SUMMARY
Falling inflation is a sign of the global economy healing after the pandemic period’s distortions, but without a recession breaking out. Despite the yields available on bonds, we recently upped our equity allocation to US small- and mid-cap growth equities.
Investors tell us that they will not allocate more to bond investments because rates will stay higher for longer. They also say they will not allocate more to equities because of an impending recession. The inconsistency of these two views is obvious.
Inflation is a symptom of a sick world economy, one suffering from too much money chasing too few goods and services. That was true of the pandemic period, but it is ending. Inflation’s drop from an 8.7% pace globally in 2022 is just one sign of the world economy healing. While supply shocks remain a risk, demand is moderating, and supply is recovering without a severe economic contraction. This is good news.
In the US, we see data that shows considerable progress toward normal levels of inflation. Wage growth, for example, is decelerating even in the services sector.
While not every CPI report will fall below expectations, this week’s soft CPI figures were not a surprise to us. Shelter costs are now coming down in earnest. We expect a material and steady drop for the next 11 months before housing costs start to stabilize towards the end of 2024.
Markets are responding quite positively to reported declines in inflation with the S&P 500 gaining 7.6% in the month to date. The 10-year treasury yield has fallen 44 basis points over the same period.
Though bonds are strong competition for equities, the Global Investment Committee (GIC) added further to our equity allocation with an overweight to the S&P 400 and 600 Growth components on October 18th. This was the first time our asset allocation to equities went “overweight” from neutral or underweight since June 2020. If inflation falls while yields moderate even while corporate profits rise, we expect it to lead to substantial gain for US equities in the coming year. If yields decline in the coming year on slower employment growth while corporate profits rise, we will raise our equities weighting further.
