a 3% decline is very modest, it’s the first decline we have seen in more than a year. To boot, a recent survey of U.S. manufacturing firms showed the manufacturing sector just entered a slightly contractionary phase perhaps because consumers are spending less. And a recent Bloomberg survey of economists showed 70% of respondents believed the economy would mildly contract in 2023 (although economists are historically bad at making predictions).

Now some good news. While the U.S. bond market declined modestly in December, it is still up almost 5% from its mid-October low point. Current yields have settled in the 3.8% to 4.7% range. International stocks have started awarding diversified investors. While international stocks declined 1% in December, they outperformed the U.S. market by about 4% for month. Both developed and emerging international stocks have outperformed the U.S. market by 10% over the past two months. Despite some negative economic data, the labor market continues to be strong. Unemployment still sits below 4% and weekly jobless claims are on par with the low levels of 2019. The most encouraging good news by far, however, came from the Bureau of Labor Statistics.

December showed that inflation data has declined from its high of 9.1% year-over-year (YoY) to the latest reading of 7.1% YoY. Moreover, this decline in inflation appears sustainable. If we annualize the last three month-over-month inflation numbers, we find the pace of recent price increases has been +4.2%. While monthly numbers are volatile, this is a very large improvement. Declines in housing costs give us another reason to believe that inflation will continue to ebb. Like home prices, lease prices have declined in price over the past three months. As the CPI begins to reflect these housing cost changes, it will provide more justification for the Federal Reserve to pause hiking rates.

So much of what drove markets in 2022 related to high inflation rather than normal economic analysis. But the combination of inflation declines, reduced profit expectations, lower interest rates and expected GDP growth leads us to believe investors have begun to shift their focus away from predicting the future actions of the Federal Reserve. If inflation is tamed over the following year, the Federal Reserve would finally be free to adjust interest rates based on overall economic health rather than the singular need to fight spiraling prices. This would mean a stronger bond market, one that would provide needed relief should the stock market fall again. Being defensive with our bond allocations made a lot of sense in 2022. If inflation continues to ebb, however, it might give us a turn to be less defensive.

We wish you and your loved ones a Happy New Year. Please reach out if we can be of service. Our team is here for you.

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