Does it matter if the Fed cuts?

Déjà vu? Another hot inflation print rattled markets last week.

Both stocks and bonds struggled as traders slashed their rate cut bets—to just 40bps worth of cuts this year, or less than 2 moves, versus 60bps before the print and more than 100bps a month ago.

We continue to believe that the Fed will be able to cut in 2024, but if we’re wrong, and the Fed keeps rates where they are, it’s worth exploring why we think this year can still shape up to be a good one for investors. Here’s why.

Inflation: It isn’t 2022 anymore

Across all measures, CPI inflation came in hotter than Street expectations in March for a third straight month. Headline prices rose +3.5% over the last year, with shelter and gas accounting for over half of the rise, while the core measure also accelerated to +3.8% on the year, with a notable surge in auto insurance costs.

Inflation data may still be stubborn for the next few months, but it’s worth noting that the drivers propping inflation up are very different today than they were in 2022.

Back then, price increases were both super-hot and broad-based, forcing the Fed’s hand to hike again and again. Energy prices—and by extension fuel costs—were at their highest in nearly a decade. Goods prices were starting to come off the boil, but services inflation was just heating up. Shelter inflation hadn’t even peaked yet. To make matters worse, a historic supply and demand mismatch in the labor market (with more than 2 open jobs for every unemployed American) was sending wages higher at the same time.

Today, the picture looks much different. Goods prices look controlled, and have been outright falling (or deflating) for the better part of the last year. Shelter inflation is still artificially high, but has already peaked and should continue falling. Last week’s jobs report showed that wage gains are back in line with the pre-pandemic trend, as the biggest immigration surge in 100 years has dramatically rebalanced the labor market (with now just 1.4 open jobs for every unemployed person). In turn, related services price categories like travel are decelerating. And while energy costs are the wildcard and oil may see further spikes, higher prices should encourage increased supply (especially from the U.S.).

Finally, it’s worth noting that the Fed’s preferred measure of inflation—PCE—continues to run at a slower clip than CPI. Accounting for last week’s CPI and PPI prints, which offer inputs into PCE, the core measure is tracking at +0.27% monthly pace and a +2.7% annual pace. If that proves accurate later this month, Q1 would continue the trend of lower inflation this year.

If the Fed doesn’t cut this year, the “why” matters most

2022 was exceptionally painful for investors because ever-higher inflation created a constant guessing-game around how much the Fed would hike and when they’d stop. While there’s still uncertainty around the “last mile” of progress for stubborn and sticky price pressures today, most Fed members now agree that policy rates are high enough – and that the next move should be a cut. That means today’s debate is just about how many cuts we might see, and when they’ll start.

Yet, the risk still stands that such cuts get pushed out even further than the September/November start expected by markets today. If that’s the case, the rationale for that delay is critical.

If the Fed is on hold because growth is good and it’s just taking longer to get inflation back to its 2% target, that’s still a constructive backdrop for corporate earnings and, by extension, equity markets. Yet, if we stay in suspension because policymakers have again lost the plot on inflation—with prices reaccelerating and the Fed forced to consider hikes—that would prove a more problematic outcome.

Good growth usually means a good backdrop for investing

A moderate-but-elevated inflation environment tends to signal a constructive backdrop for corporate profits to power stocks higher. Looking at history (from 1950-2022), the S&P 500 has averaged an 8.5% year-ahead return when headline CPI is running at a 3-5% annual pace (where we stand right now)—and that return increases to 13.8% when CPI falls to a 2-3% range (which we could still see this year).