Why Sticky Inflation Is Making Things Difficult for the Fed

Markets continued their rapid advance in the first quarter off the October 2023 lows as hope for an economic soft landing grew stronger. Soft economic data initially sparked the rally last October with investors hopeful that the Federal Reserve would cut rates six times in 2024. Fed Chairman Jerome Powell bolstered this view with dovish comments following the Fed’s December meeting. Expectations of rate cuts pushed Treasury yields sharply lower and broad equity markets higher into the early part of Q1. Surveys of consumers and CEOs alike rebounded on hopes that rate cuts would arrive in time to keep the economy growing. Simply put, the market reflected expectations that the Fed would cut rates, which would lead to a soft landing of the U.S. economy.

As the first quarter wore on, the narrative shifted in response to data that pointed to a resilient economy. The overall strength led investors to ratchet down their expectations of the number of rate cuts from six to three for the year. Both 10-year and two-year U.S. Treasurys finished the quarter with higher yields; however, equity markets were left unfazed as they somewhat surprisingly continued their advance, with the S&P 500 ending the quarter at a new all-time high. This market momentum was likely driven by investors’ fear of missing out (FOMO), particularly as it relates to artificial intelligence stocks. The strong market movement was also driven by a seemingly unshakeable belief that, despite a growing body of evidence to the contrary, inflation is set to move lower in the coming quarters. And despite what appears to be a growing divergence of opinions among Federal Reserve members, Fed Chairman Powell appears to still believe that the much hoped for “immaculate disinflation" is set to become a reality.

This is where we believe cracks in the market narrative will become evident as we push through 2024. We agree with the Fed’s current assessment that inflation of the past few years was tied to COVID and its disruptions to supply and labor. Simply put, the convergence of supply chain disruptions amid stimulus-fueled consumer spending shifting to goods knocked the U.S. economy out of equilibrium. This caused a rapid advance in goods inflation that pushed overall U.S. inflation sharply higher in late 2021 and into 2022. When the economy reopened in 2022, goods inflation eased as consumers focused their spending on the larger services side of the U.S. economy. And much like Chairman Powell, we believe the return to a more normal economic backdrop over the past year has caused inflation to falter.

However, our research leads us to conclude that this return to a more “normal” economic equilibrium is occurring at a point when the U.S. economy appears to be in the later innings of a traditional economic cycle. Historically, when the economy is in the late stages of advancement, it is growing above its long-term average capacity. This results in a low unemployment rate, causing wages to grow at an above-average pace, which results in “stickier” inflation. Also, as shown below, the Fed has not aggressively cut rates in this type of scenario.

Interestingly, despite the positive backdrop in Q1, inflation data continued to point to price pressures regaining steam and pushing higher. While the year-over-year inflation readings have declined, shorter-term measures have moved higher over the past few months. Services sector inflation appears to have reversed course, and even measures of core services inflation that exclude the lagged housing sector are now rising. The Atlanta Fed’s measure of sticky inflation has stalled out at elevated levels and is again pushing higher, while the Cleveland Fed’s trimmed mean and median Consumer Price Index are also rising. Lastly, the percentage of Personal Consumption Expenditures (PCE) inflation components that are rising by more than 3 percent remains elevated and is at a level consistent with prior end-of-cycle periods when inflation has become “sticky.” All of this is likely being driven by a tight labor market that is causing strong wage gains that help keep demand elevated. To be sure, a strong stock market is also likely causing a wealth effect that is fueling consumer spending and helping to keep inflation elevated.  

As the effects of higher rates accumulate, the greater the risk of what we believe will eventually be a mild recession. Fortunately, we believe a mild economic contraction should mark the end of elevated inflationary impulses.

This is why we believe it is going to be difficult for the Fed to cut rates in 2024. As Chairman Powell often warns, cutting rates too early carries the risk of reversing the inflation progress, while cutting too late could push the economy into a recession. Getting the timing right to avoid either scenario will be tough, and we see increasing risks to any Fed rates cuts in 2024. However, the longer rates remain elevated, the more they will be felt throughout the economy. As the effects of higher rates accumulate, the greater the risk of what we believe will eventually be a mild recession. Fortunately, we believe a mild economic contraction should mark the end of elevated inflationary impulses.  

