Risks have shifted. From the beginning of 2022 through the first half of 2023, investors were concerned about recession risk, given slowing economic growth, elevated inflation, and a hawkish Fed. These fears were further validated by The Conference Board’s index of leading economic indicators plunging toward recessionary levels.

But the U.S. economy has proven to be much less sensitive to interest rate increases than expected, and leading economic indicators have been improving for more than a year.

As recession concerns fade, a new but familiar concern has retaken center stage: inflation. A simple examination of the trends in Bloomberg’s economists’ expectations shows that GDP growth for 2024 is now expected to be a healthy 2.1%. Meanwhile, expectations for the change in the consumer price index in 2024 have steadily risen from 2.2%—a level that would have been very much in line with the Fed’s targeted level—to 2.8% as of March 22, 2024.

The steady progress on inflation since CPI peaked at 8.99% in June of 2022 appears to have halted. Just one year after the peak, CPI had fallen to 3.05% in June 2023. But over the ensuing eight months, it has moved sideways, ending at 3.17% in February 2024.

The reason inflation has become so sticky relates to its composition. At its peak, elevated goods prices—specifically the food, energy, and core goods categories of the CPI basket—were the problem. These categories accounted for approximately 6% of the 9% figure, and they also accounted for the vast majority of the subsequent fall in inflation, which was heavily driven by the normalization of supply chains.  

Meanwhile, there has been little to no decrease in services inflation, which is now responsible for the vast majority of inflation. This does not bode well for further improvement, as services inflation is typically very stubborn, outside of recessionary periods.

Perhaps even more concerning is the fact that inflation is at 3.17%, with practically zero contribution from goods categories. This means that to get inflation closer to the Fed’s 2% target, not only do we need the notoriously stubborn services inflation category to moderate, but goods inflation also needs to stay completely dormant, which is an optimistic assumption. 

The bottom line is that risks have shifted from recession to inflation, which means investors may want to consider shifting their asset allocation as well. An examination of asset returns during various levels of CPI yields interesting insights that may be helpful to these considerations.

Historically, bonds, as measured by the Bloomberg Aggregate Bond Index, have been an excellent hedge for recession, but they have not been effective at hedging against elevated inflation. During the rare periods where inflation has turned negative due to sharp economic downturns, bonds have outperformed stocks, as measured by the S&P 500 Index. But as inflation levels rise, that dynamic shifts.

Meanwhile, stocks have tended to perform best when inflation was at low, moderate, and even slightly elevated levels—posting double-digit returns when inflation was between zero and 4%. But the returns dipped sharply during recessions and also weakened when inflation moved to very high levels. However, stocks in the energy sector have historically performed quite well in periods where inflation was at very high levels.

These results imply that one way to hedge inflation risks would be to tilt portfolios toward stocks, with an emphasis on the energy sector.

Given these shifting risk dynamics, our Asset Allocation Committee has recently moved to an overweight position in stocks and an underweight position in bonds. To further complement our hedges against inflation risk, we also hold an overweight position in real assets equities, which includes a large allocation to energy and other commodity-oriented equities.