INSIGHTS

On April 15, 2024

AAM Viewpoints — CPI Moves Higher Amidst Mixed Currents: What Should Investors Do Now?

“When you come to a fork in the road, take it.”

Yogi Berra

In January, what would you have thought if we told you that the first quarter of 2024 would witness:

• A market quickly pricing out the majority of 7 eases originally expected for 2024,
• A significant, 60 basis point jump in 10-year Treasury yields from 3.9% to 4.5%,
• Energy prices rising with WTI (West Texas Intermediate) pushing north of $85 a barrel,
• Wages still growing at 4%+ and inflation remaining stubbornly sticky at nearly 2x the Fed’s 2% goal,
• Household excess savings finally reaching exhaustion with growing delinquencies on card and auto loans,
• “Mag 7” names Tesla and Apple struggling and dropping 10% and 33%, respectively.
• The solidification of the most unloved presidential rematch in history,
• A continued deterioration of the U.S. financial picture with 120% debt/GDP putting us on a path to record interest expense?

What would you expect market returns would be? We would guess for many that a 10% gain for the S&P 500 Index with stocks hitting new records, might not have been the quickest and surest answer. So, what were some of the positive currents that supported the rally, and do they still hold sway as we look forward?

Crosscurrents supporting the bullish rally in the first quarter and are they durable?

• The short-term fix of fiscal spending keeping the foot on the gas, countering the Fed’s foot on the brake.
• A Fed that significantly tilted dovish in November which may have inadvertently “front loaded” the actual easing of conditions as evidenced by rising markets, tighter bond spreads all supported an increasing “wealth effect” for consumers.
• The hope of a profit and productivity boost from AI, the hope the consumer will spend given the low unemployment rate, and the hope inflation is still poised to drop, and the Fed won’t overplay its “hold-for-longer” hand.
• Blockbuster immigration which may be boosting demand and filling some of the labor gap.

“I will not be ignored…Jay.”

So, which currents should investors ride? We continue to believe that inflation is one of the strongest currents and it will remain sticky. This is a strong and “bumpy” current. That should lead the Fed to stand pat for quite a while, and it is becoming a closer call that they could remain on hold for the year. It is becoming clearer that a bigger slowdown is required to avoid a “stop, drop and pop” rate pattern. We are at the “stop” part of the story but a “drop” doesn’t quite fit the inflation and growth narrative today. We think a “drop” soon would create even more easing and might aggravate the inflation situation leading to the need for a “pop” of tightening shortly thereafter. 

We believe the better path of risk management is to stand pat, and perhaps it takes the year to see inflation begin to slowly bend back down. However, as we examine the secular drivers embedded in current higher inflation, we think “3% is the new 2%.” What of increasing talk of a hike? Well, it’s an election year and we don’t quite see the Fed going there, but we do expect dovish jawboning by the Fed to continue to moonwalk the path of easing backwards.

Inflation — “3%+ is the new 2%”

Over the past few weeks, and certainly last few days, it seems the market is beginning to not only acknowledge this sticky inflation theme but is also beginning to acknowledge what that means for reoptimizing asset allocation. For a long stretch last year, many pointed to lower rolling 3-month inflation figures to support the thesis that we were well on our path to the ultimate 2% Fed goal. That chatter slowed this year as some of the key rolling 3-month figures stopped decelerating. This week’s hot CPI figures underscored that trend (Core CPI flatlined at 0.4% month-over-month, ticking up to 3.8% year-over-year). It still may take more time for capitulation of the ‘Immaculate Disinflation’ view, however. For example, a fiscal foot on the gas and continued consumer borrowing may be short-term positives for the economy, but create continued tailwinds, fanning inflation. As added debt burdens grow, they can potentially slow growth down the line.

As for the nominal rates, in the face of a significant increases in Treasury supply, do rate buyers seek higher risk premia in yields and when? Do long rates continue higher as some of the biggest purchasers pull-back (e.g. Fed, China, and Russia)? It seems logical to us that lower Fed rates might not mean lower rates further out the yield curve. We think investors should be prepared for this potential outcome, even if the Fed lowers front end rates.

