By Tim Courtney, Chief Investment Officer

Over the past several weeks, most of the price movements we've seen in markets have been based on the assumption that the Federal Reserve will cut interest rates. The catalyst for this sentiment was the latest inflation report released in mid-May that indicated a slight reduction in inflation¹, sparking enthusiasm in the market. Consequently, prices for almost everything increased—stocks, bonds, real estate and even commodities.²

However, we still have the sticky issue of inflation not going away. It is stubbornly holding above the Fed’s 2% target despite the initial assessment that inflation would be transitory and caused by supply chain problems. If the bulk of our inflation was due to supply chains, we should have expected to see deflation as supply chains were amended. Inflation stands 20% higher overall than a few years ago, and while it is decelerating, it still builds on that 20%.³

Outside of the supply chain issues, there are several factors contributing to increased prices: changes and shortages in labor markets, fewer hours worked, reshoring of manufacturing and an increased liquidity and money supply. Some have also suggested that companies are keeping prices high and padding their profits through collusion and anti-competitive practices. Earnings have followed GDP higher and both measures are expected to reach record levels this year, but S&P* profit margins are lower in 2023/2024 (11.7%) than they were in 2021 (13.5%).⁴

There is more discussion about whether the Fed should raise its standard inflation target from 2% to 3% or higher. Raising interest rates no doubt helped bring inflation down to the current 3%+ level, but bringing inflation down that “final mile” to 2% could require pain from higher rates, higher unemployment and perhaps a recession. Suppose inflation remains elevated either in spite of or because of our monetary policy. In that case, we should expect interest rates to remain higher than the rates from 2009 – 2022, to which the market became accustomed. All else being equal, higher rates should affect different assets in different ways.

For bonds, higher rates should help future expected returns and better protect against inflation risk. Bonds wouldn’t have the tailwind of falling interest rates to boost near-term returns, but neither would they be in the weak position they were in during 2021, where a 10-year treasury will pay a flat, measly 1.5% for a decade in which inflation is expected to average 2.75%.⁵

Real estate, especially commercial real estate, would likely continue to have headwinds with higher rates as these properties are purchased using leverage and borrowings, which would be more costly.⁶ This is also true for other strategies that routinely rely on leverage. 

Historically, 3% - 5% inflation and corresponding interest rates have had little effect on real stock returns. Over the last century, this level of inflation has, on average, produced roughly the same real returns for stocks as compared to average returns under all inflation levels. Stocks have traditionally fared worst under deflation and when inflation is greater than 5% (see 2022).⁷

If inflation remains above 3% and interest rates are higher for longer as well, markets can still produce reasonable returns for diversified investors. The inflation itself poses other risks, and we must account for the inflation in our cash flow, withdrawal and estate planning. If you have any questions, please reach out to your Exencial advisor.

Sources: 

1. The Bureau of Labor Statistics (5/15/24) — Consumer Price Index
2. The New York Times (5/15/24) — The Stock Market Is Back in Rally Mode
3. Bankrate (5/15/24) — What is inflation? Here’s how rising prices can erode your purchasing power
4. Standard and Poors (6/4/24) – S&P 500 Earnings and Estimate Report
5. The Wall Street Journal (5/29/24) — Two-Year U.S. Treasury Yields Expected to Stay Around 5% After Latest Rise
6. Business Insider (2/16/24) — Commercial real estate is in big trouble — and the problems may have major financial fallout
7. Exencial Study (1927-2020) – Inflation and Market Returns: 36 Month Average Real Returns, data from DFA Returns and Morningstar

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The S&P 500® Index (S&P 500®) is widely regarded as the best single gauge of large-cap U.S. equities. The index includes 500 leading companies and covers approximately 80% of available market capitalization.