Economic and Market Environment

Who Is Winning?

• The Fed has made clear its intentions: raise interest rates and leave them high long enough to return inflation to the target of 2%.
• The above chart indicates that monetary policy is now in restrictive territory and should be impacting overall demand.
• Latest projections indicate that the process is likely to be elongated, with normal policy not returning until 2025.
• We believe the Fed is committed to its goal. Inflation is such a serious economic problem that the Fed is willing to accept a recession in order to achieve its inflation goal.

• Amidst all of the attention on the federal funds increases, it is easy to forget about the Fed’s other tool: quantitative tightening.
• Quantitative tightening is designed to tighten financial conditions and contribute to a slowdown in aggregate demand, the Fed’s goal in reducing inflation.
• After aggressively expanding its balance sheet for Covid stimulus, the Fed is now in restrictive mode as it lets $90 billion in U.S. treasury issues mature monthly without reinvestment.

• After painful and sustained increases in inflation in 2021 and 2022, we are now seeing some reductions.
• Headline inflation peaked at 9% year-over-year in July. It has now retreated to 7.1%. Core inflation (ex. food and energy) has been stickier.
• The good news: headline inflation is declining. The bad news: we are still a long way from 2% inflation.
• It may be safe to at least assume that inflation has peaked and should continue its long decline towards 2%.

• Shelter inflation, encompassing both rental and owned homes, is a large component of the inflation indexes.
• Because changes are measured year-over-year, the trend changes gradually.
• Zillow apartment rents as measured currently are falling rapidly. It is only a matter of time before this shows up in shelter inflation. This is good news.
• This chart indicates that this major component should show significant improvement in the months ahead.

• More good news: gasoline prices are now lower than one year ago.
• This is important to consumers as a pocket book issue but perhaps more important as a psychological issue that affects overall consumer confidence.
• This good news could be fleeting. Oil supply is still constrained, and the Russia/Ukraine war threatens further supply restrictions.
• Longer term, oil prices are likely to be under pressure as alternative energy sources become cheaper.

• Supply side disruptions have been one of the major causes of high inflation.
• More good news: supply conditions are in an improving trend, lending further support to a favorable outlook for inflation.
• Longer term, there is reason to expect supply disruptions to continue to ease and help reach equilibrium with demand.

• There is a direct link between overall economic demand and corporate earnings.
• With a weak growth environment forecasted in 2023, earnings declines are expected.
• Currently, estimates of earnings for 2023 are holding up relatively well.
• Our longer-term confidence in the corporate sector and their ability to leverage economic growth into earnings growth remains high.

• Who is winning the inflation battle, inflation or the Fed? Realistically, it is hard to say at this point.
• The stock and bond markets, which may represent consensus views, are voting preliminarily for the Fed.
• Stocks bottomed at -25%. The decline has been cut to -19%. This is a small but slightly encouraging vote for the Fed.
• Bond yields have declined substantially from their high point. We consider this to be a stronger vote for the Fed.
• Caution: it is very difficult to know exactly why markets are performing as they are. If inflation continues its recent trend downward, at some point the markets should reflect this with steady to lower bond yields and higher stock prices.

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