Direction of other powerful currents not completely clear.

It is arguably too early to tell how the forces of AI and immigration will impact the economy and to what degree. Is the exuberance evidenced by the pop in stock prices even remotely attached to some AI angle justifiable? Is AI inflationary in the short run? For example, AI hogs energy and it is estimated that it will consume 25%+ of total U.S. power within five years, putting exceptional pressure on energy prices and our grid (inflationary). 

We have witnessed an explosion of immigration…is this inflationary (higher demand) or disinflationary (adding labor to a tight labor market)? When would such a high level of debt/GDP wake-up bond vigilantes or at least add further to the risk premia in bonds? When and how would that impact equities?

These crosscurrents give plenty of fodder for spirited debate. In our view, we believe that a few of these currents are stronger than others and will dictate the direction of markets. Currents can shift but determining the main direction of the flow of the river is the key consideration to make it to the destination without struggling unduly and avoiding the rocks.

Here is what we believe to be the overall direction of travel of the economic river along with major currents we need to pay attention to for the balance of the year:

• Inflation remains sticky leading the Fed to stay on hold.
  Even if they do ease, we do not expect that we are in a major easing cycle as inflation dynamics point to a moderately higher inflation regime.
  
  The Fed may have shot itself in the foot by leaning into a dovish tilt too soon, thereby easing financial conditions before they actually lowered rates, aggravating the inflation picture. The stealth ease is evidenced by record stock market valuations, near-cycle tightening in bond spreads, record household wealth creation, and interest rates that are still 50bps (basis points) lower than the November peak.
  
  The economy remains above trend (Atlanta Fed at 2.8% GDP for 1Q), unemployment is low, wages up, energy up and rents sticky. The Fed is riding the brakes, but Fiscal policy is still on the gas, and consumers keep on spending savings down and borrowing up. In our view, the Fed has not yet destroyed enough demand to get to the last mile of 2% inflation anytime soon and oil, commodities, and U.S. dollar strength may confirm that.

• Long rates may not follow, even if the Fed does ease (barring a recession).
  We are living through a “normalization” of the rate curve. Normalization is a process which takes time, not an instant result, particularly after 15 years of artificial manipulation of the curve post-GFC (Great Financial Crisis).
  
  In our opinion, the market is too focused on the front-end and not the potential market reaction function of longer rates, which is where a large portion of the economy is still leveraged (e.g. consumer and commercial mortgages, auto loans, consumer durables, corporate borrowing). With the market’s focus on the short end of the yield curve, we believe there is a good probability that if the Fed did lower rates in June or July, long rates might not follow and might actually drift higher, placing a further unexpected headwind on market valuations.

Where should rates settle in?

Prior to the GFC, before the Fed manipulated rates, the 10-year Treasury yield would approximate nominal GDP. More specifically, real yields averaged about 200bps to match real GDP and then inflation accounted for much of the rest to equal the nominal yield. We think we are reverting to normalization. If one believes, as we do, that inflation rests in a 2.5% to 3.5% range, and GDP settles at 2% then the math would point to 4.5% to 5.5% 10-year Treasury. A 4.5% to 5.5% 10-year rate is not abnormal…it is normal. We can handle that as long as inflation is stable. 

That where our markets had been for decades following Volcker cracking the back of inflation. Funny enough, no one thinks Volcker failed when inflation settled in at +/- 3%. As for the immediate rate outlook, we broke through the technical level of 4.35% on the 10-year last week and are at 4.5% as of this writing. The next technical level is near 4.8%, but as long as inflation stabilizes, even at the 2.75% level the market seems to be gravitating towards, we are not far off from fair levels as long as the Fed doesn’t ease too soon.

Source: Strategas. Past performance is no guarantee of future results.

The stock market has begun to pull-back off this growing inflation/rate concern; have we corrected enough?

