Inflation May Have Peaked, Rate Hikes Have Not

As the end of Summer draws near, and school is starting, here in Dallas we are thankful the heat has pulled back from record levels. While still hot, we are at least heading in the right direction. Similarly, inflation is at multi-decade highs, clearly running too hot to be healthy, but like with local temperatures has very recently starting heading in the right direction.

The Federal Reserve (Fed) has continued its aggressive battle against inflation, raising the federal funds rate another 0.75% at its late July meeting – the fourth rate bump this year, while continuing to posture more rate hikes are to come. We’re now in a neutral 2.25% to 2.5% range, and the central bankers are on track to raise rates to a mildly restrictive 3% to 3.5% range by the end of the year. While inflation fears remain high, it is likely that we are past peak inflation and the largest interest rate increases are behind us, explains Raymond James Chief Investment Officer Larry Adam, echoing Fed Chair Jerome Powell.

The domestic equity markets anticipated the rate change and appeared to appreciate the Fed’s firm stance. The S&P 500 climbed around 9% for the month of July-the highest monthly increase since November 2020. This is in contrast to the worst start to the year since 1970 that had the S&P 500 down 20% through June and the Bloomberg U.S. Aggregate Bond Index down 10%.

Increasing rates are providing some relief for conservative investors, and those with material reserves. Higher yields on bank deposits, money-markets, CDs, and short-term fixed income provide mildly attractive yields for the first time since pre-Covid. However, these yields are primarily attractive in an absolute sense, and won’t be fully appreciated until inflation moderates – not just peaks – and real returns are stable.

July’s reprieve came with declining oil prices (and the subsequent impact on inflation) and slowing economic activity, the second consecutive quarter of negative GDP growth, which helped spur the bond market as longer-term interest rates declined meaningfully.

None of this eliminates the possibility of a mild, short-lived recession, notes Chief Economist Eugenio J. Aleman, Ph.D. Investors should expect some challenging months ahead as we navigate uncertainty around global inflationary pressures coming from the continuing pandemic; Chinese lockdowns, which could constrain supply chains further; the Russia-Ukraine war and its implications on energy; as well as “noisy” data. For example, existing home sales weakened in the second quarter, but their prices are still climbing, just not at the pace they had in recent quarters. Meanwhile, new home sales declined to their pre-pandemic levels.

The Bureau of Economic Analysis reported that second-quarter real gross domestic product came in at -0.9% following a 1.6% decline in the first quarter. On the other hand, corporate earnings season appears to be robust thus far, buoyed by relentless consumer spending. Personal consumption expenditures, which account for almost 70% of the economy, grew by 1% during the quarter. It seems U.S. companies and consumers remain relatively healthy for now.

Following a tough 2nd quarter, the major indices landed in positive territory for the month of July. Let’s review where the headline indices stood year to date through July.

	12/31/21 Close	7/29/22 Close*	Change YTD	% Gain/Loss YTD
DJIA	36,338.30	32,845.13	-3,493.17	-9.6%
NASDAQ	15,644.97	12,390.69	-3,254.28	-20.8%
S&P 500	4,766.18	4,130.29	-635.89	-13.3%
MSCI EAFE	2,336.07	1,937.26	-398.81	-17.1%
Bloomberg Aggregate Bond	2,355.14	2,162.99	-192.15	-8.1%

*Performance reflects index values as of market close on July 29, 2022.

Now, onto the details:

What is Transitory Inflation?

With the recently signed into law CHIPS and Science Act, incentives for domestic semiconductor manufacturers and suppliers have been codified. They could see billions in grants and investment tax credits toward the expansion and construction of U.S.-based manufacturing facilities.

A reconciliation bill focused on climate/energy, corporate tax changes and healthcare policy (mainly lowering costs of drug prices and an extension of health insurance subsidies) was passed earlier this week by Biden after going through the House. While there are no energy-related mandates or other “sticks” in this reconciliation bill, there are plenty of “carrots” for clean energy technologies in the form of tax incentives. Political factors led to significant priorities being dropped from both bills, namely broader (and more hawkish) China-oriented policy provisions as well as individual tax adjustments targeting higher incomes. But that doesn’t preclude Congress from tackling China-related economic and investment policies in the future, notes Washington Policy Analyst Ed Mills.

The Global Outlook

The outlook for the global economy continues to weaken, and forecasts for economic activity outside the U.S. reflect persistent inflationary pressures, supply chain disruptions and tightening financial conditions. Downside trade pressures and higher energy prices are having an outsized effect, one that’s particularly acute in Europe and in the United Kingdom. Ongoing concerns regarding the continent’s gas supply have served to emphasize regional vulnerabilities.

Global headline inflationary pressures may have peaked, which would provide some much welcome stability to global stock and bond markets after a tough first half of the year. Recent survey data indicates that prolonged supply chain difficulties may have eased somewhat, and we may see inflationary pressures subside in the months ahead.

The Bottom Line

The past few months have once again shown the economy and markets are not the same thing. Despite weakening economic conditions globally, both equity and bond markets have rebounded strongly. We anticipate an opportunity to increase our interest rate sensitivity in bonds over the next 6-12 months, seeking more yield, but feel it is a touch premature to do so with purpose at this time. Further with recent recovery of equity and fixed income markets, we believe now is a good time to replenish cash reserves and fund near-term expenses if funding sources are exposed to the market.

Please let us know if you have any major expenses in the next 6-18 months that we have not already been discussing and planning for with you.

About the Author

Casey Kupper, CFP®, CFA, CAIA® is one of a small group of professionals with both their CERTIFIED FINANCIAL PLANNER™ certification and Chartered Financial Analyst (CFA) marks. As a principle at Cadent Capital, he is dedicated to helping each client build a better future by making better decisions today.  He understands wealth management is a journey, and each step is an opportunity to make an impactful decision on accumulating, investing, and sustaining your wealth.  If you need help developing a plan that will guide your journey, call our office at (972) 777-4991 or visit our website.

All investments ore subject to risk, including loss. All expressions of opinion reflect the judgment of the authors and ore subject to change. There is no assurance the trends mentioned will continue or that the forecasts discussed will be realized. Post-performance may not be indicative of future results. Economic and market conditions ore subject to change. The Dow Jones Industrial Average is on unmanaged index of 30 widely held stocks. The NASDAQ Composite Index is on unmanaged index of oil common stocks listed on the NASDAQ Notional Stock Market. The S&P 500 is on unmanaged index of 500 widely held stocks. The S&P 500 Value is o morket­capitalization-weighted index developed by Standard and Poof’s consisting of those stocks within the5&P500 Index that exhibit strong value characteristics. The S&P 500 Growth Index is o stock index that represents the fastest-growing companies in the S&P 500. It is currently heavily weighted toward prominent American technology companies. The MSC/ EAFE (Europe, Austrolio, For East) Index is on unmanaged index that is generally considered representative of the international stock market. The Russell 2000 is on unmanaged index of small-cop securities. The Bloomberg Barclays U.S. Aggregate Bond Index is o brood–based flagship benchmark that measures the investment-grade, U.S. dollor-denominoted, fixed-rote toxoble bond market. An investment cannot be mode in these indexes. The performance mentioned does not include fees and charges, which would reduce on investor’s returns. Small-cop securities generally involve greater risks.

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