by Ralph Cole, CFA
Director
Equity Strategy and Portfolio Management
We are expecting inflation to cool as we move throughout 2023, but we also know that it won’t move in a straight line. The Fed’s favored inflation index is called the personal consumer expenditures index (PCE). The Fed believes that the PCE better reflects consumer’s spending habits than the consumer price index (CPI). The PCE includes more comprehensive coverage of goods and services than the CPI and allows for consumers to substitute away from some goods and services as prices go up.
The personal consumer expenditure index came out today, and was hotter than most economists expected. The PCE was higher by .6% last month, while economists expected it to be up .4%. While this doesn’t seem to be a huge difference, it does suggest an annualized rate of 7% for inflation, much higher than the Fed’s long-term target of 2%. Below we have a chart that shows monthly changes in inflation in the blue bars and the left axis. On the right axis you can see year-over-year inflation denoted by the red line.
The other side of higher inflation was higher spending by consumers. The expectation was that consumption would be up by 1.3% in January but increased by 1.8%. This has been the struggle for the Fed the past six months. Despite the fastest and steepest rate increases in the last 40 years, consumers continue to spend at a surprisingly strong rate. This strong growth leads to more persistent inflation.
With the economy still growing comfortably, and inflation staying stubbornly high, it forces the Fed to continue raising interest rates. At the beginning of 2023 the market expected the Fed to raise rates 2 ½ times in 2023 (a half of a rate hike is a 50% probability placed by the markets), and even lower the Fed funds rate by the end of the year. That is no longer the case. The expectation now is for 4 ½ Fed rate hikes in 2023, and no cuts by the end of the year.
Higher interest rates mean lower stock valuations. As we came into the year, stocks surged on the idea that the Fed would stop raising rates sooner, rather than later, and actually be cutting by the end of the year. That led to stock valuations growing to over 18x 2023 earnings expectations. With 2023 earnings coming down and Fed rate hikes going up, it seems unrealistic for stocks to go up in the near-term. We must wait until the tug-of-war between the Fed and inflation is more clearly settled.
As we came into the year, we warned that the stock market would be volatile as long as the struggle between the Fed and inflation remained front and center. While we enjoyed upside volatility in the market over the first five weeks of the year, the last two weeks have been the other side of volatility.
Takeaways for the Week
We believe the stock market will remain volatile until it is clear that the Fed is done with its tightening cycle, and inflation is clearly on a down trend.
The Fed’s #1 job is to tame inflation, and we leave you with an old Milton Friedman video regarding the destructive nature of inflation.