Likely, not yet. The last couple of weeks feel bad, but only because we’ve had a long string of positive months. A 10% correction would be more in line with a capitulation, but the market probably needs more convincing and information regarding the path of the economy and inflation over the next couple of months to precipitate it. We think that a broad correction is a reasonable possibility and recommend shifting asset allocation to reflect what we think is a durable leadership shift toward quality and value which should outperform if a drawdown occurs (as it did in 2022) but importantly, will continue to outperform as we settle into this moderately higher inflation regime.

Entering an era of elevated volatility.

We think the cross currents highlighted above portend a regime of moderately higher volatility. In looking at the chart below, one can spot two volatility regimes:

1. Pre-GFC = moderately higher
2. Post-GFC = lower volatility courtesy of the Fed

Source: Strategas

Volatility Follows Real Yields:

Source: SG Cross Asset Research/Derivatives. Past performance is no guarantee of future results.

We believe we are in the process of seeing volatility “normalize” to a higher level.

The Shifting Currents of Correlation

History also shows that an important output of moderately higher inflation and higher rates is not only elevated volatility, but also less predictability of cross asset correlations — stocks and bonds have actually been positively correlated for lengths of time before the manipulation of rates.

We believe advisors should implement an asset allocation strategy focused on “Three D’s” – Diversification, Dividends, and Defense.

Diversification

• Equities: Consider a shift from overly concentrated indices, many of which favor longer duration growth, and tilt toward value. Add some international exposure, e.g. Japan has just begun a journey of recovery and growth, and will likely be a winner, along with India on global shifts in trade, in our opinion.
• Fixed Income: We believe investors should continue to underweight long duration. Conversely, we do like shorter- to intermediate-duration fixed income as yields provide ample cushion even if rates do back up a bit more. For example, a 3-year duration portfolio could back up ~200bps to a breakeven over 12 months. Considering moving some excess cash toward low to intermediate duration bonds. This may sound counterintuitive with an inverted curve, but the consensus still expects the next move in the front-end to be lower. Also, consider locking in some yield now and reducing reinvestment risk as we believe the margin of safety in 2- to 5-year bonds is robust with yields here.
• Alternatives: Consider adding some commodity exposure. We believe moderate inflation regimes have been very friendly to this exposure, and this should also help mitigate the risks of both sticky inflation and less predictable stock/bond correlations.

Dividends

• We believe counting on further P/E (price-to-earnings ratio) expansion should be de-emphasized as rates remain higher and investors should focus on more predictable components of return, like dividends from quality companies.
• Look for combinations of value and dividend growers as we believe dividends begin to revert to the mean and can produce up to 40% of overall returns, while value can provide a margin of safety.
• Consider seeking alternative sources of dividend and income in areas benefitting from a “higher for longer” world like BDCs (business development companies), as well as Preferreds and Private Credit.

Defense

• Higher rates, higher volatility, and shifting currents encourage building a durable portfolio to weather uncertainty, but without limiting upside. We believe investors should:

• Add to areas with durable long-term secular trends like infrastructure and defense.
• Add “margin of safety” into the mix with value and quality factor allocations.
• Use the “picks and shovels” approach to play less predictable winners and losers in mega-trend areas like AI and energy transition (e.g. data centers, metals, and materials).

Source: Strategas. Past performance is no guarantee of future results.

Floating down the river toward…normalization.

The crosscurrents remain strong, but the river ultimately flows downhill due to the force of gravity and from the source to the endpoint. The largest gravitational pull we see is actually a pull toward normalization in markets. That means long rates around these levels as the market (and Fed) get used to moderately higher inflation and perhaps agree that a 2.5% to 3% inflation environment is tolerable. It also portends a growing view that P/Es can’t grow to the sky and that dividends and value do matter. It hasn’t been a short ride, and the endpoint is not yet here. But adding Diversity, Dividends and Defensive properties into portfolios, we think, will allow investors to more safely navigate the currents, minimize the impact of hitting rocks along the way, and create a smoother path of positive returns as move forward.

CRN: 2024-0405-11585 R