2023 Year-End Outlook and the Grind Down to 2% Inflation

The US economy chugged along through the summer, with the sub-4% unemployment indicating little strain in the labor market and corporate earnings holding steady. The inflation rate has climbed since June from 3.1% to 3.7%, but considering the annual inflation rate for the US was at 8.9% last summer, there has been a lot of progress.

Many investment professionals, including us, have long expected the battle against rising prices to become more grinding as inflation approaches 2%. In other words, bringing inflation from 8.9% to 4%, especially when much of the inflation is caused by short-term spikes in energy prices (as it was in 2022), should be easier than bringing inflation from 4% to 2%. The reasoning behind this is twofold: the money supply tends to expand on a long-term basis in a fiat-currency system, and this often causes slight but persistent inflationary pressures over the long run . The second reason is related to the cost of housing, which represents one-third of the weighting of the consumer price index (CPI) – the most widely followed gauge for inflation in the US. Housing and rent inflation have proven especially “sticky” in recent years as Americans continue to struggle with a shortage of housing units and only trickles of new, affordable supply. Rent and housing prices will need to be tamed before inflation returns to the Fed’s 2% target.

Chart going back to 1955 plotting the annual inflation rate for shelter (rent/housing) in the United States

Source: Bureau of Labor Statistics

The Fed’s Economic & Inflation Outlook – Close but Not Done Yet

The Federal Reserve published their latest Summary of Economic Projections on September 20th. They see a strong labor market going into 2024, no recession (our data still suggests elevated risk of a slowdown), and above-target inflation. To bring inflation down to the Federal Reserve’s 2% long-run target, they indicated there would be no interest rate cuts this year, two or three in 2024, and more in 2025 and 2026. Below is their widely followed “dot plot” in which various Federal Reserve leaders indicate where they expect interest rates to be over the next several years.

Chart of the Federal Reserve's dot plot from their September 2023 Summary of Economic Projections which indicates the expected path of interest rates over the next several years.

Elevated interest rates through 2024 mean continued high costs of borrowing (things like mortgages, car loans, and credit cards) but also higher interest rates for savers and bond investors. Similarly, higher rates can place strain on corporate profitability, especially among small companies which heavily rely on borrowing for business funding—our outlook on these companies remains negative.

Will We See an Inflation Resurgence Anytime Soon?

Inflation has steadily declined from its June 2022 peak of 8.9% to its latest reading of just 3.7%, which is very encouraging. Still, it’s prudent to be aware of potential risks which could spark a new trend in higher prices of goods and services. Below are a few items we’re monitoring:

  • United Auto Workers (UAW) strikes: The price of used cars peaked in January 2022 (and has declined 9.4% since), while the price of new cars continues to plod higher. Inflation may tick higher for both items depending on the duration and spread of recent strikes, but we expect the effects to be localized and not migrate to prices of other goods/services.
  • Another economic stimulus package: While the split House and Senate make the likelihood of passing such a measure low, another economic stimulus package like the American Rescue Plan could cause a spike in aggregate economic demand and spark a renewed surge in inflation. Again, we place a low probability of this happening.
  • Rising crude oil prices:  On the heels of conflict in the Middle East and higher demand, the price of oil is close to its highest level in a year. Moving in lockstep, the average price of regular-grade gasoline recently hit a multi-month high of $3.84/gallon (US Energy Information Administration data).  We can expect gasoline to cross above $4/gallon, a level which has historically caused economic strain in the U.S., should recent violence spread to oil-producing nations such as Iran, Iraq, and Saudi Arabia.
Chart of the average gas price across the United States from 2018 through September 2023.  The current average price for gasoline is $3.84

Source: Energy Information Administration

Thankfully, there are many seasonal factors which could help mitigate any potential spikes in oil and gasoline prices over the next several months. Some of these factors include:

  • People driving less during winter
  • Cost of summer-blend vs. winter-blend fuel
  • Fewer heat waves/severe weather events to knock out refinery capacity

We’ll be monitoring geopolitical events closely and be flexible to make portfolio adjustments as necessary.

Back to Markets – Year-End Volatility Appears Likely

“Technical analysis” is a method of investment analysis that focuses on the market itself, rather than the forces which may drive it (economic growth, earnings, interest rates, etc.). It tends to be more useful for shorter-term forecasting rather than longer-term projections, and a current technical analysis of the stock market suggests stocks could be in for some volatility through the fourth quarter.

“Breadth analysis,” which falls under the broad category of technical analysis, looks at how many stocks are rising or falling at a given time. One of its main tenets is that the stock trends of small, economically sensitive companies tend to lead larger, more stalwart companies (e.g., Apple, Procter & Gamble, Walmart, etc.). Therefore, when small companies are leading the market lower, as they are now, it can be indicative of market vulnerability that could spread to larger company stocks.

One way to observe the general weakness among smaller companies is to look at a small-cap stock index, such as the Russell 2000 Index. This index was chopping its way slightly higher since last summer but has traced out a reversal pattern called a “head & shoulders top” over the last three months, which may suggest new lows for the index through year-end. Below is a chart of a popular index fund which follows the Russell 2000.

Chart of the small cap Russell 2000 index and the "head & shoulders" reversal pattern which formed between June and September 2023.

This is an example of a technical analysis “chart pattern,” and different patterns have different levels of reliability. Statistician Thomas Bulkowski conducted analysis on this pattern and indicated that 81% of these patterns across thousands of stocks resulted in a decline of 5% or more, and the average stock in the study fell 16%. Chart patterns aren’t perfect, but they at least indicate a potential downward bias for small- and, likely, large-cap stocks going into the fourth quarter.

Final Thoughts: Taking Longer than Expected, but Still Cautious

It’s been over a year since our suite of leading economic and stock market indicators suggested a potential economic slowdown on the horizon. Our data-driven process continues to suggest merit to a conservative investment approach. Some of the indicators which are currently suggesting caution include data on business order flow, survey data on business inventories, and the general costs of borrowing. Whatever the market and economy have in store for us through year-end and 2024, we will be prepared and put our best work into growing and protecting your wealth.

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