Three Key Thoughts:
1. Inflation Progress?
2. China: COVID Zero to COVID 24/7
3. Expanding Return Opportunities

Inflation Progress?
Bond and stock markets have started the year out optimistically as they expect inflation to continue falling as it has over the last four months. If that fall continues, the Federal Reserve can ease off its interest rate hikes and we could see bond and stock prices rise, reversing some of 2022’s dismal results. The headline numbers just reported for the Consumer Price Index supported that optimism. However, a precipitous fall in energy prices was the biggest contributor to softening inflation. Food and shelter price increases remain reasonably strong. While we expect shelter costs to moderate slowly in the coming months, it is also likely that we could see higher energy prices as demand from China grows with its post-COVID reopening. The labor market also remains surprisingly tight, contributing to inflation by raising compensation costs for businesses and increasing demand for goods and services funded by higher wages.

Bottom line, the Fed’s inflation-fighting job is certainly not done yet and we won’t be surprised to see some significant bumps along the path to lower inflation. We are just starting to see the impact of higher rates on the economy, with recent surveys showing manufacturing activity already in contraction even while services have stayed in growth mode. It usually takes 6-12 months for Federal Reserve actions to work through the real economy and we are just into that time period now. Ironically, one way to make a great deal of progress on inflation quickly is for the economy to slow dramatically. That seems like a significant risk right now.

China: COVID Zero to COVID 24/7
China’s policies surrounding COVID are nothing short of baffling to the rest of the world. After nearly three years of stringent lockdowns, quarantines and contact tracing, China has completely abandoned this strategy and is supporting a full reopening. What is perhaps most surprising is that the old approach was held onto through President Xi’s re-election and then quickly shelved immediately thereafter. No rationale has been given but it seems clear that Xi recognized the dire impact the COVID Zero policy was having on the economy and on the psyche of his population. (For example, China’s birth rate dropped to nearly zero, contributing to an already looming demographic problem.) For now, we have no hard numbers to indicate how this reopening is going but anecdotal evidence indicates that, as would be expected, infections and deaths have soared.

While we don’t know how long it will take for this “cold turkey” approach to move through the population, China views the new re-opening strategy as part of a bigger plan to stimulate their flagging economy. The government has also taken steps to assist the ailing property market, a key part of the China growth story. And they have opened their borders, both inbound and outbound, so that travel can resume. So far, the Chinese stock markets have celebrated, rising more than 30% off their lows reached this summer.

We view all this change with some skepticism, as the government can just as quickly take away what they have given. However, assuming the plan sticks, we can look forward to a greater contribution to global GDP from China. While this is certainly positive, we should also expect higher energy and commodity prices from the resurgent Chinese demand.

Expanding Return Opportunities
Being cautious in the short term about the US economy and China re-opening doesn’t mean there aren’t some positives to focus on. With short term US interest rates now getting close to compensating for inflation, we can invest in higher quality short term bonds with annualized returns of 4-6%. For a low risk investment, this is a pretty attractive return.

The US dollar is showing signs of weakness, which makes sense if we are getting close to the end of the Fed’s hiking program. A weak dollar makes investments in non-dollar stocks and bonds more attractive.

Valuations of US stocks are far less challenging today than they were a year ago. We still believe that there is a significant risk that corporate earnings will drop more than anticipated in the coming year and that could bring stocks down. We view that as a short-term risk but a long-term investment opportunity. We are more optimistic about return prospects over the longer term than we have been in a while.

Our optimism is aided by believing that (1) the Federal Reserve is near the end of its interest rate hikes for this cycle and (2) markets typically bottom well before the economy does.

Investment Implications
We are investing clients’ cash in short-term bonds to take advantage of rising rates. And we continue to evaluate stocks of companies we believe will thrive long into the future and expect to use pullbacks in US stocks to add to exposure there. For the first time in a while, we are looking at when to begin to add to US small cap stocks, which typically do well coming out of an economic downturn. With China’s economy likely reopening and Europe faring better than expected with their energy challenges, we are also considering adding to investments in international stocks.

The short-term risks don’t yet justify our being aggressive in making these moves. But should we see more weakness in the economy and the markets, we will likely use that opportunity to add to investments that we believe will do well over the longer term.