Is Disinflation Still Positive for Markets?
The S&P 500 rallied last week but the reason wasn’t because of falling inflation, it was because of strong tech earnings and AI enthusiasm. Because of that, investors have somewhat “missed” the fact that the “rest” of the market (non-tech) mostly declined last week despite seemingly positive events of 1) More evidence of falling inflation, 2) Increased expectations for Fed rate cuts and 3) More “bad” data.
To that point, while the S&P 500 rallied 1.58% last week, the Russell 2000 fell 1.25% (Small Cap Stocks, which we are not in), the Dow Industrials lost 0.54%(30 industrial stocks) and RSP (S&P 500 equal weight) declined 0.53%. The reason the “rest” of the market declined last week was that while disinflation is occurring, it may not be “immaculate” and that’s a potential negative for stocks.
As a refresher, “Immaculate Disinflation” is a term/ concept that was invented last year and it essentially means that inflation declines but economic growth doesn’t slow. Normally, the only way inflation can decline is if economic growth slows. That’s normal disinflation. But investors convinced themselves that, because of the pandemic, we could get Immaculate Disinflation where inflation declines but growth stays solid.
For the past year, that’s exactly what’s happened as goods prices, which were artificially inflated by pandemic-driven supply chain problems and lots of cash created by the FED, gradually returned to more normal levels as the world got back to “normal.” However, once those declining goods prices returned to “normal” the decline in inflation stalled, mainly because growth was too strong to push inflation lower. That’s what we saw in January through May.
Now, inflation appears to be declining but it also appears to be declining because of a loss of economic momentum, i.e., regular disinflation. Here’s the point: If inflation falls because growth is slowing, that’s not an automatic positive for stocks anymore and we saw that this past week as sectors and stocks that weren’t attached to AI declined, despite the drop in CPI and rising Fed cut expectations.
So, what does this mean for markets going forward? First, it means AI mania better not subside anytime soon because that’s literally the reason the S&P 500 rose last week. Second, it means the market has seen one (and perhaps two) of the four “pillars of the rally” (stable growth, falling inflation, sooner-than-later rate cuts, AI enthusiasm) somewhat damaged and while the S&P 500 is at new highs, the outlook for the “rest” of the market worsened over the past week, not strengthened. Tactically, things aren’t bad enough to reduce exposure but it again reinforces our desire to control volatility and beta in portfolios.
I am currently reassessing all portfolios and looking to make sure we have the best protection to a temporary downturn. My take on current economic data is that the markets will struggle during the summer months and then rally before and during the election. As a result, we don’t want to be out of the market but be correctly position from 25% to 33% in value stocks. In my Jackson accounts, I am happy with the current positions. In my AXIOM accounts, I am looking for a replacement for two funds. I am looking to have the best value positions possible. I will be making those move within the week. In my mutual fund accounts, I am satisfied with the positioning. This should prepare us for the summer months.
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