Tag: inflation
Asset Allocation Bi-Weekly – The PCE Makeover (August 3, 2026)
by Thomas Wash | PDF
The Federal Reserve’s preferred gauge of price inflation is set for a methodological update, as the Bureau of Economic Analysis (BEA) is expected to implement revisions to its price index for Personal Consumption Expenditures (PCE) as early as September. Early estimates suggest the changes will modestly lower measured PCE inflation, potentially easing the path toward the Fed’s 2% target by reducing the index’s sensitivity to the AI-driven stock market rally.
The timing is notable. As shown in the chart below, the Fed has failed to achieve its inflation objective over the past five years, and a downward shift in the index could finally make the target more attainable — both mechanically and in perception.
The revisions to the PCE price index, scheduled for incorporation in the September 30 release, aim to better align the index with actual household spending patterns. Key changes include updates to core inflation calculations and modifications to several categories that have disproportionately influenced recent readings, namely legal services, portfolio management, and computer software and accessories.
The most consequential adjustments are likely to come from portfolio management and software-related components. The BEA will revise its software price index — an area that has been distorted by the surge in AI-fueled demand — by incorporating a broader set of prices, including video game software and web hosting services. This change is expected to lower measured inflation by roughly 0.1 percentage points.
In parallel, the treatment of portfolio management services will shift away from a fee structure tied to assets under management and toward a measure based on firm revenues relative to services rendered. This adjustment is expected to reduce inflation by an additional 0.2 percentage points. Legal services will also be revised, with greater reliance on producer price data, though the impact there is likely to be more modest.
These changes are small but important, since these components have contributed disproportionately to volatility in the core PCE index. While the components account for roughly 4% of the core PCE index, they represent just over 1% of the core consumer price index, underscoring their outsized influence. Their growing weight has amplified swings in measured inflation, complicating the Fed’s effort to return inflation sustainably to target following years of overshooting.
The divergence largely reflects differences in weighting methodology. PCE weights adjust dynamically with shifts in consumer spending, and in recent years, portfolio management services have captured a larger share of expenditures amid rising retail participation in financial markets. At the same time, the recent surge in demand for computing and software has increased the relative weight of technology-related categories.
As a result, the PCE price index has become more sensitive to equity market dynamics. The chart above highlights the close relationship between rising asset prices and the growing influence of these components, suggesting that a portion of recent inflation pressure has been indirectly linked to strong market performance. This relationship has not gone unnoticed by Fed Governor Miran, who has suggested that a strong stock market should not count toward inflation.
These revisions will likely lower recent PCE inflation readings, implying that the Fed may have been closer to its 2% target than previously estimated. The most meaningful adjustments stem from changes to portfolio management and software-related categories, which should moderate the influence that the AI-driven surge in equity and software prices has had on the index.
However, this comes with a trade-off. By dampening the sensitivity of these components, the index may become less responsive to downside moves in asset prices. In the event of a correction, particularly if the AI rally were to reverse, the disinflationary impulse flowing through these channels could be more muted.
In short, the revisions may bring measured inflation closer to target, but they do not necessarily make underlying inflation easier to achieve or sustain at that level.
Don’t miss our accompanying podcasts, available on our website and most podcast platforms: Apple | Spotify
Bi-Weekly Geopolitical Podcast – #88 “Excess Capacity and Policy Change” (Posted 6/11/26)
Bi-Weekly Geopolitical Report – Excess Capacity and Policy Change (June 8, 2026)
by Patrick Fearon-Hernandez, CFA | PDF
A key challenge of the big-picture, top-down investment analysis that we do at Confluence is tracing the real-world impact of a country’s economic policy initiatives. Whether policymakers are trying to boost economic growth, bring down price inflation, or achieve another goal, our aim is to figure out if the reform will be successful and the unintended consequences, be they positive or negative. Our ultimate objective, of course, is to determine the implications for financial markets and investment strategy.