Delayed impact of rate hikes  

Federal Reserve rate hikes have historically impacted the U.S. economy with a lag mainly because debt doesn’t reprice to higher interest rates all it once. Perhaps it’s the impact of a 24/7 news cycle, but certainly this time feels like it is taking even longer for the hikes to dent the economy. This has led many to conclude that if a recession hasn’t occurred yet, and the Fed is done hiking, then the coast must be clear. However, a look at history shows that prior to the past eight recessions it has taken between four and 16 quarters from the first rate hike to the beginning of a recession, with an average of 10. With the current hiking cycle beginning in Q1 2022, we are now a mere eight quarters into this process. 

While this hiking cycle has been sharp and fast (with the Fed Fund’s rate moving from 0.25 percent to 5.5 percent), the reality is that higher rates have likely not yet exerted their full impact on the U.S. economy given the composition of consumer and corporate debt. Remember that 65 percent of aggregate consumer debt is mortgage debt, and following the Great Financial Crisis of 2007–09 consumers have opted for fixed-rate mortgages. This has shielded many from rising rates and explains the dramatic slowdown in existing homes sales. The effective interest rate on all mortgages debt outstanding as of the end of 2023 was just 3.8 percent. Contrast that with current rates that have been at 7 percent or more over the past couple of years. This gradual repricing has resulted in a gradual increase of aggregate interest paid of tenant housing moving from $459 billion at the start of the cycle to $576 billion as of the end of 2023. However, the longer rates stay higher, the greater the impact will be on consumers as more people eventually buy homes at elevated interest rates. 

Contrast this with credit card debt and auto loans that have seen sharp increases and experienced a rapid impact from rising rates. Since the rate hike cycle began, interest costs on this segment of consumer debt have more than doubled, rising from $277 billion to the current level of $524 billion. The result is overall interest costs to consumers have risen from 1.25 percent of disposable personal income in early 2022 to today’s level of 2.5 percent. 

The rise in interest costs is being felt in particular by lower-income consumers at a time when excess savings accumulated during the pandemic are dwindling. The result has been an increase in both credit card and auto loan defaults.

Lastly, U.S. corporations smartly took advantage of the lower rates of the previous decade and extended the maturity of their borrowing and are only beginning to see their interest expenses increase. However, over the next three years an additional 22 percent of current outstanding debt comes due and will need to be refinanced at higher rates. Higher-interest expenses along with still elevated wage costs will likely result in margin compression on corporate income statements. Should this scenario play out, corporate executives may try to protect profit margins by raising prices, which would lead to rising inflation and fly directly in the face of the Fed’s mission to push inflation lower. We’ve already gotten a glimpse of this from the National Federation of Independent Businesses’ Small Business Optimism survey that shows companies are continuing to pay higher wages and have been forced to try to offset those costs by raising prices. If that fails and all else is exhausted, the unfortunate reality is that companies will likely resort to job cuts, which often coincide with recessions.  

The question now is whether sticky inflation will force the Fed to keep the drain open and liquidity draining—or will they be able to begin shutting the drain by cutting interest rates?

We have previously used a bathtub analogy to describe the U.S. economy after COVID’s arrival in early 2020. At the onset of COVID, both fiscal and monetary policymakers filled the bathtub (i.e., U.S. economy) with water (liquidity) and closed the drain to get us through the economic uncertainties caused by the pandemic. Then in early 2022, the Fed turned off the water (liquidity) faucets and opened the drain to remove excess liquidity from the U.S. economy in an attempt to slow economic growth and bring down heightened inflation. However, as we noted, just as with an actual bathtub, not all liquidity drains from the economy all at once. And given the overall strength and relative interest rate insensitivity of the U.S. consumer, we believed in 2022 that the U.S. economy would continue advancing. The big question has always been how fast the liquidity would drain and how far the Fed would keep the drain open through higher rates and quantitative tightening. Recent economic growth and our analysis of interest costs would suggest that excess liquidity remains. The question now is whether sticky inflation will force the Fed to keep the drain open and liquidity draining—or will they be able to begin shutting the drain by cutting interest rates? 

