US Strategy Weekly                    

Lower Inflation Ahead

We like to find “crowded trades” or extremes in sentiment regarding an investment and then find the flaws in the view. One of these crowded views is the global stance on the US dollar. According to a recent Bank of America survey, global fund managers have the most bearish outlook on the US greenback in over a decade. Analysts attribute this weakness to concerns regarding US policy predictability and Federal Reserve independence. In both cases, we feel the fear is overhyped and would not hold up to scrutiny. Nevertheless, pessimism has been correct with the dollar down over 11% since its peak in early January 2025. But we would point out that part of the dollar’s weakness is a result of the narrowing of the trade deficit since this results in less demand for dollars. Analysts may simply be using policy and the Fed as the reason for the weakness. Ironically, a weaker dollar makes US exports more attractive so in the long run a weaker currency can be good for the economy. In our opinion, a weaker dollar is not a major concern — although it can be inflationary — and the reason is simple. Modern currency is fiat money backed only by trust and confidence in a country. This trust is based upon the stability and transparency of its government and banking system, the strength of its economy, the relative level of inflation, and geopolitical and military power. In sum, the US has more of these important qualities than any other competing currency. Dollar weakness could simply be the greenback’s adjustment to the narrowing of the trade deficit.   

In terms of measuring US economic strength and relative inflation there were two important reports last week. January payrolls are always a problem — for several reasons. Each January, the establishment survey is benchmarked to new data gathered from the Quarterly Census of Employment and Wages – QCEW – which counts jobs covered by the unemployment insurance tax system. In addition, seasonal adjustments are reworked with more current data. This January the BLS also changed the birth-death model to include current sample information.

The household survey also undergoes an annual adjustment for new population data from the Census Bureau in January; however, this adjustment was delayed this month. And finally, the BLS noted that severe winter storms resulted in the household data response rate falling to 64.3%. In short, the January jobs report was riddled with issues making any worthwhile analysis impossible. Nevertheless, we did see the growth rate for total household employment fall from 1.5% YOY to 0.4% YOY. The establishment growth rate was also low at 0.2% YOY and has been relatively unchanged since October. In short, recent data releases suggest weak job growth. See page 3.

We have been writing about the weak growth in total employment which began in 2024 and continued in 2025. One risk is that AI will continue to dull job growth. If so, we worry that this could lead to a recession, particularly since a recession is best defined as a year-over-year decline in total employment. Nonetheless, the unemployment rate fell from 4.4% to 4.3% in January. The underlying data showed a significant divergence in unemployment rates among levels of education. The rate for those with less than a high school diploma fell from 5.6% to 5.2%. High school graduates saw unemployment jump from 4.0% to 4.5%. The rate for those with some college or an associate degree fell from 3.8% to 3.6%; whereas a college degree or higher saw a rate increase from 2.8% to 2.9%. These were unusual changes, but due to the various adjustments and low survey response in the January jobs report we believe the numbers are too unreliable to draw any conclusions. See page 4.   

January’s inflation numbers were better than expected with the headline CPI index falling from 2.7% YOY to 2.4% YOY and core inflation falling from 2.6% YOY to 2.5% YOY. However, many of the components of the CPI grew faster than headline, especially the index for fuels and utilities which rose 1.1% for the month and 6.1% YOY. This inflation in utilities and energy services is taking place even though energy commodities fell 6.6 % YOY in January after falling 3.0% YOY in December. This contradiction is due to supply and demand disruptions at the consumer end. The previous administration’s environmental policies resulted in the subtraction of nearly 17 gigawatts of reliable baseload power generation in the US. These 17 gigawatts are enough to power 12 to 15 million homes or the equivalent of the output of 17 large nuclear reactors. This huge decline on the supply side was coupled with soaring demand for energy from large data centers which support AI and crypto mining. These two factors are the likely causes for the differentiation between falling raw material prices and soaring energy services pricing. See page 5.

The debate regarding the inflationary impact of tariffs on consumers is answered by the chart on page 6. There was some increase in durable and nondurable consumer prices in the middle of 2025, but this never rose to more than 1.9% YOY in durables and 2.3% YOY in nondurable. In January 2026, the price indices for durables rose 0.4% YOY and nondurables rose 1.3% YOY. However, service sector inflation rose 3.2% YOY. Service inflation has been high, first driven by housing prices, then by motor vehicle insurance, followed by a spike in hospital & related services, and more recently led by household insurance pricing. These rolling spikes in pricing have kept service inflation above 3% YOY for the last four years. Nevertheless, the 3.2% YOY seen in January matches the November 2025 level, both of which were the lowest since August 2021. Note that service sector inflation is closely tied to employment costs and the employment cost index (ECI) was 3.4% in the fourth quarter, the lowest since the second quarter of 2021. AI should also help to keep employment costs low and employee productivity high in coming years. See page 6.

