Contributors

Madison Faller

Global Investment Strategist

Déjà vu? Another hot inflation print rattled markets this week.

Both stocks and bonds struggled as traders slashed their rate cut bets – to just 40 basis points (bps) worth of cuts this year, or less than two moves, versus 60 bps before the print and more than 100 bps a month ago.

We continue to believe the Fed will be able to cut in 2024, but if we’re wrong and the Fed keeps rates where they are, it’s worth exploring why we think this year can still shape up to be a good one for investors. Here’s why.

Inflation: It isn’t 2022 anymore

Across all measures, Consumer Price Index (CPI) inflation came in hotter than Street expectations for a third straight month in March. Headline prices rose +3.5% over the last year, with shelter and gas accounting for over half of the rise. The core measure also accelerated 3.8% on the year, with a notable surge in auto insurance costs.

This line graph shows year-over-year U.S. CPI inflation.

Inflation data may still be stubborn for the next few months, but it’s worth noting that the drivers propping up inflation are very different today than they were in 2022.

Back then, price increases were both super-hot and broad-based, forcing the Fed’s hand to hike again and again. Energy prices – and by extension fuel costs – were at their highest in nearly a decade. Goods prices were starting to come off the boil, but services inflation was just heating up. Shelter inflation hadn’t even peaked yet. To make matters worse, a historic supply and demand mismatch in the labor market (with more than two open jobs for every unemployed American) was sending wages higher at the same time.

Today, the picture looks much different. Goods prices look controlled, and have been outright falling (or deflating) for the better part of the year. Shelter inflation is still artificially high, but has already peaked and should continue falling. Last week’s jobs report showed that wage gains are back in line with the pre-pandemic trend, as the biggest immigration surge in 100 years has dramatically rebalanced the labor market (with now just 1.4 open jobs for every unemployed person). In turn, related services price categories such as travel are decelerating. And while energy costs are the wildcard and oil may see further spikes, higher prices should encourage increased supply (especially from the United States).

Finally, it’s worth noting that the Fed’s preferred measure of inflation – Personal Consumption Expenditures Price Index (PCE) – continues to run at a slower clip than CPI. Accounting for this week’s CPI and Producer Price Index (PPI) prints, which offer inputs into PCE, the core measure is tracking at a +0.27% monthly pace and a +2.7% annual pace. If that proves accurate later this month, Q1 would continue the trend of lower inflation this year.

This line graph shows measures of U.S. inflation on a year-over-year basis.

If the Fed doesn’t cut this year, the “why” matters most

It was exceptionally painful for investors in 2022 because ever-higher inflation created a constant guessing game around how much the Fed would hike and when it would stop. While there’s still uncertainty around the “last mile” of progress for stubborn and sticky price pressures today, most Fed members now agree that policy rates are high enough – and the next move should be a cut. This means today’s debate is just about how many cuts we might see, and when they’ll start.

Yet the risk still stands that such cuts get pushed out even further than the September/November start expected today by markets. If that’s the case, the rationale for this delay is critical.

If the Fed is on hold because growth is good and it’s just taking longer to get inflation back to its 2% target, this is still a constructive backdrop for corporate earnings and, by extension, equity markets. Yet if we stay in suspension because policymakers have again lost the plot on inflation with prices reaccelerating and the Fed forced to consider hikes – it would be a more problematic outcome.

Good growth usually means a good backdrop for investing

A moderate-but-elevated inflation environment tends to signal a constructive backdrop for corporate profits to power stocks higher. Looking at history (from 1950 to 2022), the S&P 500 has averaged an 8.5% year-ahead return when headline CPI is running at a 3–5% annual pace (where we stand right now) – and that return increases to 13.8% when CPI falls to a 2–3% range (which we could still see this year).

This bar graph shows the average S&P 500 one-year rolling returns in different U.S. inflation regimes from 1950-2022.

Recession risks are relatively low, profit margins are wide and this upcoming earnings season should add confidence that profit growth is set to accelerate further.

The backdrop for bonds is more challenging (U.S. core bonds are down more than 2.5% so far this year), but today’s current yields embed a meaningful cushion against further rate spikes. If we saw yields surge another 50 bps from yesterday’s levels, both 2-year and 10-year Treasury yields would still have a positive return a year from now. In fact, such elevated levels mean that hypothetical returns across a number of potential rate move scenarios are asymmetrically skewed to the upside.

This bar graph shows the illustrative 12-month forward returns based on a change in yield

In the end, steady hands often prevail

Predicting where the market might be headed can be complex and overwhelming, but the real key to investing can be as simple as having perspective and sticking to your plan. As we build portfolios to protect and build wealth across cycles and a range of economic scenarios, different tools in your toolkit can work for you in different ways.

Despite pullbacks, stock markets have rewarded long-term investors. Even in a year that could see Fed rate cuts kept further at bay, we think earnings will offer meaningful support. While bonds might not have the blockbuster year some were hoping for, investors can still rely on the asset class to be the ballast to their portfolios in the event of a downturn. Investors should also consider exploring real assets as a more effective hedge against inflation risks than cash.

Your J.P. Morgan team is here to discuss what this means for you and your portfolio.

All market and economic data as of 04/12/2024 are sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

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