Continued Growth & Sticky Inflation

Last week’s hotter than expected core PCE print, coupled with the lower-than-expected GDP reading, put a dent in the widely-held view that interest rate cuts and a soft landing were on the near horizon. While the data looked promising for a while, the extreme confidence so many had was always confusing to me for two simple reasons: that consensus wasn’t consistent with anything we had seen historically, nor was it consistent with how hot the labor market remained. The charts below are two of my favorites from our investment playbook back in late 2022/2023, and both show this conclusion. When inflation breaches 5%, on average it takes 10 years to get back down to 2% (chart 1). In the U.S., a recession has always been the remedy to bring us back down (chart 2). Why was the herd so confident this time would be different?

So, what now? I think we are going to be in an environment where growth remains resilient, and so does inflation. I believe equity owners will win, while those on the sidelines will see purchasing power diminish. In this month’s newsletter, we dive deeper into why we expect growth and inflation to remain resilient and the implications for investors.

Higher Rates Aren’t Spurring Economic Growth, Opposing Forces Are ?

When discussing growth, I think it’s important to first put to bed the common theories stating that higher rates are spurring it on. Interest rates may not be as restrictive as many thought, but the idea of the excess consumer interest earned from money markets, savings accounts, and government debt providing a tailwind to spending is off base. Income from these cash and cash-like instruments may be up, but payments on consumer debt have risen as well. In my view, it’s a zero-sum game.?

In reality, persistent growth has been driven by several forces working in opposition of one another. First, government spending continues at an unprecedented clip. In the first quarter alone, the Biden Administration ran a $510B deficit. That puts us on pace for a $2T, or 7% annual deficit as a percentage of GDP. Rates may be restrictive, but this type of spending is stimulative.

Second, liquidity in the market remains robust. This is the exact opposite of what many, including myself, thought would happen once the Fed determined to steam ahead with quantitative tightening. Reducing the size of their balance sheet removes liquidity, and since the peak in 2022, the Fed’s balance sheet has shrunk $1.6T. That is a big number and a lot of liquidity removed! However, after the collapse of Silicon Valley Bank, the Fed stepped in with the introduction of the Bank Term Funding Program (“BTFP”), allowing banks to pledge their Treasury holdings as collateral at par, despite those securities being worth significantly less due to the spike in interest rates. While the BTFP expired in March, Banks heavily used the program, exceeding $160B weekly at times! As shown in the graph below, liquidity rose following the introduction of the program.

Finally, we warned of the potential consequences of dovish Fed rhetoric back in December, as Powell affirmed rate cuts were likely coming soon. In essence, these comments had a similar impact to rate cuts themselves. The equity market ripped higher, yields fell, and financial conditions eased substantially. Also, a stimulative, offsetting force.

Living with High Growth & Sticky Inflation

If we are truly set on the 2% target, I believe something will need to break to get us there. I’m also not confident the powers that be will allow it to happen (case and point with the Bank Term Funding Program). ?As such, I think we have to prepare for more of the same…continued growth and sticky inflation.

What does this mean for investors? Number one, you have to be an equity owner. The backdrop should continue to support robust earnings growth, and prices moving higher. Those that choose to be on the sidelines will continue to see purchasing power erode.

Second, prepare for an environment where bonds, low-volatility stocks, and defensive sectors don’t behave as expected (portfolio defense).? Higher inflation typically means stocks and bonds move in the same direction. The chart below shows this dynamic, with diversification benefits kicking in when inflation falls below 3%. It remains pertinent to sever the link between portfolio defense and interest rate sensitivity. That’s true for long duration bonds, as well as traditionally defensive/low volatility stocks.

In my view, current themes such as big tech/AI for growth and hedged exposure to equities for defense may serve you well in the near term.

Tim Urbanowicz is the VP of Research & Strategy at Innovator Capital Management, LLC (“Innovator”). This material contains the current research and opinions of Tim Urbanowicz, which are subject to change without notice. This material is not a recommendation to participate in any particular trading strategy and does not constitute an offer or solicitation to purchase any investment product. Unless expressly stated to the contrary, the opinions, interpretations, and findings herein do not necessarily represent the views of Innovator or any of its affiliates.

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