We continue to forecast that inflation is not yet sustainably on the path to 2 percent. As a result, the Fed is likely to stay on the sidelines and leave interest rates elevated. We continue to believe that higher rates for a sustained period will continue to chip away at the strength of the U.S. consumer and corporations, which will increase the risk of recession for the U.S. economy as 2024 unfolds. Certainly, paths to a soft landing have grown stronger over the past year. However, we believe that the bulk of the data, especially the shortage of labor (that has been relieved over the past few years by rising immigration) and rising wages, point to a U.S. economy later in an economic cycle. Unfortunately, neither the Fed nor fiscal policymakers have yet figured out how to circumvent the natural course of a business cycle.  

Equity markets 

We believe that equity markets and the economy are closely tied. Rising economic outlooks often coincide with rising equity markets, while dimming economic prospects are frequently tied to faltering markets. Interestingly, over the past year we’ve seen a historically large divergence between economic and market performance. 

The Conference Board has created indices of current economic indicators and leading economic indicators (LEI). As the chart below shows, over the past years leading economic indicators have moved sharply lower relative to current economic indicators. Indeed, since mid-2022, the Conference Board’s index of leading indicators has been at levels consistent with each of the past eight recessions. This suggests that the economy is set to slow in coming quarters because leading indicators are weakening relative to current indicators. This type of backdrop—particularly during the past 15 years—has been challenging for equity market investors. 

Astute readers may note that the Conference Board’s leading index ironically has the S&P 500 as one of its 10 components. Furthermore, a look at the above chart shows that faltering LEIs haven’t always led to negative equity markets (e.g., 1990s) and that the S&P 500 may actually lead the LEI series. We acknowledge this but still believe the analysis is meaningful because of the size of the divergence between LEI and market performance and the reality that we believe improving economic growth is likely to keep inflationary pressures and interest rates elevated, which will eventually lead to a mild recession and weigh on equity markets. Importantly, we also think the chart provides a framework when thinking about the market’s narrow and concentrated advance that has driven the broader index higher over the recent past.   

While the S&P 500 index of U.S. Large Cap stocks notched an all-time high in Q1 and is now up 30 percent year over year, the reality is the advance has been driven by a narrow subset of the large stocks. Indeed, according to our research friends at Piper Sandler, only 31.8 percent of the S&P 500 stocks reached an all-time high in Q1. The overall increase in the index has largely been driven by the so-called “Magnificent 7,” a group of technology stocks that are tied to the artificial intelligence boom. This group is up 52 percent over the past year. These stocks have helped push the largest 10 stocks in the S&P 500 to account for 34 percent of the index, easily surpassing the prior peak of concentration of around 27 percent in 1999–2000 during the internet boom.  

History would suggest this is not sustainable. Typically, a company reaches the top 10 after a long period of strong fundamental growth and some valuation expansion. For strong equity returns to persist into the future, the company must continue to exhibit strong growth and maintain the current valuation profile. That’s where it gets challenging. These large companies tend to be in a position where they already stand out versus their competition—usually by earning the majority of profits. As a result, history suggests that favoring the field (versus the top 10) is a worthwhile investment consideration. According to a study from GMO from 1957 to 2023, the top 10 companies in the S&P 500 have on average underperformed an equal-weighted basket of the rest of the 490 companies by an average of 2.4 percent per year.  

Returning to our FOMO comments, the stocks that performed the best in the recent past were those that had already posted strong returns for several months. Indeed, price momentum as a factor had one of its best starts to a year ever. Think of this as simply buying the stocks that have done the best, with investors rushing to get invested so as to not miss out on what are perceived to be spectacular future growth opportunities. The winners keep winning and getting bigger and, unfortunately, more expensive, with the overall index becoming more concentrated. 

