After ten months of the Federal Reserve's interest rate hiking campaign, inflation finally appears to be on the decline. Consumer prices increased 7.1% in November, compared to an expected increase of 7.3%. Though still a high rate by historical standards, this represents a sharp slowdown from the 7.7% rate posted a month ago. Markets cheered the report briefly before the Fed hit it with a stark reminder that it is not done hiking rates. In a Dec. 14 press conference, Federal Reserve Chairman Jerome Powell committed to lowering inflation to its 2% target and holding it down. To do so, the committee believes that the Federal Funds rate will need to rise above 5% and stay there for some time. With the Fed Funds rate currently at 4.5%, another increase of 50 basis points is likely still in the cards. Recession fears are understandably rising entering 2023.

November's inflation report was everything market participants were asking for, with signs of easing in both goods and services. Supply chains have corrected in the back half of 2022, and overstocked inventories are developing. Price increases in goods have eased for months and could soon become a drag on the broader inflation measurement. Service price increases also dropped last month despite an exceptionally tight labor market. With wages still growing at 5.1%, the Fed has kept a close eye on the services category. So far, we look to be avoiding a wage/price spiral. Shelter costs still rose at a sharp rate in November's survey, but the measure does not accurately capture the true state of the rental market. More timely indicators show that rent increases are rapidly declining.

While inflation appears anchored, the Federal Reserve wants to avoid past mistakes. In the 1970s, inflation persisted because of weak resolve on the part of the Fed. Today, the Fed is committed to finishing the job, even at the risk of a recession. With the Fed Funds rate below the rate of inflation, it is hard to argue that policy is overly restrictive. The plan is to push the Fed Funds rate into restrictive territory and hold it there for as long as necessary. The difficulty is that parts of the economy are already weakening, and the rate hikes are beginning to be felt. Consumers are the lifeblood of the U.S. economy. Though still strong, layoff announcements are increasing, and credit utilization is rising sharply. As banks tighten their belts, consumer spending could find itself in the crosshairs.

So far, corporate earnings estimates do not reflect a slowdown in consumer spending. Analysts believe companies are on pace to grow earnings between 5% and 6% in 2023. A downward adjustment to these earnings estimates would be a meaningful headwind for equity prices. As such, we continue to position in the stocks we believe are best suited to weather a decline in earnings. Companies with strong balance sheets, robust cash flows, and sustainable dividend practices stand out in the current environment.

Preston May, CBE®
Research Analyst

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