Yields Rising, Inflation Falling

For anyone having had an economics class in school, you were likely taught the negative relationship between inflation and unemployment. This is known as the Phillips Curve. As illustrated below, the negative correlation of labor and price trends has a strong track record. The surging inflation (CPI) to 40-year highs in 2021 and 2022 did indeed correlate with plunging unemployment, yet after 12 months of falling CPI, unemployment has not risen as most expected. Has the Phillips Curve broken down or merely been delayed? That is the multi-trillion-dollar question. What adherents fail to understand is the degree of stimulus already allocated to the budgeting pipeline combined with aging demographics that require above normal monetary tightening to cause unemployment. The Fed can wake up the Phillips Curve by draining bank reserves faster and hiking bank lending rates much higher to create a major economic contraction and panic. However, we expect the Fed to continue their astute measured approach until the Phillips Curve reveals either normalized inflation or higher unemployment. This 65-year-old economic model works, but let’s hope the Central Bank doesn’t try too hard to push unemployment higher.

In 2023 we stayed optimistic about the economy, yet virtually all forecasters expected the US economy to be in an economic contraction with rising unemployment during 2023. Not only has the economy failed to slow, but it’s accelerating, and labor markets remain stuck at full employment with an enormous 9.6 million unfilled job openings. Retail Sales today, led by restaurants and bars, were reported well above expectations. The Atlanta Fed’s new 5.4% GDP estimate for Q3 would be extraordinarily hot if confirmed. Core Personal consumption spending grew over $4 trillion this past year. This is down from the $5.6 trillion the previous year, but still far above the $2 to $3 trillion a year growth that the Fed needs to see in order to stop tightening credit. This data will keep the Fed on inflation watch with higher for longer short-term rates. 

The stronger economy and recent rise in gasoline prices caused an uptick in consumer expectations of higher inflation last month. The Fed needs this consumer mindset to continue below 3%.

Headline inflation did move back up in September, but core CPI less food and energy continued in a straight line lower. It’s still far from the 2% target, but by the summer of 2024 the CPI is on track for a 2% handle.

Consumer spending and inflation over the past 3 months have returned to the high side of “normal”. If this trend continues into 2024, while unemployment remains below 4.5%, then the Fed will be applauded for the first ever economic “soft landing”.

Large cap tech and industrial stocks continue to be the main beneficiaries in this environment, however the big investment shift for 2024 will be equities sensitive to falling interest rates. Small cap, utility, real estate, bonds and select laggards in healthcare will shine.

October stock market update: The early October low arrived as forecast and was confirmed by heavy put option buying that signaled overly negative trader sentiment. Despite the caveat emptor warning due to an escalating war surrounding Gaza, the equity market trend should otherwise continue higher into November with a strong earnings season ahead and a continued pause in Fed rate hikes.

 

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