Lower Inflation

The capital markets have been hyper focused on inflation for the past three years. Since the end of 2022, the inflation rate has been steadily dropping, and that has been good for the markets. That trend continued during the third quarter of this year with overall PCE (personal consumption expenditures) increasing at an annual rate of 2.2%, the lowest annualized increase since February of 2021. Both stock and bond investors benefited from this as both markets posted solid gains for the quarter.

We have spoken about this before, but it is worth repeating. The mandate of the Federal Reserve is to create conditions that will allow the economy to grow while at the same time keeping price stability, or low inflation. The Fed was reluctant to raise rates as we were coming out of the economic calamity of the pandemic fearing higher rates would cause a recession. The result of keeping rates near zero while the global economy came roaring back was high inflation. The Fed has admitted they kept rates too low for too long. Since inflation has been low for many years (it peaked more than 40 years ago) most people were caught off guard and were unprepared for the damage it creates. The resulting sell off in stocks and bonds was definitely a wake up call.

To their credit, the Fed has seemingly made the right decisions since then. The inflation rate has dropped to near the Fed’s 2% target, and they have done it while the economy continues to grow. The Fed cut rates during the third quarter with a 50 basis point cut, larger than most people were expecting. Markets rallied as a result. Low interest rates are good for both stock and bond investors and a low interest rate environment is the best condition for the economy to do well. It is unlikely we will see rates back to near zero, but we believe they will drop to the 2.0-2.5% range on the short end of the yield curve.

While economic conditions have improved, it is important to note that there are still issues that can derail economic conditions. European and Middle Eastern wars are always disruptive and have the ability to spread. It is also possible that the Fed has miscalculated conditions and we could fall into an economic recession. We think this is unlikely, but it can’t be ruled out. Consumers have very high levels of debt, which can lead to rapid spending cuts and high bankruptcies. Stocks are trading at high valuations, which can lead to larger than normal drops.

As long as we see strong GDP growth and low inflation, investors should continue to be rewarded. Unforeseen events happen, so there will always be bumps in the road, but we are cautiously optimistic that this year will end on a high note.

Wabash Capital