Last week's cooler-than-expected inflation data offered some relief to investors and the Fed, potentially indicating that October could be the start of a disinflationary trend that lasts through next year. The headline consumer price index (CPI) reading was up 7.7% from a year ago, the smallest annual increase since January, and down from September's 8.2% pace. More importantly for the Fed was that the core index, which excludes food and energy, slowed more than expected, advancing 0.3% from the prior month (vs. 0.6% in September) and 6.3% from last year (vs. 6.7% in September). Stripping out shelter, core CPI fell 0.1% last month, marking the first decline since May 2020¹.

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In response to the CPI surprise, stocks surged, Treasury yields sank, and the dollar weakened, showcasing once again that inflation remains the No. 1 driver of market outcomes this year. We offer our take on the recent data, along with implications for Fed policy and investment strategy.

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Downward consumer price pressures in the pipeline

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One month of cooler inflation doesn't make a trend, and markets learned that the hard way after the downside surprise in August more than reversed in the subsequent months. But at the same time, a month of better data is needed to start a trend, and several leading indicators of inflation that we track point to further moderation ahead. Also, the breadth of the deceleration in prices across different categories this time suggests a more lasting change in direction for inflation. Below are some of the major trends observed in October along with a forward-looking view of what could be in the pipeline.

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• Goods inflation – Easing supply shortages, lower consumer demand, and excess retailer inventories are all contributing to a sharp slowdown in goods inflation, with prices declining 0.4% month-over-month. The biggest drag came from a drop in used car prices, consistent with the decline in auction prices observed since February. The Manheim index, which tends to lead the CPI used car price index by at least one month, is currently 15% off its high and points to further easing in November¹. Beyond autos, prices for household furnishings, apparel and electronics all declined, helped by lower shipping costs and discounts from retailers that are looking to reduce stockpiles.
• Services inflation – Price increases for services tend to be persistent and slow-moving on the way down but are also starting to shift in the right direction. Housing inflation (shelter) which is the biggest services component and accounts for about a third of the overall CPI index, accelerated from last month, but that was driven by the volatile lodging category (hotel rates). More encouraging, prices for rents slowed for the first time in four months¹. Housing activity and home prices tend to lead the shelter CPI by several quarters. Because both sales and prices have rolled over in response to the spike in borrowing costs, we think that it is just a matter time until they are reflected in the CPI. Elsewhere, October saw a notable decline in medical-care services prices and a drop in airfares. More broadly, as the labor-market tightness and wage growth cool, we expect a further slowdown in services inflation.
• Food and energy inflation – Food inflation remains high, but the food-at-home index posted its smallest monthly increase since December 2021. On the energy front, after three straight monthly declines, gasoline prices exerted some upward pressure on headline inflation last month, though that was partially offset by a decrease in natural gas prices¹. High geopolitical uncertainty makes changes in commodity prices hard to predict. Yet a broad basket of commodities has been mostly range-bound over the past five months and is currently 15% off its June high². Last week China announced the relaxation of some COVID-19 restrictions, reducing the negative impact of its zero-COVID-19 policy on domestic economic activity. With China a major commodity consumer, the gradual reopening of the economy is likely to support commodity prices in the coming months.

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The graph shows inflation for goods and services, with the former dropping and the latter starting to stabilize.

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The bottom line is that we see a sustained path of moderation in inflation next year, though we doubt it will be a straight line. Prices paid for inputs by manufacturing and services firms have historically been good leading indicators of inflation. An average of both measures is consistent with inflation falling below 4% sometime in 2023.

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The graph shows that the prices paid PMI index has historically led inflation by about six months. It is currently consistent with CPI falling below 4% sometime in 2023.

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Cooler inflation gives the Fed room to downshift but not yet pivot

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For the Fed, the deceleration in prices is a welcome development and provides some validation to slow the pace of rate hikes starting next month. After four consecutive 0.75% rate hikes, a slowdown to 0.5% in December seems the most probable move. But we don't expect policymakers to abandon their higher-for-longer narrative just yet. Inflation remains too high for comfort, and officials will want to see several consecutive months of lower readings before considering a pause. The upcoming job reports and inflation releases over the coming months will continue to shift interest-rate expectations, but we think that the Fed will be able to conclude its tightening campaign sometime in the first half of next year once the policy rate reaches 4.75% - 5.00%. While a pause is now in sight, any hopes for a pivot to rate cuts are unlikely to be confirmed anytime soon.

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U-shaped rebound still our base-case scenario

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The better-than-expected data triggered the biggest one-day rally in the S&P 500 since 2020 and the biggest drop in the Treasury yields and the U.S. dollar since 2009¹. As investors and policymakers gain more comfort with the idea that a trend of disinflation is gradually developing, that sentiment can be a catalyst for lower bond yields, an easing in valuation pressures, and the start of a durable recovery. But we don't think a V-shaped recovery is in the cards, and volatility is unlikely to subside soon. Any major easing in financial conditions via higher asset prices and lower borrowing costs would work against the Fed's effort to slow down the economy and bring inflation back to its 2% target. Therefore, a sharp rally in financial markets could be self-limiting in the near term because it could trigger a more hawkish response from the Fed. Still, we think we are in the midst of a bottoming process for the markets, navigating a U-shaped recovery and likely spending most of 2023 in the right-half of the "U".

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Better news for the 60/40 portfolio ahead

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The simultaneous decline in both stocks and bonds this year has generated a lot of talk about the demise of balanced portfolios. The traditional 60/40 portfolio has experienced historic losses and was down 21% at its low last month, matching the decline in 2008, a year of a deep and prolong recession and bear market¹. Because of the inflation overshoot and the Fed's most aggressive tightening cycle in 40 years, bonds have failed to provide the diversification benefit that they have historically provided, smoothing returns during equity-market pullbacks. Our view is that balanced portfolios are not dead, especially as we consider that 1) the inflation tide looks to be turning; 2) yields have reset higher, and as a result, the income component can better offset price declines; 3) the Fed has more work to do but is near the end of its tightening campaign; and 4) there is no strong alternative to serve the same role as bonds. Both equities and bonds are likely to rebound at the same time as we move past the firmest period of inflation. But even if equity-market volatility continues, we think that bonds are now better positioned to help diversify investment risk.

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The graph shows the total return of a traditional 60/40 portfolio of stocks (60% S&P 500) and bonds (40% Bloomberg US Agg). This year's decline is one of the worst on record, matching the 2008 drawdown.

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Looking for better balance between growth and value

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A couple of weeks ago we wrote that at some point in the coming months the focus will shift away from inflation, and if that happens, it should be the catalyst for lower bond yields, a softening U.S. dollar, and improved performance from Big Tech and other growth segments of the market. That dynamic was in full display last week, with the tech-heavy Nasdaq rising 7%, though it is still down 28% for the year¹. Value-style (dividend income) investments continue to have a valuation advantage over growth (capital appreciation) investments. However, incrementally less hawkish central banks, peaking inflation, and peaking bond yields argue for better balance between the two styles in the year ahead.

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Weekly market stats

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Source: Edward Jones

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