What drove inflation down over the past year?
Inflation, by many official accounts, peaked at over 9% about this time a year ago. Most recently, we have been informed that inflation, based upon CPI, is approaching 3% (currently around 3.2%). The question on many investors’ minds is who, or what, has made it happen? According to the Associated Press, it is not one thing, but rather a combination of things.
First, the drop in energy = mainly oil and gas prices. After spiking over 60%, gas prices came down as did a barrel of oil. Next was aggressive action in raising rates on the part of the Federal Reserve. One year ago, the Federal Funds rate was .25%. Today it is 5.33%. That is one of the fastest rises in U.S. history. When the Fed raises rates, savers and buyers of short-term investments see higher rates in money market funds, CDs and the like. That rate does have an intended effect on slowing borrowing and, thus, slowing the economy = adding to the decline of inflation. Lastly, there is the supply chain. The pandemic caused significant disruption in the development and distribution along the national and international supply chains. Many of those disruptions no longer exist and that, too, has helped bring prices down.
Home prices and mortgage rates are higher for sure. Many “would be” homeowners can no longer afford the note now that mortgage rates are near their highest levels in over 20 years (close to 7% after bottoming at less than 3% in 2020). Housing makes up a significant portion of CPI and, when that slows down, it brings inflation down.
What is The Phillips Curve?
According to the Corporate Financial Institute, the Phillips Curve suggests that when inflation is down, unemployment is up. Put another way, it suggests that when inflation is up, unemployment is down. Something strange is happening right now: Inflation is down, and unemployment is down (or employment is up, remains high). Why might this be so? There are a couple of points of view we have heard lately. One is from Professor Jeremy Siegel of the Wharton School (University of Pennsylvania). He stated recently on CNBC and notes that productivity is getting stronger, and the economy is growing. Rick Rieder, who is the CIO of Global Fixed Income at Blackrock, said on Wall Street Week recently that with an economy that is 70% services and 70% consumption (consumers), the historical levers of higher rates have not hurt the economy as they have in the past. Also, when it comes to long-term borrowing, Reider points out that a lot of high-tech companies’ self-fund versus borrow for their cap ex (capital expenditures budgets). He notes that for sure there have been some parts of the economy hurt (commercial real estate, regional and small banks, some parts of the manufacturing economy), but for the most part, there has not been widespread pain. Hence, we have the cost of living going down, employment remaining resilient and the economy growing.
Is this a trend or a short-term thing?
Is this just a short term thing or is this a trend? We think the answers are multifold: 1) Strides in technology with AI and other innovations continue to bolster growth. 2) Liquidity remains high – a.k.a. there is still a lot of money in the economy in checking and savings accounts. 3) The labor shortage keeps unemployment low. It also looks like – depending upon what you read and believe = that the labor shortage may be here to stay for a while. According to the U.S. Census Bureau, the population growth rate of the U.S. was 0.4% for the 12-month period ending in July 2022. This means that approximately 1.3 million people were added to the U.S. population during that period. Put another way, the U.S. population is growing at over 100k people per month. That is a key driver of consumption. However, according to a report by the Federal Reserve Bank of St. Louis, there will be around 10,000 people turning 65 each day for the next two decades. This means that approximately 300,000 people are retiring each month in the U.S.
Is the labor shortage here to stay or here just for a while?
We went back in time, and reviewed an article written in 2005 in the ERE newsletter (a newsletter for human resource professionals) that predicted the labor shortages starting in 2010 and going well beyond 2020. They, of course, had no idea that a pandemic was coming. The net result is that baby boomers did retire as predicted, but at an accelerated rate in recent years. Add to that, many companies have demonstrated they encourage employees to retire early at 55. There is also a coming shortage across many employment sectors: Airline pilots and air traffic controllers, for example (we understand mandatory retirement is 65). Significant numbers are at or near these ages. The labor shortage is going to be with us for awhile. Will that prove inflationary? Believe it or not, it has not so far. Wage inflation is not having the impact that many predicted it would have.
What’s an investor to do now?
So, where does that leave our investors? We think this is a time where short-term rates offer yield not seen in a long time (savings and money markets over 5%). We also look at equities across the board; not concentrated in any one area and representing opportunities for long-term buy-and-hold (and patient) investors. Fixed income rates (think bonds) have climbed again lately. The increase in longer-term rates is largely due to the U.S. Treasury issuing more bonds (the main lever) and longer dated bonds as well. That will drive yields up and prices down. We think investors could lock in good, long-term yields be they in treasuries, corporate or municipal bonds. We caution investors to always review the duration before investing in a particular bond. CDs certainly offer significantly higher yields now, but we encourage investors to think about what those represent: Mainly higher yields over shorter terms.
We hear many investing pundits wondering where and when rates will peak. With Federal Funds at 5.33% now, we are aligned with opinions that see them coming down in 2024. We think that will be 3.5 – 4%.—another potential reason to lock in a short-term CD or a longer-term fixed rate bond now. It may be a good idea to complement that with a diversified basket of stocks, as companies will continue to reap the productivity gains we are seeing now.
Diversification and asset allocation does not ensure a profit or protect against a loss. Holding investments for the long term does not ensure a profitable outcome.
Maurice Stouse is a Financial Advisor and the branch manager of The First Wealth Management/ Raymond James. Main Office: The First Bank, 2000 98 Palms Blvd., Destin 32451. Phone: 850.654.8124. Raymond James advisors do not offer tax advice. Please see your tax professionals. Email: Maurice.email@example.com.
Securities offered through Raymond James Financial Services, Inc. Member FINRA/SIPC, and are not insured by bank insurance, the FDIC or any other government agency, are not deposits or obligations of the bank, are not guaranteed by the bank, and are subject to risks, including the possible loss of principal. Investment Advisory Services are offered through Raymond James Financial Services Advisors, Inc. The First Wealth Management and The First Bank are not registered broker/dealers and are independent of Raymond James Financial Services.
Views expressed are the current opinion of the author and are subject to change without notice. The information provided is general in nature and is not a complete statement of all information necessary for making an investment decision and is not a recommendation or a solicitation to buy or sell any security. Past performance is not indicative of future results.
There are special risks associated with investing with bonds such as interest rate risk, market risk, call risk, prepayment risk, credit risk, reinvestment risk, and unique tax consequences. To learn more about these risks and the suitability of these bonds for you, please contact our office.