Elections and Inflation
Overshadowed by the recent mid-term elections, the latest tabulation of inflation was released. Despite its relative absence from the headlines, inflation is by far the more important near-term driver of both stock and bond performance, as opposed to political winners and losers. With inflation actually lowering a bit, the Federal Reserve should be able to ease off the economic brakes—a bit—and potentially create a more hospitable environment for investors.
Inflation - What's the Deal?
Prices for both consumers and companies have been soaring at a rate not seen in decades. That rapid increase in prices makes it harder for companies to plan their operations. When companies pay more for goods, they can be hard-pressed to maintain their profitability without raising prices on consumers. Understandably, companies often loathe increasing prices for fear of alienating otherwise loyal customers.
Inflation also eats into consumers’ paychecks. For many individuals, paying more for gas, eggs, or electricity means having to pay less for something else. Higher wages have offset some of the price increases, but not fully.
Consumer Price Increases
Year-over-year percent change
Source: Kestra Investment Management data from U.S. Bureau of Labor Statistics. Inflation in a selection of categories of the Consumer Price Index. Data as of October 31, 2022.
Think of the Federal Reserve as playing "Goldilocks"—trying to find the “just right” level of inflation somewhere between “too fast” and “too slow.” Policymakers aspire to some increase in prices that is relatively stable over time and one that runs below the overall level of economic growth. The Fed has argued that an inflation rate of 2%, in which goods and services in aggregate increase year after year at a moderate and predictable pace, is the most healthy for the economy. Interestingly, for years, particularly after the financial crisis, inflation was more likely to be below that target than above.
What About Economic Growth?
Investors aren’t just worried about the direct effects of inflation; they’re worried about the collateral damage from the Fed’s fight against rising prices. To combat inflation, the Federal Reserve has been raising interest rates, hoping to weaken economic demand. If, for instance, higher interest rates have made loans more expensive to pay for, then a company will be less willing to borrow money to, say, build a new factory. And a homebuyer will be forced to buy a less expensive house. Those forces in aggregate mean economic growth slows and sometimes turns negative, tripping the economy into recession.
Does Slowing Inflation Drive Stock Gains?
In October, consumer prices rose by 7.7%, almost four times the rate of the Fed’s target and definitely in the “too fast” camp. But because that rate was less than economic experts had expected and lower than the prior month when prices rose by an even hotter 8.2%—stocks rallied as the S&P 500 posted its best one-day performance since April 2020, climbing 5.5%! Bond yields fell, anticipating that inflation will continue to ease and allow the Fed to be less aggressive in hiking interest rates and slowing the economy.
Inflation Shows Signs of Slowing
Source: Kestra Investment Management data from U.S. Bureau of Labor Statistics. Data as of October 31, 2022.
Slower inflation will make the Fed’s job easier, assuming this trend continues. With price increases moderating, interest rates won’t have to climb as much as some had feared in order to beat inflation back to that “just right” place. Considering that, the Federal Reserve is expected to raise interest rates by half a percentage point in mid-December—a rate that would be considered hefty in other cycles but is slower than other hikes this cycle, a positive for both stocks and bonds.
The hope is that with less dramatic interest rate increases from the Fed, economic growth will not slow as much as feared. All that said, the economy will continue to face headwinds from earlier interest rate hikes. The Fed’s brakes take a while to work their way through an economy and will continue to be felt for some time. But the market has already started looking past that slowdown to brighter days ahead and to a “just right” level of inflation.
What to Do Now?
We believe the call to action is actually a call to...in-action! Recall the mantra at Henry Wealth Management is, "Build a portfolio you can live with, and then live with it." Trying to out-smart markets by buying and selling at the "right" time is an activity pursued by gamblers, not investors. Be understanding of what's going on economically, yet we believe the best strategy for your portfolio is to be patient and long-term focused.