Journeying Down the Disinflation Road
In February, stock market volatility rose as interest rates moved higher. Short-term rates continued to advance due to the interest rate policies directed by the Federal Reserve (Fed). In only twelve months, the Fed raised the federal funds rate from practically zero to almost five percent. As most investors know by now, the past increases are significant, especially when considering the speed at which the Fed took action. Further, these new interest rates can raise uncertainty both financially and emotionally.
Short-term interest rates are rising and chasing prices in the economy. Higher short-term rates generally make borrowing in the economy more expensive, from credit cards and new mortgages to corporate debt. Overhead expenses for companies financing labor and material using short-term debt will also increase. Naturally, market conditions during rising interest rate environments can sour economic demand and bring on disinflation as supply responds to weaker demand. Unfortunately, losing aggregate demand to higher short-term rates can slow economic and financial growth.
After January's strong rebound in stocks, investors became more nervous in February, considering the Fed's interest rate hike pause may be farther away than initially anticipated. February's inflation data may have contributed to slowing this market down. Consumer price increases slowed less than expected, and prices tracked in personal consumption expenditures, the Fed's preferred inflation index, accelerated last month. This data rippled through the markets and likely signaled that the Fed's job as a rate hiker and inflation fighter isn't yet complete.
The inflation problem and the interest rate response have produced a negative gap between long-term and short-term yields. As a result, on an annualized basis, long-term yields earn considerably less than short-term yields. This inverted yield curve creates an investing paradox requiring probabilistic weightings of two extremes. On the one hand, if disinflation settles in quickly, short-term rates can move down and find long-term rates. On the other hand, price increases stubbornly stuck above the Fed's inflation target could mean long-term rates rise to meet short-term. In reality, the future yield curve outcome could be a combination of those two extremes, but the path to get there faces uncertainty.
One area of focus regarding the stock market is the future of company earnings. Corporate earnings declined in 2022 compared to 2021. Profits were down due to slower revenue gains and higher input costs. As a result, profit margins narrowed last year, but the stock market declined in advance of the earnings reports, which is common. But the past is now old news, and investors are more interested in what 2023 will bring for earnings. Current forecasts indicate earnings will grow in 2023 as companies cut expenses and expand profit margins. A meaningful year of growth makes a compelling case for investors to demand stocks. However, expectations regarding the future are always subject to change, and investors will never escape the chance that earnings may stall and slow. Regardless, stock prices actively seek to forecast the future of earnings and profit growth rates.
The Fed is addressing inflation with higher interest rates in the short run, but the long run plan to maintain low inflation and economic vibrancy likely comes from technological gains and a growing working population. Thankfully, capitalism is pushing the limits of science in fields such as genomics, space travel, nuclear fusion, augmented realities, and artificial intelligence. These technologies can lead to discoveries that can improve lives and reduce costs in a variety of ways. Regardless, stock market volatility can rise and fall for many reasons, which can result in uncertainty and behavioral responses by investors. But stocks perform positively more frequently than they do negatively, and long-term stock investors are generally rewarded with appropriate returns relative to the level of risk. We encourage continued communication on each investor's unique time horizon, risk tolerance, liquidity needs, and various other factors, as those characteristics should ultimately dictate the specific investment mix.
