Inflation rates have been falling recently, albeit slower than we would like. After record-high CPI readings in 2022, monthly readings have been declining for the past 12 months. We think this trend will continue, especially next month, once June’s figures are made public.
If inflation rates fall to 2010 levels, we think this can be a boon for higher-growth (and higher risk) investments. However, value-oriented investments are more attractive if inflation remains elevated and sticky.
As most investors are keenly aware, the Federal Reserve’s interest rate policy has immense sway over all asset classes. Over the past year, we’ve seen a significant shift with the Fed taking aggressive action to mitigate inflation by hiking the Fed fund rates from 0% to a 5.0% – 5.25% range.
As expected, inflation figures have fallen, and risk assets have been rallying this year. As we look ahead, there is likely more relief from the Fed ahead. Let’s dive into why.
Year-Over-Year Figures – The Roll-Off
The Federal Reserve targets a 2% inflation rate. However, in June 2022, the CPI hit a multi-decade high of 8.9%—more than quadruple this target.
However, everyone loves to quote CPI numbers as an annual figure, including the Federal Reserve. So as we look ahead to next month’s annual CPI figure, the June 2022 CPI print, which was extremely high (1.2% for the month – for the month!), will no longer be counted in the annual CPI figure. This simple roll-off makes the biggest difference, especially in a world driven by headlines and short-termism.
Assuming that June 2023 CPI figures stay within the previous 12-month CPI figure range, we will see the annual CPI rate somewhere between 2.9% and 3.6%, with a target YoY rate of 3.2%.
This, combined with lower-trending monthly CPI figures, makes for a more accommodative Federal Reserve.
2023 Inflation Relief?
Now, let’s take a step further and consider the potential scenarios for the rest of 2023. This is where it gets a bit more difficult. If the inflation figures continue to reflect similar trends, the overall annual 2023 CPI figure ranges between 1.4% and 5.6, with a target figure of 3.5%. This big range is hardly the exact science we all want, but forecasting something as complex as the U.S. inflation rate is nearly impossible.
Nonetheless, it seems we may be safely removed from the steep inflationary cliff towards more moderate, manageable levels.
However, the natural question presents itself – where do inflation rates go from here? Will we see ~2% inflation rates like we saw in the 2010s? Or do we see higher inflation rates like we saw during the mid-2000s?
What Does This Mean For Stocks?
On the surface, the Fed’s target rate of 2% seems like a pretty achievable goal. After all, we all experienced these levels for years until COVID wrecked the party.
The reality, however, is that there is a pretty high chance that inflation rates remain elevated. This, combined with the fact that the risk of a recession remains elevated, makes for a challenging position.
If the Fed can somehow walk the fine line between a low inflation rate and stable employment, we should see the discount rate (interest rates that drive everything from mortgages to bank yields) collapse.
Under this scenario, long-duration assets should do well. We saw this during the 2010s when access to capital was easy and cheap (and especially in 2020 and 2021 when the U.S. government dropped rates and printed trillions of dollars). This fueled bubbles and high-risk endeavors (think tech companies that had little-to-no profits – we see you Peloton and Snap!).
As the stimulus hangover settled in and as rates began to rise, investors realized that profits matter, especially when access to cheap capital is hard to come by.
If inflation proves to be sticky and somewhat elevated, this is not conducive to these high-growth, thin-margined, expensive investments. So far, 2023 is on pace for an annual inflation rate of 3.5%. Not brutal, but certainly higher than what we’ve seen over the past few decades.
If this continues, the cost of debt will be more expensive than what we saw during the 2010s, preventing risky endeavors from even getting off the ground.
In short – value does better in higher-inflationary environments and growth does better in lower-inflationary environments.
Think of the Fed’s interest rate policy as a valve that controls the flow of business activity in the U.S. If the monetary valve is tighter than usual, growth companies will have difficulty achieving their high revenue targets. More profitable companies with a lower revenue growth rate will become more attractive in this setting. Value investing will be back! This is where Warren Buffett and his disciples typically shine.
The Road Ahead
The gradual decline of inflation rates, the anticipation of June’s figures, and the Federal Reserve’s response to these changes will shape the investment landscape for the remainder of 2023.
Many are starting to bet that the recession of 2023 will not arrive, and there is nothing but blue skies ahead. This is not the case. Economic growth is slowing, and consumers have been feeling the pinch of elevated prices. Remember, even though inflation rates are falling, this doesn’t mean that prices are falling – only that their rate of growth is slowing. Discretionary income is not what it once was.
We think that the road ahead is still bumpy and that profitable companies are still the way to invest (always).
If you have any questions, please do not hesitate to reach out to us. We are more than happy to assist.
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