Investors’ High Class Problem

Investors were surprised earlier this week by a report which showed inflation accelerated more than expected last month. The Consumer Price Index (CPI) ticked up .4% from February levels primarily due to higher gasoline and shelter costs. In addition, we’re seeing persistent inflation in some services like elder care, auto insurance & repair, and transportation. The annual rate of consumer inflation rose to 3.5% in March from 3.2% in February. So-called “Core CPI,” which excludes food & energy, held steady at an annual rate of 3.8%.

You may remember that CPI topped out at annual rate of 9.1% back in June 2022 and for the next year steady decelerated to 3%. The Federal Reserve’s many interest rate hikes were aimed at bringing consumer & business demand down in order to tame inflation, and until recently seemed to work like a charm. In fact, last December Fed officials announced a plan to gradually lower rates in 2024 back toward more normal levels. But inflation has picked up over the last three months due to persistent strength in the economy. It’s a high-class problem. We’ll take growth over recession any day, but that growth is preventing inflation from falling back to the Fed’s long-run target of 2%. All of this makes it increasingly unlikely that the Fed can begin lowering rates over the next several months.

And that explains why interest rates jumped immediately after the announcement. Bond traders, who at the end of last year were betting on six rate cuts in 2024, have pared that figure back to two or maybe three. Despite Fed guidance that really hasn’t changed, traders priced-in the wrong expectations and now have to re-price the market. So this week the 10-year Treasury Note yield ticked up to 4.50% from 4.42%. And lending rates (i.e. mortgages, credit cards) followed suit. Stocks fell in sympathy. After all, stocks generally like lower vs. higher rates.

Stepping back, however, the broad investing landscape remains positive. Federal Reserve Chairman Jerome Powell recently delivered a speech at Stanford University in which he said a “soft landing” appears to be happening. That is, despite raising rates to fight inflation, the economy has held up. If this scenario plays out as he expects, it will be appropriate to begin lowering interest rates later this year. but of course he needs further proof that the path of inflation is lower. Given today’s CPI report, he may have to wait a little longer.

Recent economic data serve as a good example of the wider balancing act between growth & inflation that the Federal Reserve is trying to manage. The Institute for Supply Management’s (ISM) closely-watched Manufacturing Index unexpectedly improved last month as business activity turned positive for the first time since September 2022. The survey pointed to improving current production as well as new orders from customers. This report may at last signal recovery. Here again, though, growth seems to come with attendant inflation. Respondents noted higher prices for raw materials and labor. On the other hand, ISM’s Services Index had been very strong until March data showed lower supplier deliveries and new orders. But, as you might expect, businesses also reporting lower cost inflation. In fact, the survey’s “prices paid” component fell to levels not seen since March 2020.

The bottom line is that investors need to accept uncertainty with regard to timing the Fed’s rate cut cycle and instead focus on the economy and corporate earnings. Earnings season kicked off this morning, and soon we’ll learn how Corporate America is getting on. First quarter expectations are not terribly high (revenue growth +3.4%; earnings-per-share growth +2.2%) and most Wall Street analysts believe S&P 500 companies can exceed them. According to Zacks Investment Research, “the [profit] margin outlook will continue to improve.”