As a result of this reality, the S&P 500 ended the quarter trading at a trailing price-to-earnings ratio (p/e) of over 23x and a forward 12-month estimate p/e of 21.7x. On a price-to-cash flow basis, the index is now trading at 17.8x, trailing 12-month numbers and 15.5x 12-month forward estimates. With the exception of a brief period during COVID, these are the highest levels since the mid- and late 1990s.  

The good news  

While parts of the market are trading at steeper valuations due to a runup in stock prices, we note that other parts of the market have not done as well and are not trading at such elevated levels. An equal-weight version of the S&P 500 has advanced “only” 19 percent over the past year and is trading at 17x forward earnings. U.S. Mid Cap stocks trade at 16.8x earnings, while the S&P 600 index of U.S. Small Cap stocks remains 8 percent off its all-time high and is trading at just 15.8x earnings. Importantly, these are near or even below their longer-term average valuations.  

This is why we believe there is good news for intermediate- to long-term investors who maintain or even increase exposure to these parts of the market in the coming quarters. The difference between the recent haves and relative have-nots has been their exposure to economic outcomes. Simply put, the names that have done well are not only higher quality but also perceived to be less dependent on the economy for their future growth. And much as we forecasted, the movement of interest rates has had a relationship with the relative performance. When interest rates rise, U.S. Large Caps have outperformed each of these market segments.   

This is why we like the optionality some of these overlooked stocks provide investors. If the U.S. economy does witness an immaculate disinflation aided by Fed rate cuts, it’s reasonable to expect the market to broaden out and the more economically sensitive segments of the market to rise, particularly given the large discounts at which they trade. If we do have a recession, we believe the Fed will be able to cut rates aggressively given that we believe the last inflationary impulses will be eliminated. This backdrop of faltering rates will likely cause forward-looking investors to reposition toward these names in anticipation of an economic resurgence that would bolster future growth prospects for these companies. We acknowledge the path to their outperformance could be bumpy as rates remain high in the nearer term given our inflation outlook. However, we believe that investors must contemplate how much they are willing to pay for the perceived safety of mega-cap names particularly in light of the fact the economic sensitivity of the overlooked parts of the market has already been priced in by investors. 

While we continue to voice our concerns that a recession is still somewhere on the horizon, we believe there is plenty of good news for intermediate- to long-term investors.

While the past never perfectly repeats, we believe it rhymes. Consider what happened during the late 1990s, when U.S. Small and Mid-Caps and the equal-weighted S&P had dramatically underperformed their market-weighted Large Cap peers toward the end of that economic cycle. When it became apparent to investors that a recession was likely on the way and rates began moving lower prior to the recession that ensued in early March to November of 2001, these segments suffered less during the selloff and outperformed their Large Cap peers over the next economic cycle.  

Zooming out to other economic cycles, we again note that every economic cycle from 1980 forward has witnessed changing market leadership as the economic environment has shifted. Indeed, leaders of the prior economic cycle have often become laggards of the next economic cycle, a phenomenon we discussed in our March Asset Allocation Focus.   

While we continue to voice our concerns that a recession is still somewhere on the horizon, we believe there is plenty of good news for intermediate- to long-term investors. In addition to parts of the market remaining cheap, investment-grade bonds once again yield 5 percent. Forecasting the exact date of a recession is difficult in any economic cycle, let alone this unusual post-COVID period. The reality is that the weight of the data suggests the U.S. economy is later in an economic cycle. We are not suggesting any dramatic changes to your carefully thought-out asset allocation—merely that investors pay heed to uncertainty and risk by remaining diversified and sticking with their long-term plans. Do not overreact or take unnecessary and concentrated risks.  

Recessions are a natural feature of the business cycle, as are market downturns. The end of each business cycle gives way to the next, much as each market downturn eventually turns into the start of the next bull market. Owning multiple asset classes should put you in a stronger position in the long run—especially given that markets are likely to continue to vary from one year to the next. If you feel you may be taking on unnecessary or unintended risks in your financial plan, we encourage you to reach out to your financial advisor. 

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