When we started writing about inflationary risks in January of 2021, we were on the leading edge… Since then, the markets have become obsessed with inflation reports and with Federal Reserve pronouncements regarding its inflation fight.
Headlines lamenting “historic inflation” and “fast and large rate increases” have dominated news outlets over the last 9 months. Markets’ reactions to each have been pronounced, both positively and negatively – which has created higher volatility throughout. These reactions are reminiscent of the 1970’s and 1980’s when the markets were engrossed with weekly money supply reports. At some point, the markets should return to this same obsession.
As we’ve seen in the recent market rally, the Core PCE report and recent Fed commentary are not exceptions. So where do we stand today? Let’s look through the noise of the short-term news to gain a better understanding.
Volatility In The CPI And PCE
When discussing inflation, the Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE) are used. The headline CPI is the most volatile as it includes less stable food and energy prices. The Core CPI (without food and energy) is less volatile. The least volatile is the Core PCE, or personal consumption index which is intended to measure the actual impact on consumer purchases (ex food and energy).
In the table below we compare the average monthly (annualized) inflation readings for all three indices – first from 1959 and then from June, 2020 (June 2020 is the first positive print after the three-month deflation that occurred during the initial stage of the pandemic).
Inflation is elevated according to all three measures. And all three series are volatile month over month (as shown below). No need to trace each one in this chart – the pattern of volatility is the key.
A Better Long-Term View
To get a better long-term view of where we’re heading, we prefer to smooth out the monthly volatility with 6- and 24-month moving averages. When the Fed suggests they need to see “solid and sustained” evidence that inflation is under control they are likely using something similar. Below we outline the status of the Core CPI series.
The 6-month average has been stable over the last 15 months while the 24-month average continues to rise.
The market is clearly looking for a sign that we’re on the right track and that the Fed will soon soften their inflation-fighting posture.
The fact of the matter is that inflation is hard to forecast. Just ask any of the 400 PhD certified economists at the Federal Reserve. However, several trends can be identified:
Short Term – it appears that supply chains are functioning better, a positive that should reduce upward pressure on prices.
Intermediate Term – labor costs will continue to add to inflationary factors as the labor market continues to be extremely tight, which would support higher prices.
Long Term – there is a clear trend developing to “on shore” or “near shore” production facilities. While this will not be a volatile component of monthly price indices, it will likely be a steady, long-term factor with an inflationary impact.
So, are we on the right track? Can we expect a less hawkish Fed in 2023? For us, the jury is still out.
What Does All Of This Mean For Our Investment Portfolios?
Like we’ve said in previous market commentaries, we remain committed to our fundamental market pricing and sector valuation process.
For our equity portfolios that means we’re generally focused in large cap companies, ensuring that more defensive sectors are represented. Healthcare remains a standout. Our fixed income portfolios remain positioned in short-term and high-quality debt instruments to reduce the risk of principal that occurs in a rising rate environment.
If you’d like to discuss our strategies, the markets, or the economy, we encourage you to reach out to us here. We’d love to speak with you.
The information and opinions in this report have been prepared by the investment staff of Advanced Asset Management Advisors (AAMA). This report is based upon information available to the public. The information herein is believed to be reliable and has been obtained from sources believed to be reliable, but AAMA makes no representation as to the accuracy or completeness of such information. Opinions, estimates and projections in this report constitute AAMA’s judgment and are subject to change without notice. This report is provided for informational purposes only. It is not to be construed as a recommendation to buy or sell or a solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy in any jurisdiction in which such an offer or solicitation would violate applicable laws or regulations.
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