Core CPI indices have been steadily decelerating since the cyclical peak made in September and are now clustered in a range of 1.8% YOY to 2.4% YOY. In all cases, core indices are equal or down from January a year ago. This is good news for consumers. But a few sticking points remain, and these currently include necessities such as utility and housing insurance costs. See page 7.  

A main reason for our optimistic inflation forecast of 2.2% or less in 2026 is that crude oil prices continue to be negative on a year-over-year basis. Inflation has rarely if ever moved substantially higher when energy commodity prices are falling. However, as we noted, policy factors and demand changes have impacted energy services pricing. We expect the current administration will address both supply and demand issues this year. If so, the fed funds rate could move lower in 2026, but we would not be surprised if the FOMC required several more months of data before cutting rates. Traders are currently pricing in a 63% chance of a 25-basis-points rate cut at the June meeting, which is a recent upward shift. Note that in March 2022 the real fed funds rate was at its lowest and most dovish level in over 75 years! See page 8. This was a contributing factor to the 9.1% YOY peak in the CPI in June 2022. If the Fed delays cutting rates again in the face of a weakening job market, they risk being wrong one more time.

Technical indicators favor the bulls, particularly the NYSE cumulative advance/decline line which made a new high on February 17, 2026. However, the 10-day average of daily new lows has moved above 100, shifting this indicator from positive to neutral. The rotation of leadership and questioning of AI-related fundamentals is a positive factor for the longer run in our view; but we would not be surprised if the S&P index spends more time consolidating below the 7,000 level. We remain a buyer of weakness.

Gail Dudack

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There has been a string of data releases this past week, but the most important reports on employment and inflation for January are still ahead. The combination of these two releases could shift the consensus view on rate cuts in 2026, which now stands at one or two 25-basis point cuts and would bring the current range of 3.5% to 3.75% closer to 3% by year end. The FOMC dot plot projects only one 25-basis point cut this year, but the Fed’s dot plot is less a projection of interest rates than a data trend follower. And there is reason to be cautious about inflation since economic activity as measured by GDP has been strong. The 3.8% and 4.4% growth rates in the second and third quarters of 2025 were the best economic activity seen since the 4.7% and 3.4% rates seen in the third and fourth quarters of 2023. However, it is important to point out that inflation did not accelerate in 2023, and we do not believe it will accelerate this year either.

One reason inflation is less likely to accelerate this year is that employment costs are down. A recent employment cost index (ECI) report shows that total compensation, wages & salaries, and benefit costs for civilian workers each rose 0.7% in the final quarter of 2025. This was better than expected, and on a year-over-year basis, total compensation rose 3.4%, benefits rose 3.4%, and wages rose 3.3%. In each case, these were the lowest increases seen since 2021. See page 3. In the second half of 2023, the ECI was falling from a peak of 5.1% in the second quarter of 2022, but costs were still rising 4.4% and 4.2%, respectively. And despite this fact, inflation continued to decelerate. In our view, inflation is likely to slow in 2026 as well, particularly since crude oil prices remain relatively low. The fourth quarter deceleration in the ECI indices has been a positive for businesses and is showing up in recent corporate earnings releases as margin improvement.

The January jobs report will be an important data point for the Federal Reserve to ponder, but it will be a difficult report to analyze due to annual adjustments to seasonality and population benchmarks. Nevertheless, a weak employment report coupled with mild inflation could be a recipe for the dot plot to raise its estimates of rate cuts for this year. If so, it would spark more demand for equities.

Despite our concern about the weakening job market, there are signs that the consumer remains resilient. Outstanding consumer credit surged $24.1 billion in December, nearly five times the increase seen in November. Revolving credit, which includes credit cards and other short-term borrowing, grew $10.2 billion, or at an annualized rate of 13.4%. This gain was in sharp contrast to November’s annualized decline of 1.5%. Total credit grew 3.3% YOY, which was the highest growth rate seen since September 2023. Revolving credit rose 2.4% YOY, the first YOY increase since November 2024. We welcome this growth in consumer credit since negative revolving credit growth, like that seen in revolving credit recently, is closely correlated with recession. See page 4.

The advance estimate for retail and food services sales in December (adjusted for seasonal variation, holiday and trading-day differences, but not price changes), was $735.0 billion, virtually unchanged from the previous month, but up 2.4% YOY. Real retail sales rose 1.1% YOY. This report was viewed as a disappointment by most economists, but total sales for the 12 months of 2025 were up a healthy 3.7%. Nonstore retailers were up 5.3% YOY and food service and drinking places rose 4.7% YOY.