One thing we’ve noticed is that many strategists attempting top-down analysis make overly simplistic assumptions about the likely effect of specific policy changes. They often ignore the fact that the same policy can be wildly successful or unsuccessful, depending on the pre-existing economic structure or conditions in place at the time. In this report, we show that one vital issue is the level of excess capacity in an economy. Many vaunted reforms in history were successful only because they were implemented when the economy had plenty of excess capacity to accommodate them. Many then conclude that those reforms would always be successful no matter what. We caution here that a deeper analysis is required to really understand any reform’s success and its financial market implications.
Don’t miss our accompanying podcasts, available on our website and most podcast platforms: Apple | Spotify
Asset Allocation Bi-Weekly – #160 “Wars, Price Shocks, and Inventories” (Posted 4/17/26)
Asset Allocation Bi-Weekly – Wars, Price Shocks, and Inventories (April 13, 2026)
by Patrick Fearon-Hernandez, CFA | PDF
Since the launch of the US-Israeli war against Iran on February 28, if there’s been one dramatic feature, it’s that the conflict and official statements about it have shifted dramatically almost on a daily basis. By the time this report is published, the war could be going in a wholly different direction from when we started writing it. Nevertheless, we do think we can make some predictions about how the conflict will affect the global economy over the long term. One such prediction touches on how corporate behavior may change in the future. Specifically, we think the war will spur companies to once again embrace high inventories to shield themselves against supply disruptions and associated price jumps. A broad return to higher inventories will likely have important implications for corporate profitability, facility-site decisions, and stock valuations.
The chart above shows the inflation-adjusted value of US private sector inventories as a share of gross domestic product (GDP) since the end of World War II. Clearly, the overall trend has been for companies to hold less inventory compared with their sales. What explains this? We believe many factors are responsible. For example, the extremely high inventories around World War II and the Korean War probably reflected hoarding at a time of limited consumer sales. Inventory holdings would have naturally fallen as the end of those conflicts allowed for normalized supply dynamics and rebounding consumer spending. At the same time, innovations in transportation quickened delivery times and reduced freight costs, while the information technology revolution improved the ability of firms to optimize inventory holdings. And, as we’ve argued many times before, the end of the Cold War convinced many business managers that global peace was at hand and that competing in the era of globalization required using just-in-time inventory management.
Equally noteworthy, the decline in price inflation since the early 1980s has made inventories less needed. Indeed, the chart above shows a long, steep decline in inventory ratios starting in the early 1980s when the Federal Reserve under Chair Paul Volker hiked interest rates and Congress passed a series of deregulation bills, both of which slashed price pressures on the economy. Just as important, the chart clearly shows how rising inflation in the 1960s and the energy crises of the 1970s prompted a big jump in inventory holdings equal to about 1% of GDP. The chart also shows that after commodity prices surged around 2005, firms boosted their inventory holdings. That inventory investment was short-circuited by the US housing crisis, but once the recovery started, inventories climbed back to almost 14% of GDP.
This review of history suggests that as company management internalizes the commodity supply shocks and rising prices associated with the war in Iran, there will likely be a rebuilding of inventories. More broadly, as it becomes increasingly clear that the war reflects a wider geopolitical change marked by a US retreat from hegemony, global fracturing, and increased international tensions, we think the rebound in inventories could be bigger and longer lasting than the one in the early 2000s. We also believe this trend will extend beyond the US, with companies around the world incentivized to boost their inventory holdings again.
What firms will be most affected? In the chart above, we focus on the US Census Bureau’s current series of monthly business sales and inventory data, in nominal terms, which allows us to trace corporate inventory/sales ratios by sector. The chart clearly shows that the rise in the overall inventory/sales ratio since the early 2000s has come from higher manufacturing stockpiles. This makes sense to us, as supply disruptions and higher costs for inputs and components are probably more important for manufacturers than for wholesalers or retailers. Going forward, we suspect that the Iran war will especially boost inventory holdings at the factory level.
