A personal note. After 40 years in the investment business, I’ve been retired now for more than a year. My last job was a 5-year stint as Chief Investment Strategist at the Leuthold Group. Before that, for 20 years, I was the Chief Investment Strategist at Wells Fargo’s institutional asset management arm. I have thus far enjoyed the slower pace and freedom that retirement allows. A chance to smell the roses a bit and do some things you never seem to have the time for when fully employed. I do, however, still enjoy following the economy and the financial markets – although not nearly as diligently or regularly as I use too – and still have an occasional thought on things. Although I have not published for over a year and have no plans to unretire, I may from time to time, indulge in something I have always enjoyed -- bringing an idea on the economy or the markets to life with some charts and a story. Here is my first installment since retirement. No assurances as to how frequently I will write - other retirement pursuits including just being lazy will likely take precedence. However, I welcome anyone who wants to follow my thinking. My pieces will be available at @Paulsenperspectives.Substack.com and whenever a new one is released, I will post a notice on X at @jimwpaulsen. It’s free for now. Thanks for taking a peek!
The POWER of Disinflation
For many, since October 2022, how the U.S. economy has avoided a recession and why the U.S. stock market continues to rise represent conundrums. The number, magnitude, and variety of serious impediments which have emerged make the ongoing economic and market strength appear miraculous. Numerous well-known and smart CEOs have long called for an imminent recession and stock market strategists have mostly been suggesting caution in the face of such headwinds.
Hurdles to Success
Interest rates have been the most significant weapon unleashed on both the economy and the stock market. The Federal Reserve began one of its most historically aggressive tightening campaigns in March 2022. Since, the Funds rate has been lifted from zero to 5.5%! During the same time, the 10-year Treasury yield has risen from about 2% to over 5% at its peak late last year. And, from its low in the immediate aftermath of the 2020 Pandemic, the U.S. 30-year fixed mortgage rate increased from about 2.5% to a peak above 7.5%! Moreover, these policy actions forced the yield curve into inversion since November 2022. In addition, the Federal Reserve also saw fit to shrink its balance sheet by almost 17% since early 2022. Perhaps this is why the annual growth in the M2 money supply has persistently “contracted” in an unprecedented fashion since November 2022. Considering these restrictive economic policies, it is indeed puzzling how well the economy and the stock market continue to perform.
The economy has also been bombarded by chronic pessimism since the Fed began its inflation-fighting mission. Consumer confidence measures and small and large business confidence have remained stubbornly depressed. Overall, compared to most historical expansions, “animal spirits” remain oddly elusive.
The unemployment rate has remained below 4% since February 2021. Conventionally, once the unemployment rate gets this low, it is a sign the economy is running out of resources and is nearing a recession. Chronic shortages of laborers often hold back productivity and lead to higher wage costs tending to raise recession risks. Indeed, the U.S. expansion has persevered despite 24 consecutive months with unemployment readings below 4%. There have only been two expansions is post-war history which have lasted longer with an unemployment rate persistently below 4%!
This economic recovery has also overcome relatively paltry earnings results. U.S. after-tax corporate profits have declined by slightly more than 4% since mid-2022 while S&P 500 trailing earnings per share is off by almost 11% from its peak in October 2021.
Both the economy and the stock market also continue to battle with the latent negative impacts from the 2021-22 surge in the inflation rate and a current inflation rate which remains stubbornly above target. They have also managed to persevere despite widespread national angst surrounding political strife and the uncertainty of a pending presidential election, outsized, war-time like government deficits (currently about $1.7 trillion which is more than 6% of nominal GDP), global warming concerns, mass shootings, rampart crime, an immigration catastrophe, widespread union strikes, a looming downtown commercial real estate crisis, a highly concentrated leadership in the stock market (the S&P 500 Mag-7) which also appears overvalued based on historical standards, and the financial support provided for and ongoing anxiety associated with two world wars.
The problems which have and continue challenging the country, the economy, and the financial markets do seem numerous and daunting. So why does the economic expansion remain so enduring (real GDP is up by 3.1% in the last year and 3.3% annualized in the last quarter) and the stock market continues plowing northward (S&P 500 recently at a new record high above 5000 and the small cap Russell 2000 is up nearly 18% in the last three months)? The answer, in my view, is because the U.S. is in the midst of a major “disinflationary cycle”.
The “Predictive” Power of Disinflation!
Currently, the Fed, investors, and the media are fixated on the “level” of inflation. However, the level of inflation (e.g., whether it is 2%, 3%, or even 4%) is not nearly as important nor as predictive as is the “direction” of inflation.
