Three weeks ago, stocks were down 10% from their late-July highs and most market pundits were predicting more pain to come. Although we at Carson didn’t see it that way, as discussed in this Weekly Market Commentary in real time, it was an uncomfortable period for most investors.
- Stocks continued to climb last week, as the year-end rally we’ve been expecting takes shape.
- Some market watchers have complained the rally has low participation, with only large companies experiencing gains. That changed last week as overall breadth was strong.
- Inflation data last week likely took an additional rate hike off the table.
- Services inflation excluding housing is trending in the right direction but would have to move further for the Fed to begin to cut rates.
- In 2024, even a slightly less restrictive Fed may be welcomed by markets, which may cheer a federal funds rate of 4.5% at year-end.
Fortunately, stocks have soared over the past three weeks, and the S&P 500 has gained more than 7% so far this month.
Let’s take a step back, as it’s important to remember that stocks had one of their best starts to a year just a few months ago. In fact, it was the best first six months for the Nasdaq ever and the best first seven months for the S&P 500 since 1997. Should typical third-quarter weakness really have been that shocking? In fact, bullish investors may have wanted a market breather to help set up an end-of-year rally.
Previous years with big first-half gains have also tended to see weakness (or at least consolidation) into late October. The chart below shows years in which markets were up by double digits at mid-year and then consolidated during the historically weak months of August, September, and October. The good news going forward? It would be perfectly normal for the markets to rally by year-end, as years with a big start tend to see more strength late in the year.
Lastly, many bears believed the rally was on weak footing because only a few large companies accounted for most of the gains. There was some validity to this argument, as small and mid-cap stocks lagged significantly. But after the much improved inflation data last week and the realization the Fed is likely done hiking rates (more on this below), these laggards soared. On Tuesday, the Russell 2000 Index, which is composed of small-caps, gained nearly 5.4%, marking one of its best days ever. Also, the number of NYSE stocks on the rise surged, which is exactly what was needed for the next phase of this bull market to continue.
Inflation Report Sets Up Serious Rate Cut Expectations
The October Consumer Price Index (CPI) report was chockful of good news. Headline inflation was flat in October, below expectations of a 0.1% increase. The October “surprise” came on the back of lower gasoline prices, which fell 5%. That is particularly meaningful because households have more income to spend elsewhere — keeping consumption and the economy humming. Headline inflation has pulled all the way back from 9% year-over-year in June 2022 to 3.2% in October. The big decline was accompanied by lower energy prices, but as the chart below shows, all the other contributors are shrinking, too.
The Federal Reserve prefers to look at inflation stripped of food and energy, since these are volatile. Core inflation rose just 0.2% in October, translating to a 2.8% annualized pace. Over the last six months, core CPI has run at a 3.2% annualized pace — well below peak levels of 6-7% from a year ago — and is closing in on the Fed’s 2% target. Core CPI averaged about 2.3% before the pandemic.
The positive news from the October CPI report is the economy is experiencing broad disinflation, and there’s more to come. As a result, further rate hike expectations are likely over. In fact, we believe expectations for rate cuts in the first six months of 2024 will increase.
Inflation Picture Improves Across Three Key Areas
Prices for core goods, excluding food and energy, have fallen for five consecutive months and are down almost 1% over the last six months (annualized). Much of this is because supply chains are recovering. We expect prices to continue to fall over the next several months, especially as auto production continues to ramp up and inventories increase, pushing vehicle prices lower.
Housing disinflation has been expected for a while now, with falling market rents indicating that official data will follow. Housing prices spiked briefly in September, but the downtrend resumed in October, with housing inflation running at close to a 5% annualized pace — the slowest pace since December 2021. More disinflation is likely, as private market data indicates that rents continue to fall.
Core services, excluding housing, is worth a deeper look as it plays a significant role in how the Fed views inflation, the labor market, and the economy.
Core Services ex Housing, the “Last Mile” of Inflation
Fed Chair Jerome Powell recently said the inflation decline is welcome. October data for the Fed’s preferred metric, the Personal Consumption Expenditures (PCE) Index, has not yet been released, but core PCE has declined from 5.5% a year ago to 3.7% as of September. However, Powell wants to see more evidence of disinflation to help ensure the economy is not vulnerable to the type of stop-and-go inflation experienced in the 1970s.
Powell also noted the pullback in inflation is due to the improvement in supply chains. For core inflation to decline from above 3.5% to the Fed’s target of 2%, he believes demand must moderate, which means the economy must slow to below trend. The unemployment rate may also have to rise. Powell said he doesn’t think a recession is necessary but that a slowdown is required to get through the “last mile” of curbing inflation sustainably.
Fed members have talked about core services excluding housing inflation being key to restoring inflation to target, which they believe will depend on weakening employment. Strong employment leads to higher incomes, which can lead to higher demand for expenditures such as restaurant and bar sales, hotel accommodations, live entertainment, dry cleaning, air travel, etc., pushing prices higher. Further disinflation in these areas would go a long way to convincing the Fed that inflation is not only lower but stable.
Encouragingly, disinflation is occurring even in the core services ex housing categories. That’s happened as the economy has accelerated above trend the past year and the unemployment rate has remained under 4%. We reviewed the items that make up core services ex housing — about 105 in the PCE data — and calculated the distribution of year-over-year price increases in three periods:
- December 2019, before the pandemic
- September 2022, near peak inflation
- September 2023, the most recent data
The chart below shows how the distribution has evolved. Inflation broadened significantly for these items by September 2022. In fact, 31% saw inflation rates above 7%.
But conditions have pulled back over the last year, and there’s continued movement toward pre-pandemic levels. Only 17% of the items are running above 7% inflation. More progress is needed, but we’re moving in the right direction.
We believe this is evidence that a significant economic slowdown may not be necessary to move core inflation toward the Fed’s target. Combined with easing housing inflation, all signs point to inflation falling further in 2024. As a result, the Fed does not have to raise rates again. In fact, by spring of 2024, the Fed could even start considering rate cuts. If inflation is on a sustainable path lower, there’s no need to keep policy rates restrictive, especially when there’s risk of breaking the economy. Powell’s recent comments suggest the Fed is increasingly unwilling to take that chance.
While not outright accommodative, even a less restrictive Fed could help buoy both stock and bond returns in 2024. In fact, the days of seemingly entrenched ultra-low rates may be over, and markets may even cheer a fed funds rate in the 4% range next year. That was unthinkable before the pandemic when just a 2.5% fed funds rate sent markets into a panic. While it will take some work to find the rate level that really is neutral (neither accommodative nor restrictive) just moving in that direction in 2024 may help extend this young bull market.
This newsletter was written and produced by CWM, LLC. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The views stated in this letter are not necessarily the opinion of any other named entity and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.
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