Are bullish investors misreading the Fed?

• The economy has been stronger than expected, and overall inflation has been on a downtrend. 
• Equating this to a Fed victory, investors now assume the central bank will cut rates in 2024, which would help sustain high stock valuations.
• But the Fed may need to keep rates higher for longer as its focus remains on “core” inflation, which stands well above target.
• Consider rebalancing toward value-style equities or those with “growth at a reasonable price” attributes.

With the S&P 500 Index up about 19% for the year to date, equity investors appear to be cheering the Federal Reserve’s ability to deliver an economic soft landing. But despite solid economic growth and falling overall inflation, the Fed may not yet be ready to deliver the five interest rate cuts by December 2024 that bullish investors are expecting.

Economic growth certainly has been notable, particularly amid one of the most aggressive cycles in decades for monetary policy tightening. During the second quarter of 2023, the US economy grew by an annualized 2.4% on an inflation-adjusted basis. Not only was this better than the 1.8% forecast, but it was also better than the first quarter’s pace, meaning growth is accelerating, thanks in part to still-robust demand. As for inflation, the headline Consumer Price Index (CPI) rose by just 3% in June, after decelerating for months since the June 2022 peak of a 9% increase.

But investors’ eagerness to declare an end to high interest rates may still be wishful thinking.

Despite progress in reducing headline inflation, core inflation is likely to matter more. Core inflation, which strips out the more volatile price moves in food and energy, is the Fed’s preferred gauge of inflation, and remains far from the 2% target.

In June, the core CPI and core Personal Consumption Expenditures (PCE) registered increases of 4.8% and 4.1%, respectively, and it’s unclear how quickly these will fall given still-sticky inflation components. Recent labor strikes and disputes, for instance, suggest wage pressures are unlikely to moderate anytime soon. There’s also resilience in existing home sales, just as home prices have begun to rise again.

Besides inflation, the economy currently also features a labor market reflecting full employment and financial conditions that are still relatively loose. These factors mean that, while investors may think the Fed’s tightening cycle is basically over, policymakers may stay committed to higher-for-longer interest rates.

In this environment, investors should keep an eye on inflation metrics and prepare for interest rates to stay higher for longer, which likely will weigh on stock valuations. Consider reducing exposure to the most richly valued stocks and rotating toward value-style equities or those that have “growth at a reasonable price” attributes, with clear earnings achievability.

The source of this article, Are Bullish Investors Misreading the Fed? was originally published on August 1, 2023.