Markets are currently being heavily influenced by artificial intelligence stocks and speculation about when the Federal Reserve will make its first interest rate cut. These factors not only impact day-to-day market movements but also reflect broader trends in innovation, productivity, and the overall health of the economy. They’re also a consequence of the loose monetary policies and fiscal stimulus implemented during the pandemic, which fueled tech sector growth and rapid price escalation. As the dust settles on the inflationary episode of the past few years, what should investors do to maintain perspective in their portfolios?
While economists and historians will no doubt spend the next decade documenting the many causes and policy decisions that drove the worst inflation in 40 years, it’s evident that the various disruptions to supply and demand are easing. Some prices remain stubborn, such as those for the important category of shelter (i.e., the cost of rent and mortgages), but most measures have improved significantly. This sets the stage for the widely-anticipated Fed rate cuts later this year.
Current inflation measures slowing
The latest Consumer Price Index report, for instance, showed that prices rose 3.2% on a year-over-year basis in February. This represents a slight uptick from the prior month due to an increase in energy prices. Energy drove the Producer Price Index higher as well, although both the headline and core measures are both still at or below 2%. Core CPI came in at 3.8% but excluding the shelter component results in a year-over-year growth rate of only 2.2%.
These data points suggest that consumer price inflation is gradually moving back toward the target of 2%, though it may take some time to fully get there. This progress reflects the best-case scenario that investors could have hoped for less than two years ago. However, the Federal Reserve is cautious about declaring victory prematurely. This cautious approach is wise because headline inflation is heavily influenced by energy prices, which can be affected by unforeseen global events such as the conflict in Ukraine or past oil shocks experienced by OPEC in the 1970s.
While many comparisons have been made between the current situation and the inflationary shocks of the 1970s and early 1980s, the response from policymakers and the resulting economic outcomes have been markedly different. During the 1970s, the Federal Reserve changed its approach several times as it grappled with the concept of “stagflation,” where inflation increased despite weak demand. Fortunately, perhaps due to the extensive study of that period by current policymakers, stagflation has been avoided so far this time around.
The money supply has stabilized
Perhaps most relevant for investors today is that disinflation then made way for “the Great Moderation” beginning in the mid-1980s. During this time, business cycles grew longer, inflation was subdued, unemployment fell, and markets performed well. While this is only one historical example, it does suggest that falling inflation and a return to more normal monetary policy will likely be positive for the economy and markets.
One concern among investors has been the supply of money, reflecting the famous quote by the economist Milton Friedman that “inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” Whether or not this view, known as “monetarism,” is right is a subject of debate among economists. Either way, the accompanying chart shows that the money supply has shrunk relative to its post-pandemic peak. This reflects monetary tightening by the Fed, including the shrinking of the Fed’s balance sheet at a pace of around $1.1 trillion per year.
Markets are pricing in the 1st rate cut for the summer
Thus, daily market swings continue to be driven by changing expectations for the economy and Fed rate cuts. Recent volatility has been the result of the market shifting to a first cut occurring in June or July rather than in March. For long-term investors, whether this takes place today or a few months out should be immaterial given the broader historical context. What matters is the underlying trend of improving inflation and steady economic growth. A return to more normal monetary policy should also help interest rates to stabilize, resulting in a more attractive financial market environment.
The bottom line? Regarding AI stocks, the typical 60/40 portfolio has approximately 14-16% of the equity exposure in companies involved in the AI space. Prudent investors should continue to focus on broad economic trends and historical perspectives rather than on day-to-day market swings in specific stocks.
For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based upon third party data which may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Data and analytics provided by Clearnomics, Inc. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed the adequacy of this article. ITOT sector exposure used as proxy for AI exposure within stock holdings.
