Mixed (Inflation) Signals

A late February report we penned began by stating that "mixed signals" were a cornerstone of the current cycle. The focus of the rest of that report was the valuation and earnings backdrop for the stock market. This time, we'll use that same set of words to describe the recent slew of inflation and consumer data, which has—you guessed it—continued to send mixed signals regarding the trajectory of the economy and monetary policy.

The overarching theme as it relates to inflation is that disinflation at the macro/headline level remains intact. The consumer price index (CPI) eased favorably in March, from 6% year-over-year to 5%. Not only that, but momentum has eased across shorter-term horizons.

Shown in the chart below are a handful of "inflation curves" for CPI. Moving from left to right, you can see the different ways changes in the index's level are calculated. What we don't want to see is a pattern like the red line (March 2022), where shorter-term momentum is higher. Fortunately, the most recent curve for March 2023 is mostly downward sloping and has a wide gap between the one-month annualized and year-over-year changes, which suggests momentum has cooled considerably.

That's unfortunately where most of the good news stops. Core CPI was a bit hotter than expected in March, given its annual rate moved up from 5.5% to 5.6%. As shown below, the curve for core CPI is downward sloping, but the annualized gains over a one-, three-, and six-month timeframe are close to each other. Plus, across all timeframes, core CPI is now outpacing headline CPI. That means underlying inflation pressures are not yet abating or getting close to the Fed's goal of 2%. [Caveat: The Federal Reserve's preferred inflation measure is Personal Consumption Expenditures (PCE).]

Nearly all the core pressure is being driven by the services side of the economy, which has been the case for a while. As shown below, core services inflation is outpacing core goods inflation by a significant degree. Interestingly, though, the annual change in core goods inflation ticked up for the first time since summer 2022, while the annual change in core services ticked down for the first time since summer 2021.

The changes are barely noticeable in the grand scheme of things, but one dynamic worth watching in the near term is the potential slowdown in goods disinflation. Should that take hold as services remains sticky, it could keep core inflation elevated for longer. That would clearly present a challenge for the Fed.

Fortunately, there was a much clearer disinflationary (and in some areas, deflationary) tone in the producer price index (PPI) that was released shortly after its consumer counterpart. As you can see in the chart below, the PPI fell by 0.5% month-over-month in March, while the core index fell by 0.1%. That was the largest drop for both series since April 2020 and was also the first time since then that both contracted.

Keeping in mind that the PPI and CPI are constructed differently, it's still worth noting that we are starting to see clearer signs of easing prices in the services sector. As shown below, the finished services component of PPI fell by 0.2% in March, which was the largest drop since April 2020 (there's that month again). One caveat worth noting is that most of the decline was driven by trade and warehousing/transportation. Airline passenger services rose by 1.3%, underscoring the persistent strength in the CPI's airfare component.

Another positive sign within PPI was the finished consumer goods component, with the maximum inflation pressure likely in the rearview mirror. On a three-month annualized basis, growth in consumer goods prices has eased considerably and stayed negative for the second consecutive month in March.

The deceleration in producer price inflation has been a feature of the past year. It correctly led the rolling-over in consumer prices, but the admittedly long lag time is both frustrating and a symptom of how drawn out this inflation cycle has been. We expect disinflation to continue to build across inflation metrics, but are also quick to recognize the fact that stickier components will continue to challenge the Fed, especially if the labor market stays tight.

The famous phrase coined by my (Liz Ann's) first boss and mentor—the late, great Marty Zweig—is certainly getting its workout these days. We'll get to some of the market "fights" that are happening today at the end of this report, but first, a final note on inflation indexes is warranted. Most market participants and Fed watchers are aware of the Fed's 2% inflation goal, and that the central bank is more focused on core measures (which strip out food and energy). However, this current Fed has taken an extra step to home in on core services ex-housing, as that is where officials believe most of the inflation and wage pressure is stemming from.

Thus, many investors cheered the update to the core services less housing component in last week's CPI report. As shown chart below, the year-over-year change has continued to ease from its peak. However, the rub is that the Fed is more focused on the PCE version of core services ex-housing. Its weight is about twice the size of the CPI version, and unfortunately, it's been going in the opposite direction (caveat that the March update for PCE is not yet available).

This all speaks to the nuanced way we should look at inflation data these days. If anything, it is an important reminder that, in the current cycle, there is often a huge difference between what investors think the Fed should do and what the Fed says it's planning to do.

The recent slowdown in key data metrics—be it sentiment or consumer spending—might convince investors that the Fed should stop tightening, but it isn't that simple. Indeed, small business sentiment around credit conditions reversed lower in March per the update from the National Federation of Independent Businesses (NFIB). As shown below, recent stress in the banking system has dented small companies' expectations of better credit conditions in the coming future.

While the Fed expects a tightening in credit conditions to speed up the disinflationary process, it hasn't wavered on its fight against inflation in the here and now. Part of that is due to some officials' fear that inflation expectations might get unanchored in the face of a still-tight labor market. As shown below, some of that fear was confirmed by the huge move higher in year-ahead inflation expectations within April's University of Michigan consumer sentiment update. However, there was no commensurate move higher in long-term inflation expectations (they were unchanged).

Equally as important moving forward—as peak inflation gets further in the rearview—are consumers' expectations for the labor market. This was another sour development in the April sentiment update. As shown below, the share of consumers expecting higher unemployment in a year climbed back to 45%—quite close to levels seen in prior recessions.

Amid several narrative shifts in just the past few months, one consistent theme has emerged: the presence of multiple fights among the Fed, the stock market, and the bond market.

• The bond market is clearly fighting the Fed by pricing in rate cuts later this year.
• The Fed is fighting back by adamantly stating it will keep the fed funds rate at its peak throughout the year.
• The stock market is fighting the Fed as longer-duration/growth segments of the market have been advancing over the past few months (essentially accounting for all gains).
• The Fed is fighting back by banking (no pun intended) on the fact that credit tightening will lead to a weaker economy (and thus further tightening in financial conditions).

Traders have eased back on their expectation that the Fed will cut by an aggressive amount this year, but as shown below, they still don't expect the Fed to stay at the terminal rate for long.

Given the Fed's strong desire to not repeat mistakes of the 1960s/70s—when policy was eased too soon several times, allowing inflation to crawl back out of the bag—we think parts of the market have grown too optimistic in pricing in rate cuts. Any quick pivot to rate cuts would likely only occur in the face of more dire economic/labor market developments and/or a significant worsening of banking system strains. At the outset, that would not be a positive backdrop for risk assets.

We expect volatility to be driven by the push and pull between differing expectations among the Fed and markets, along with a rocky path lower for core measures of inflation. We continue to emphasize a factor-based vs. sector- or style index-based strategy, with an emphasis on quality/short-duration factors, including strong free cash flow, healthy balance sheet, positive earnings revisions, pricing power, and dividend growth. As detailed by our colleague Jeffrey Kleintop, we are also emphasizing global diversification—specifically developed market international stocks.