As the following charts illustrate, regardless of the level of inflation, “disinflation” (for our purposes defined as a decline in the trailing 12-month inflation rate compared to what it was a year earlier) has historically had a powerfully positive impact on both economic results and financial market health. And perhaps more importantly, it is “predictive” of future economic and financial market results. That is, as shown by the charts below, disinflation during the “previous year” has typically led to superior economic results and healthy financial market returns in the “ensuing year”. A rising inflation rate in the last 12-months has historically led to a disappointing economy and subpar financial returns in the coming 12-months. By contrast, when the inflation rate has moderated in the previous 12-months, economic results and stock and bond performance have usually been superior in the coming 12-months. History suggests investors do not need to predict disinflation to position for success. Rather, if disinflation has been in force during the last year, odds favor both stock market and bond market success in the coming year.
Disinflation – Perhaps the “Most” Powerful Positive Force
We often believe monetary and fiscal policy are powerful and overwhelming forces impacting the economy and the financial markets. But this analysis suggests there is little that is more impactful than inflation or disinflation.
As shown in chart 1, since 1949, the annual average ensuing 4-quarter real GDP growth is nearly 50% stronger (3.8% vs. 2.6%) in the coming year after a past year of disinflation than it is after a year when inflation accelerated. Part of the outsized gain in real GDP growth “after” a year of disinflation, is because productivity tends to be much stronger in post-disinflation years than after years of rising inflation (i.e., chart 2 shows productivity rising by 2.4% after disinflationary years compared to only 1.8% after rising inflation years).
Chart 3 demonstrates that, on average, a year of rising inflation tends to be followed by a year of significantly weak job creation (i.e., only 0.3%). However, after a disinflationary year, job creation in the coming year is typically very healthy (i.e., 2.0%).
As shown in chart 4, consumer confidence in the coming year is also dramatically altered by what inflation has done in the last year. Perhaps confidence is boosted after a year of disinflation (i.e., it rises by an average of 8% in the years following disinflation compared to a decline on average of -17.6% after a year of rising inflation) because job creation is healthier, real wages typically rise, or maybe because prices at the pump typically decline after a year of disinflation.
Chart 5 highlights a major boost for the stock market after a year of disinflation – much improved earnings! Since 1950, trailing S&P 500 EPS rise on average by 23.8% in years following an annual decline in the inflation rate compared to only 4.2% average gains in years following a rise in the inflation rate.
Finally, disinflation years have historically been followed by stellar results in the ensuing year for both stocks and bonds (charts 6 and 7). Since 1949, disinflation in the previous 12-months has been followed by an average S&P 500 Index gain in the next 12 months of 11.6% compared to only a 6.8% gain after a rise in the inflation rate. And, a year of disinflation has been followed on average by a 14.6 basis point decline in the 10-year Treasury Bond Yield whereas year of rising inflation has been followed by an average 17.3 basis point rise in bond yields.
Concluding Comments
As of January 2024, the trailing annual CPI inflation rate is 3.1% compared to a trailing annual rate of 6.4% a year earlier. Based on how we have defined disinflationary periods (a decline in the trailing 12-month inflation rate from the same rate a year earlier), the U.S. has been enjoying “disinflation” since December 2022 and will likely remain in this trend yet for several more months.
Disinflation does not guarantee a healthy economy and solid financial market results in the coming year, but history suggests the odds are strongly biased in this direction. So, stop worrying as much about an imminent recession, a pending stock market collapse, or a surge in bond yields. Any or all of these bad outcomes could of course happen, but “disinflation” has historically been a gift for the economy and the financial markets which should not be underappreciated.
Try not to get overly concerned about whether the Fed will cut rates in March, May, or August. Or get too obsessed with potential bad outcomes from the inverted yield curve, large public deficits, the pending presidential election, or the ongoing Russian and Israeli wars.
Why, when facing so many significant headwinds, has the economy and the stock market both performed far better than feared in the last year? The answer is probably like the old political adage, “It’s Disinflation Stupid!” Disinflation won’t be here forever, but it is now. So, rather than worrying about when it will finally end, focus on its “predictive historical relationship” and, for now, embrace the ongoing economic recovery and stay bullish on both stocks and bonds.
Thanks for taking a peek!!!
Jim P
Disclosures__________________________________________________________________
Please note that stocks are inherently risky. Any stock can lose most of its value at any moment, including any stock I mention here. You should never rely on a single source for investment decisions, including me. I am a retired investment strategist offering opinions and observations on the markets, the economy and companies. You should do your own research, and also consult a qualified financial planner and investment advisor before making investment decisions.
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Great to hear from your....big follower when you were at Wells....look forward to more.