In our view, any broad, sharp rise in manufacturers’ inventories from here on out will have significant investment implications. For example, holding more inventories will tie up more of manufacturers’ capital and increase costs. Investors are therefore likely to put higher valuations on the stocks of manufacturing firms that can better control their inventory levels, all else being equal. Given that the US is now a net energy exporter and has significantly greater levels of secure supplies of oil, gas, and other key commodities, we expect many foreign manufacturers to move production to the US, helping to reindustrialize the US economy and stimulating business for US suppliers. The need to store more inventory could also lead to increased demand and stronger rents for firms that own commercial warehouses. All the same, higher inventories will generally result in a less efficient economy than in the just-in-time world of globalization, so price inflation is still likely to be higher and more volatile than in years past, and the same will likely be true for interest rates.
Don’t miss our accompanying podcasts, available on our website and most podcast platforms: Apple | Spotify
Asset Allocation Bi-Weekly – #158 “Are Long-Term Treasurys No Longer a Safe Haven?” (Posted 3/16/26)
Asset Allocation Bi-Weekly – Are Long-Term Treasurys No Longer a Safe Haven? (March 16, 2026)
by Patrick Fearon-Hernandez, CFA | PDF
Historically, major geopolitical or economic crises, such as the war against Iran, have prompted investors to sell riskier assets and buy “safe-haven” investments whose values were expected to remain stable or even rise amid the disruptions. The most popular safe havens have been the US dollar, gold, and longer-term US Treasury obligations. Faced with the crisis, or the prospect of one, investors would typically bid up the value of the dollar versus other currencies. Many would also avidly buy up gold, driving prices for the precious metal upward. Others would snap up Treasurys, boosting their values and pushing their yields down. However, market action so far during the Iran war has defied expectations. Treasury demand has been relatively muted, and yields have been markedly resilient. This raises the question of whether long-term Treasurys are still a safe haven. And if not, why?
One way to see the unusual performance of long Treasurys is to compare their recent total returns versus shorter-term Treasurys. In the chart above, we show the total return (price change plus interest) for exchange-traded funds (ETFs) tracking Treasury obligations maturing in 20+ years (TLT), 10-20 years (TLH), 7-10 years (IEF), 3-7 years (IEI), 1-3 years (SHY), and 0-1 year (SHV). The graph shows how Treasurys of all tenors were bid up starting in mid-February, when it became clear that the US was prepping for a potential strike against Iran. However, once the war started, investors sold off Treasurys. The selling was especially strong for long-duration obligations as investors began to realize that the conflict could be more drawn out than anticipated, driving up global energy prices and rekindling consumer price inflation.
Importantly, the outsized selling of long Treasurys came after a protracted period of weak returns. The chart above displays Treasury total returns by duration over rolling one-year periods. It shows clearly how one-year returns from long Treasurys have lagged since early 2025.
Indeed, long-term Treasury returns have lagged for quite some time. The final chart, on the next page, shows that three-year returns for long Treasurys have not only lagged shorter-term Treasury returns, but they have also lost money in the latest three-year period. This happened even though the Federal Reserve has been cutting its benchmark fed funds interest rate since September 2025. In contrast, shorter-term Treasury securities have offered steady positive returns. Shorter-term Treasurys have largely held their value even after the Iran war started and it became clear that the conflict would threaten global energy supplies and risk reigniting inflation.
Why have long Treasurys lost their attraction as a safe haven? We believe their weakness reflects increased investor concerns about US fiscal dynamics, prospects for a more politicized Fed, and fear of currency debasement. The key evidence for this has been the sell-off in long Treasurys after the war started, once it became clear that the conflict could last long enough to seriously disrupt energy supplies and cause rising global inflation. If investors were truly confident that the Fed would temporarily hike interest rates as needed to wring the inflation out of the economy and protect the purchasing power of the dollar, then demand for Treasurys should have gotten a boost from wartime safe-haven buying. However, the fact that Treasurys have not behaved as usual suggests they may have lost a lot of their cache as a safe haven. As investors also sell off gold to cover margin requirements and raise needed cash, it seems like they only see one true safe-haven asset these days, i.e., cash.