Market Performance During Periods of Falling CPI
As I listened to Powell outline the Fed’s Policy Statement and answer questions during their press conference following the meeting in late July, my main two take-aways were:
1. The resolve of the Fed to give up on its dual mandate and explicitly state their sole effort was to focus on maintaining price stability, with a willingness to sacrifice employment and growth.
2. Powell’s humility about how their efforts would play out from here, which led them to decide to move future actions to being data dependent.
If we focus on these two observations, our conclusions are: CPI is headed lower (don’t fight the Fed), and we don’t know what it means for the economy (but if it’s that employment and growth are destined to move lower, that seems to be fine with the Fed).
With this as the backdrop, we decided to look at periods where inflation was falling rapidly and see what that meant for market performance in the coming year. We found reasons that substantiated the Fed’s humility. We went back to 1970 and looked for periods where CPI fell by more than 1.50% from levels six months prior. We’ll call these periods “high velocity falling CPI periods.” This doesn’t exactly capture our current situation because CPI has yet to fully enter a high velocity falling period, but it captures the most recent directional movement. Much of our research is conducted based on trying to understand trajectories rather than simply absolute levels, so we are really interested in vectors, such as velocity and acceleration.
We found twelve periods since 1970 where CPI had dropped 1.50% from levels six months prior (high velocity falling CPI periods). Likely one of the reasons for the Fed’s humility is that exactly 50% of these periods were associated with recessions. It’s hard to draw conclusions when the data says you have a 50/50 chance. Some observations about the data:
1. Six periods out of twelve where CPI fell at a high velocity (50% of the time) the economy slipped into a recession.
2. The last period where interest rates were rising into high velocity falling CPI were in 1980 and 1975.
3. In the last decade, high velocity CPI periods were associated with no changes to Fed Funds Rates.
4. Post 1980, in all instances, when CPI was falling at a high velocity, rates were either stable or falling.
5. In the last 20 years high velocity falling CPI has been associated with lower-than-average equity returns over the following twelve months.
6. The major differentiator in expected returns over the sample period was the relationship between falling CPI and recessions. If there was a recession, twelve-month forward returns had a high probability of producing negative returns.
7. The period before 2000 presents challenges to draw analogies because the interest rate environment was dramatically different at the beginning of the period which led to a different set of dynamics and possible outcomes.
Tying this analysis in with the Fed’s statements, our conclusion is that we are in uncharted waters. The last time the Fed raised interest rates while CPI was falling was over 40 years ago, in a world with entirely different interest rate dynamics because debt levels were so much lower. The Fed’s guidance was that they feel there is a path to a soft landing, which would be consistent with higher markets, with lower intermediate-term returns, but are uncertain if it’s possible because if the higher rate environment tips the economy into recession, the path for equities is likely lower.
There are two likely scenarios that may unfold from here:
1. The Fed raises rates sufficiently high at a forceful pace to tamp down inflation and inflation expectations. This case brings with it a high probability of severe slowdown.
2. The Fed backs off the pace of rate hikes and takes a “wait and see” approach, which elongates the period for inflation to cool down to their desired range. This is the soft-landing scenario and would likely be associated with a period of higher nominal GDP growth, but weaker real GDP growth, providing a reasonable environment for equity returns.
We don’t know which route the Fed will ultimately choose. We do know that Powell wants his name associated with Volcker, the legendary slayer of inflation, not Burns, who wears the title of the Fed Chair that let inflation get entrenched, which points to scenario 1. As long as inflation is moving lower, Powell has a chance of capturing the title as an inflation slayer and the equity markets will remain optimistic about attaining the second scenario. However, there will be periods in the coming months where inflation will come in hotter than expected, which will drive investors towards worrying we are headed for the first scenario. The oscillation between conviction in these two views is likely to keep the markets trading with a floor and ceiling and caught in a trading range. If we continue to see inflationary data improve at a steady and uninterrupted pace, it may signal that the second scenario is solidifying, which could provide a catalyst to break out of the trading range on the upside.