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Inside Medical Liability


Asset Side

Walking a Narrow Path

It’s All About Inflation

By Marco Bravo

The macro-economic outlook for the U.S. continues to be heavily influenced by the outlook for inflation. After peaking at a 40-year high of 9.1% year-over-year last June, the headline Consumer Price Index has steadily fallen and ended 2022 up 6.5% year-over-year. As Figure 1 shows, the headline CPI over the final six months of 2022 fell to below the Fed’s 2% target on an annualized basis. The decline in CPI witnessed over the second half of 2022 was largely due to falling energy prices as the energy component of the CPI index over the last six months of 2022 was down -35% on an annualized basis.



Core consumer goods, which excludes food and energy, also experienced a deflationary trend during the second half of 2022 as supply chain disruptions began to ease and consumer preferences shifted away from goods to services (Figure 2). While prices of core goods have fallen, prices of core services have continued to move higher. Core services make up about 57% of overall CPI with shelter/housing making up more than half of core services. With home prices having declined by -8% over the last six months on an annualized basis due to weakened demand for housing, the expectation is that shelter-related prices should eventually follow home prices lower.


Overall inflation rates should continue to decline in 2023 as consumer spending weakens and supply disruptions continue to get resolved. According to the March 2023 Blue Chip Forecasts, the headline Consumer Price Index is expected to continue to move lower in 2023 and average 2.6% on an annualized basis during the fourth quarter of this year, a drop of 160 basis point from the fourth quarter of 2022. At AAM, we think upside risks to inflation remain as wage growth remains strong due to the tightness in the labor market. Although we think inflation will continue its downward trend this year, we don’t think it will decline as quickly as the consensus is currently projecting.

Fed Policy and the Labor Market

Since March of last year, the Federal Reserve has increased the Federal Funds Rate target range by a total of 450 basis points in an attempt to slow the economy enough to bring inflation back down to the Fed’s 2% target. With the economy showing signs of slowing and inflation moving lower, the market believes the Fed is getting close to ending its rate-hiking policy. Pricing on Fed Funds Futures is implying another 50 to 75 basis points of additional rate hikes before the Fed pauses. Recent comments from Fed chairman Jerome Powell suggest that once the Fed pauses, they (the Fed) will keep rates unchanged until inflation has fallen back to their target level.


Based on the Fed’s summary of economic projections, released in December, the Fed is not expected to begin easing policy and cutting rates until 2024. One reason why the Fed doesn’t expect to be cutting rates this year is the tight labor market, which will keep upward pressure on wages. As Figure 3 shows, there are almost two times the amount of job openings versus the total amount of unemployed persons. This demand/supply imbalance of labor has pushed wages higher, and the Fed fears will continue pressure prices on those services most impacted by wages.



We think the Fed will want to see a marked decline in the number of jobs wanted and an increase in the unemployment rate before contemplating any easing of monetary policy and cutting in rates. If labor markets remain tight, then the risks are skewed towards higher rates for longer. The Fed Funds Futures market seems to be disregarding the tight labor market and is expecting the Fed to “pivot” and begin cutting rates in the fourth quarter of this year. AAM expects the Fed to raise rates an additional 50 basis points, bringing the Fed Funds rate to a range of 5.25% to 5.50% and then pause and leave rates unchanged thru the end of this year.

Economic Growth and Market Risks

The 450 basis points of rate hikes by the Fed is beginning to take its toll on the U.S. economy, especially the more interest-rate sensitive sectors such as housing. The increase in mortgage rates has reduced home affordability and demand for housing. In addition, recent activity data is showing signs of a slowing economy as the effects of the Fed’s rate hikes reduces spending and investment. While a healthy and tight labor market environment should be supportive of consumer spending in the near term, we’re expecting labor market conditions to begin to weaken and the unemployment rate to rise later this year.

With personal excess savings having declined, we expect consumer spending to be challenged in 2023. Business spending will also be challenged due to the expectation of modest revenue and earnings growth. After rising 0.9% last year, the consensus forecast is projecting real GDP to rise by only 0.2% in 2023. We believe the odds of the U.S. entering a mild recession this year are high with the balance of risks skewed to the downside. Against this backdrop of a slowing economy and falling inflation, we expect Treasury yields to trend lower in 2023.

The pricing of risk assets appears to be taking on a more optimistic view regarding economic growth. Risk premiums have fallen significantly since last October as the market has replaced a 2023 recession forecast with a soft-landing scenario. The investment grade corporate sector’s average option-adjusted-spread (OAS), a measure of the yield premium over Treasuries required by investors, has narrowed by 30 basis points since October and currently sits below its long-term average. In the below-investment grade high yield corporate sector (or high yield), the average OAS has tightened by 110 basis points over the same time period.

While corporate fundamentals have largely remained relatively stable, expectations are for revenue, earnings, and capital spending to increase by single digits in 2023. At AAM, we believe the risks to all these estimates are skewed to the downside due to a slowing economy and above-consensus estimates for inflation. For quite some time, companies had been operating within a low interest rate, high growth rate environment that was very supportive for the marginal company. This past environment masked a number of fundamental challenges that we believe this year will become a problem for those companies with weaker balance sheets.

For our insurance client fixed income portfolios, we are being more disciplined as we expect credit spreads to widen due to the uncertain economic environment. We’re targeting those industries with stable cash flows that are less vulnerable to cyclical pressures. We are staying up in quality and building liquidity, walking a narrow path, and waiting for what we believe will be better investment opportunities to add risk.


Marco Bravo, CFA, is a Principal, Vice President, and Senior Portfolio Manager with AAM.


Overall inflation rates should continue to decline in 2023 as consumer spending weakens and supply disruptions continue to get resolved.