Summary
- Inflation may remain elevated through mid-2023, but evidence is mounting that lower inflation is coming.
- Potential for lower inflation also means potential for lower rate hikes in the coming months.
- With odds of recession rising, stocks may see more downside pressure in the months ahead.
- Which asset class has the greatest potential for significant price appreciation in 2023?
As of this writing, the Fed was poised to raise its funds rate by 75 bps at its November 1-2 meeting. The Fed Watch Tool forecasts a 50-bp rate hike at its next meeting in December, followed by a 25-bp hike in early 2023. Meanwhile, the risk of recession in 2023 is rising.
Let's take a deeper look at evidence of falling inflation and a weakening economy, then consider how to invest in this environment.
Signs Pointing to Lower Inflation Ahead
While in historical terms high inflation isn't exactly going away fast, as unemployment remains near record lows and consumers continue to spend, there are many signs pointing to lower inflation ahead, including falling rents, declining JOLTS, and slowing U.S. business activity.
Falling Rents
Rents, a subset of Shelter, are the largest single piece of the CPI (Consumer Price Index basket) at 22%. Although rents are still high, rising 8.5% year-over-year in the last monthly rent report , rental costs were down from a 12.3% YoY jump in the previous month.
Thus, rents are still rising, but at a slower pace. Furthermore, since leases are typically renewed on a 12-month basis, this piece of the CPI is slow to move. This points to a slow but potentially steady pace of lower inflation by mid-2023.
Declining JOLTS
The Job Openings and Labor Turnover Survey, or JOLTS, measures monthly job openings, how many workers were hired, how many were laid off or quit their job, as well as other separations. The JOLTS figure still remains significantly below its March 2022 peak, and continues to trend lower on average since then.
Slowing U.S. Business Activity
U.S. business activity, as measured by the Composite PMI, contracted for the fourth straight month, declining to 47.3 from 49.5, measuring its steepest decline since 2009. A reading above 50 suggests improvement. A reading below 50 suggests deterioration.
End of Easy Money for Consumers
With the 30-year mortgage above 7.0%, which is the highest it's been in 20 years, refinancing activity is down 86.6% year-over-year. And with the GOP almost certainly gaining a majority in the House of Representatives for the next two years, fiscal stimulus will decline.
Potential for Recession in 2023 Is Rising
The probability of recession is relatively low but rising. Statistica recently reported 25.15% odds of a recession by August 2023, which is up from the previous probability of 17.63%. While recession would be bad for stocks, it could be good for bonds.
Regarding recession's impact on inflation, the CPI has fallen during or immediately after every recession since 1950 , sometimes by a significant margin. On average, the inflation rate has fallen by 2.2 percentage points from the month the recession began through the month one year after it ended.
A possible canary in the coal mine for recession was a report that PC shipments declined 15% in Q3 . This represented the "steepest decline since the 1990s," which seems to be more than just an outlier, or just people getting tired of PCs. This could point toward consumers starting to shift away from discretionary spending.
General Outlook for Long-term Stock Investors
For a long-term investor, it's never a bad time to pick up shares of high conviction holdings, especially in a bear market. It's always preferable to buy at lower prices, as opposed to chasing return and buying on the high side. Thus, ignoring short-term noise and sticking to your long-term plan is wise.
Deep value and defensive sectors can be smart plays now, and long-term investors may find small-cap stocks attractive for dollar-cost averaging at current valuation levels.
That said, there's still short-term downside risk for stocks in the aggregate, as high inflation, in combination with a slowing economy, will likely lead to lower earnings over the next few quarters. Thus, for the long-term investor, holding the stock positions (but not buying) for now can be a good idea.
The Case for Bonds Going Into 2023
Taking a cautious approach, and buying investment assets with relatively low downside risk but higher upside potential, can work in this environment. With this idea in mind, perhaps the best asset class to buy now is bonds. However, with rates still rising, a DCA approach from now through mid-2023 can work well to mitigate price risk.
Here are some highlights from my recent article, The Case for Bonds Now :
- Bonds are headed toward the second consecutive year of declining prices. Never in history have prices declined for three consecutive years.
- There are only two instances in history, 1955-1956 and 1958-1959, where the US Treasury Bond fell in price for two consecutive years. In the following years, 1957 and 1960, the US T Bond jumped 6.80% and 11.64%, respectively.
- For the "total bond market," I like iShares Core U.S. Aggregate Bond ( AGG ) and Vanguard Total Bond Market ETF ( BND ). For greater upside price potential in 2023, albeit more price risk, I like Vanguard 20+ Treasury ETF and PIMCO 25+ Year Zero Coupon U.S. Treasury Index ( ZROZ ).
Bottom Line
There's no doubt that investing during the height of uncertainty is a risky venture. But one of the most fundamental aspects of investing is that the more risk an investor is willing to take, the more return they may potentially receive.
This aggressive approach (buying stocks on extreme weakness) has worked well since the lows in mid-June, late September, and mid-October. If stocks continue their Q4 rally, cautious long-term investors can hold stock positions and consider dollar-cost averaging into bonds from now through mid-2023.
For further details see:
Lower Inflation, Lower Rate Hikes, Weaker Economy: Where To Invest?