April’s market turbulence has served as another stark reminder that predicting the future remains an elusive endeavor for investors. The latest surge in volatility can largely be attributed to the recent inflation data. Inflation’s significant impact on market dynamics is well-documented, having steered monetary policy, consumer behavior, and returns across asset classes for the past several years. Despite inflation’s critical role in the economy and the markets, economists and investors have done a terrible job anticipating its ebb and flow.

The Changing Narrative

The market’s narrative has closely followed the inflation data. In late 2021, it became apparent that elevated inflation was not ‘transitory,’ and the Fed was forced to shift monetary policy. Bond yields spiked in 2022 as the Fed embarked on a series of aggressive interest rate hikes, and stock prices plummeted amid widespread concerns that these measures could trigger a recession.

By 2023, the narrative shifted. It became clear that inflation was cooling faster than expected despite economic data remaining surprisingly resilient. A ‘Soft Landing’-where the Fed successfully tames inflation without causing a recession-became the market’s base case. This optimism fueled expectations of potential rate cuts in 2024, igniting a significant rally in both stock and bond markets.

January data revealed that inflation was hotter than expected. Initially, the Fed downplayed this development, considering the inherent volatility of economic data. Subsequent evidence has continued to point to a resurgence in price pressures, implying the Fed’s 2% inflation target might be more challenging to achieve than previously thought. Recent statements from Fed officials indicate that interest rates may need to remain ‘higher for longer,’ prompting another shift in the market narrative.

Failures in Forecasting

Most forecasts are simply extrapolations of recent trends. They often prove to be reasonably accurate until there is a divergence from that trend.  Each example over the past few years where the trend in inflation has diverged has been completely missed by forecasters, including: 

• How intense and persistent inflation would be when it began to rise in 2021.
• The resilience of the economy and the rate at which inflation would decrease in 2023.
• The potential for a resurgence of inflation pressures in 2024.

Monetary Policy Outlook

The market began the year expecting the Fed to deliver six interest rate cuts of 0.25%. The Fed’s expectation had been a little less aggressive than the market’s, with three cuts for 2024 reflected in the most recent Summary of Economic Projection (SEP). As the outlook for the path of inflation has been revised, so has the outlook for monetary policy. The market’s outlook has been revised to reflect just one cut of 0.25% to occur late in the year.

The Fed will deliver its next rate decision on Wednesday, May 1st. While the market does not foresee any changes to the benchmark rate at this time, it is widely anticipated that Chairman Jerome Powell will emphasize the notion of ‘higher for longer’. The forward guidance on the path of policy provided by Powell during his post-meeting press conference has the potential to move markets if it is more hawkish or dovish than the market anticipates⁽¹⁾.  

What this Means for the Market

Ultimately, the prospect of higher for longer rates is negative for stock prices for a variety of reasons:

• Higher interest rates slow economic activity, which leads to lower revenues and earnings for most businesses.
• Most assets are valued by discounting future expected cashflows to a present value. High interest rates lead to high discount rates, which lowers present values and, therefore, asset prices.
• As the expected return increases for a risk-free asset like a short-term government bond, the relative attractiveness of a risky asset like a stock declines. To attract potential investors to take risk, the expected return on risky assets must increase. This occurs via a decline in the risky asset’s price.

Looking Forward

In light of this, investors should be prepared for the potential for markets to become more volatile than they have been on average for the last 18 months. With most major stock and bond indices declining in April, we have already gotten a taste of this. Will this emerging trend continue? Or will economic data, asset prices, and the market narrative shift directions once more? 

The best prediction we can offer is that the market, economists, and Fed officials will continue to struggle with predicting the path of inflation. The consequence of this includes more data surprises, swings in asset prices, and shifts in market narrative. Nobody predicted the path that has led us to where we are today, and nobody can predict where the path will take us from here. Given the inability to accurately predict the future, the best course of action is to remain disciplined and diversified.  

1. The terms ‘hawkish’ and ‘dovish’ are terms commonly used in the financial media to describe actions/comments that are more aggressive in combating inflation (hawkish) or less aggressive (dovish).

Week in Review

• The initial reading on Q1 GDP was released last Thursday and showed that the US Economy grew at an annualized rate of 1.6%, lower than economists’ expectations of 2.4%. The report also showed that inflation, measured by Core PCE, rose 3.7% annualized in the first quarter. While lower economic growth could inspire hope of lowered interest rates, the Core PCE reading complicated that viewpoint and sent the yield on the Ten-Year Treasury to briefly touch 4.70%, a level not seen since November.
• The Japanese Yen briefly weakened to 160 per US Dollar on Sunday night, the weakest level since April 1990. The Yen recovered intra-day to a high of 154.4 yen per US Dollar, causing speculation that Japanese Financial Authorities had intervened to support the currency.
• According to FactSet, 46% of the S&P 500 have reported Q4 results as of last Friday, April 26th. The earnings growth rate, blended between companies that have reported with the estimates for those that have yet to report, is at 3.5% year-over-year. This rate is above expectations of 3.4% at the beginning of earnings season. Major companies to report this week include Amazon, Coca-Cola, Mastercard, and Apple. 

Hot Reads

Markets

• Even If the Fed Cuts, the Days of Ultralow Rates Are Over (WSJ)
• All the Data So Far Is Showing Inflation Isn’t Going Away, and Is Making Things Tough on the Fed (CNBC)
• Here’s Everything to Expect When The Fed Wraps Up Its Meeting Wednesday (CNBC)

Investing

• Not Scared of Bears (Jonathan Clements)
• Ten Years From Now (Ben Carlson)
• A Few Short Stories (Morgan Housel)

• How to Hit a 50 Yard Wedge – Tiger Woods & Fred Couples (YouTube)
• How Las Vegas’ Sphere Actually Works (YouTube)
• Mel Kiper And The Crazy Feud That Changed The TV Draft Forever - NFL 1994 Draft Story (YouTube)

Markets at a Glance

Source: Morningstar Direct.

Source: Morningstar Direct.

Source: Treasury.gov

Source: Treasury.gov

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

Economic Calendar

Source: MarketWatch

IMPORTANT DISCLOSURE INFORMATION