Plentiful Pessimism and Positive Inflation Surprise

Ready to talk about inflation? The US Consumer Price Index (CPI) inflation rate slowed to 6.5% y/y in December, continuing its decline from June’s 9.1% peak.^[i] While this stemmed primarily from energy prices (down another -4.5% m/m), “core” CPI—which excludes volatile energy and food—also continued easing.^[ii] Its 5.7% year-over-year rate is down from August’s 6.6% high.^[iii] Month-over-month, core CPI rose 0.3%, matching its long-term average.^[iv] All good news, and we think inflation is likely to continue easing further from here. You can see our recent commentary for more on why (here, here and here). Today, we will focus on what matters most for stocks: Is the high likelihood of continued improvement priced in? Based on how headlines reacted to today’s news, we doubt it.

Over meaningful stretches of time, markets move most on the gap between reality and expectations. Sentiment—opinions and forecasts—today sets the baseline, and stocks then price the likelihood things go better or worse than the masses anticipate over the next 3 – 30 months. In the very near term, emotions fueled by distant possibilities can cause big swings. But over that 3 – 30 month stretch, we think probabilities rule the day. Again, we think continued improvement in inflation is overwhelmingly likely. So the question is, will that surprise?

Headlines suggest to us it will. A lot of them focused on the higher rate of services inflation, arguing these prices are “stickier” and will keep the headline inflation rate elevated, bringing households more pain and the economy more Fed rate hikes. Which, implicitly, add headwinds. (We disagree.) Some coverage pooh-poohed CPI’s easing entirely, arguing the Fed is focused more on high wage growth. (Bad logic, as we explain here.) Some economists zeroed in on individual items, like eggs (skewed by bird flu), as evidence high prices will linger and bring more pain. Others said that even if improvement continues and the Fed manages a “soft landing” of slower inflation and no recession, it probably means the longer-term inflation rate will stay above-average, keeping interest rates high—and economic growth slow—for the foreseeable future. Perhaps best illustrating sentiment, one piece flat out said investors are “too optimistic” about improving inflation before going into the very speculative (and in our view, unfounded) reasons inflation will stay high for many years to come.^[v] 

Fisher Investments’ Founder and Executive Chairman, Ken Fisher, has a term for this: the pessimism of disbelief. It reigns as bear markets trough and new bull markets begin—the starting point for Sir John Templeton’s famous observation that “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” When the pessimism of disbelief abounds, financial news coverage tends to take two main approaches. One, bad news gets top billing. Two, good news gets dismissed or couched as soon to turn bad. Both were prevalent today. The vast majority of commentators focused on the cloud, not the increasingly bright silver lining.

To which we say, great! When there is this much pessimism, it sets a low bar for reality to clear, making positive surprise that much easier to attain. It means things don’t need to go swimmingly from here, and inflation doesn’t need to rapidly descend to the Fed’s 2.0% year-over-year target to justify a stock market rebound.^[vi] Continued gradual, uneven improvement probably does the trick. Pairing that with recession being economists’ baseline expectation shows slowing inflation plus a mild recession wouldn’t pack much of a negative punch. But slowing inflation with sluggish economic growth would be a large positive surprise.

Stocks don’t need perfection, especially as a bull market dawns. Not as bad as feared usually suffices. Also? After a spell where a given fear weighs on sentiment, as inflation did last year, that fear’s fading can bring big tailwinds. Improving inflation should bring that this year, helping power stocks up the wall of worry. More on that soon.