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August Monthly Update

By Thomas O. Herrick
Chief Investment Officer, Managing Director

Epic dis-inflation. That is the short answer regarding what has been driving markets since last October.

Both equities and bonds typically bottom at inflation peaks, responding to the DIRECTION of inflation. The last time headline inflation fell by more than 6% from over 9% in 12 months was in 1952. As a recap, headline CPI peaked in June 2022 at 9.1% and printed an annual increase of 3% in June of this year. Core CPI peaked later in the fall, the pivot point for equities. The S&P 500 Index has gained 29.82% since last October. The same trend in headline is evident in core. While the Fed policy committee has continued its Fed-funds-rate-raise campaign, going from zero to 5 ¼% over the last 18 months, the market reflects that this campaign is in the 25th mile of its marathon. Equity markets hate higher rates as those rates feed directly into lower valuations. Consequently, an end to this campaign is crucial, and the data to which the Fed ultimately reacts is inflation.

From a market perspective, the inflation dynamic has resulted in entirely opposite performance characteristics from 2022. Not only are equities higher in 2023 as opposed to 2022’s decline, but growth issues have gone from laggard to leadership within the market. The Russell Large Cap Growth Index is up 33.17% versus the Russell Large Cap Value Index, which is up 8.49%. Given the performance dispersion, exposure to the growth side of the market has been vital this year. Growth stocks typically react positively to a lower inflation dynamic that leads to lower rates. They are long-duration equities, companies with solid prospects over a longer time frame. Growth stocks have been very sensitive to rate increases and struggled mightily last year as Fed funds came off the zero mark. Since October, they have been potent performers due to the same rationale as inflation has trended lower, setting the stage for an end to rate hikes.

We have published a lot on inflation over the last two years. The commonality within those publications is referencing money as the primary driver of inflation. Massive money supply growth led inflation by around 12 months to the upside, and negative M2 growth is leading it with the same lag to the downside. M2 growth peaked in Q1 2022 and has been negative since late last year. Negative money supply growth has not been seen since data collection began in 1959. Consequently, we continue to see higher odds of below-expectation CPI prints. Further supporting this viewpoint is the lagging shelter data within CPI, which accounts for 70% of the June MOM increase. If the Bureau of Labor Statistics used real-time data in its calculations, the current CPI would be close to its 2% target. The shelter catch-up will be a second-half tailwind for lower-than-expected CPI. We would also add one additional support over the remainder of 2023—base effect on core CPI. Keep in mind core did not peak until last fall; consequently, comparisons will be relatively easy for core over the next quarter or two.

Stocks are in a solid uptrend with very good momentum. They are ahead of themselves short-term from time to time, but these are buyable pullbacks, in our opinion. The timeliest support to equities is the much-improved breadth and participation that began about Memorial Day. The very narrow market we saw for two or three months before that point is history. Breakouts of breadth proxies, such as the advance-decline line, have been decisive. Economic growth remains solid, with no sign yet of what was touted as the most forecast recession of all time. So far, this recession looks a lot like Sasquatch.

Many economists are obsessed with labor market strength and continue forecasting rate hike damage leading to recession. We don’t have a viewpoint on recession, but it is noteworthy that only 11% of US consumer household debt is exposed to variable rates. Most of America is locked in at sub 3-4% mortgage and auto loans. Markets often bottom out early in recessions, but that is due to inflation typically peaking at that point. Within the current cycle, inflation peaked well before any potential recession. We are focusing on what is moving markets, such as continued improvement in monthly CPI data, which feeds into improved odds of the rate hike campaign ending.

The narrow market is history.

Cumulative advance-decline line graph of NYSE stocks shows dis-inflation.

Source: Fairlead Strategies


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Any opinions expressed here are those of the authors, and such statements or opinions do not necessarily represent the opinions of Cary Street Partners. These are statements of judgment as of a certain date and are subject to future change without notice. Future predictions are subject to certain risks and uncertainties, which could cause actual results to differ from those currently anticipated or projected.

These materials are furnished for informational and illustrative purposes only, to provide investors with an update on financial market conditions. The description of certain aspects of the market herein is a condensed summary only. The source of certain market data is Bloomberg. Materials have been compiled from sources believed to be reliable; however, Cary Street Partners does not guarantee the accuracy or completeness of the information presented. Such information is not intended to be complete or to constitute all the information necessary to evaluate adequately the consequences of investing in any securities, financial instruments, or strategies described herein.

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