A separate report on vehicle sales was a concern since it showed that total vehicle sales were 15.4 million units (annualized rate) in January, down 6% month-to-month and down 3.5% YOY. Unit sales were reported to be 16.4 million in December 2025, down an even larger 5.2% YOY. In short, there has been a sharp 2-month deceleration in auto sales. A good part of this may be due to severe weather across much of the US but it is a trend worth monitoring since it could point to a weakness in consumption. See page 5.

The NFIB Small Business Optimism Index fell 0.2 to 99.3 in January. Seven components declined and the only improvements were in expectations for expansion, sales and credit. Hiring plans edged lower, and the uncertainty index, which dropped to its lowest level since mid-2024 in December, rose modestly in January. The most significant problems reported by small business owners were taxes (18%), followed by labor quality (16%) and insurance cost (13%). See page 6.

The University of Michigan consumer sentiment survey inched up to 57.3 in February from 56.4 in January, due primarily to the 2.9 point increase in present conditions, which rose to 58.3. Expectations slipped to 56.6 from 57.0. However, sentiment surveys have been in recession levels below 60, for ten of the last twelve months despite steady growth in the economy and retail sales. In our opinion, sentiment indicators have become victims of negative media coverage and are less useful than they had been in the past. See page 7.

All in all, recent economic reports show a healthy, although somewhat sluggish, economy. Fourth quarter earnings season, on the other hand, has been stellar. At present, the 12-month sum of operating earnings shows a gain of 16.7% YOY, far better than the 75-year average of 8.1% YOY. Consensus operating earnings estimates for the S&P 500 this year are currently $314.24 for LSEG IBES and $310.64 for S&P/Dow Jones. Our $315 estimate looked high in December when we published our outlook for the year, but it is becoming consensus view. But as we stated in December, our estimates are likely to prove to be too conservative. See pages 8 and 15.

Technical indicators continue to favor the bulls, even though our 25-day up/down volume oscillator, now at 1.78, remains in neutral territory. However, the 10-day average of daily new highs was strong at 553 this week and new lows ticked higher at 162. This combination of daily new highs above 100 and new lows above 100 lowered this indicator from positive to neutral last week. But most importantly, the NYSE cumulative advance/decline line made a new high on February 10, 2026, confirming new highs in the broad indices. See pages 10 and 11. Investors should be aware that the backdrop for the financial markets includes several risks. On the geopolitical front Israeli Prime Minister Benjamin Netanyahu will be visiting Washington this week to discuss possible military options against Iran with US President Donald Trump. There are reports that Israel is preparing contingencies should US-Iran talks collapse. We are also concerned about possible liquidity issues linked to cryptocurrencies following the roughly 45% decline in Bitcoin (BTC – $68,758.59) from its October peak of $126,000. One analyst estimated that there were roughly $10 billion in realized losses locked in by investors last week, the second-highest total since June 2022. Massive selloffs in one asset can create liquidity pressures that roll into other parts of the financial system. Nonetheless, we remain a buyer on weakness.

Gail Dudack

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Just like the market was not concerned about last week’s FOMC meeting, it was unaffected by the current partial government shutdown. Both are rational reactions in our view. Lower interest rates in a good economy are less necessary (and could be inflationary), and more importantly, fiscal policy will “trump” monetary policy in 2026. Plus, the anxiety surrounding a government shutdown and the political posturing during one has become far less relevant to equity investors today, particularly since the record-breaking 43-day shutdown that began on October 1, 2025, did little to nothing to impact the overall economy last year.

This latter statement is quite amazing, particularly since federal government employment fell by 179,000 in October 2025 during the shutdown, reaching its lowest level since July 2014. Recent data shows that over 212,000 civil servants have left the federal workforce through voluntary and involuntary mechanisms aimed at reducing the number of federal employees. This should dampen employment levels; nevertheless, in October 2025 while retail sales slowed to a gain of 3.3% YOY from 4.1% YOY a month earlier, this pace was still better than the 3.2% YOY gain seen in October a year earlier.

But, as we go to print, the threat of a shutdown is ending since the House of Representatives has voted to end a four-day partial shutdown. The legislation will fully fund five sectors of the federal government through the end of the fiscal year (September 30, 2026), while extending funding for the Department of Homeland Security for ten days, or until February 13, 2026.

And despite all the political bluster the economy appears to be strengthening. The ISM manufacturing index increased from 47.9 to 52.8 in the month of January, and this gave a boost to the stock market earlier this week. It was the first reading above the breakeven 50 level since the back-to-back 50.9 and 50.3 readings seen in January and February 2025. However, these two readings were preceded by 26 straight months of readings that were below the breakeven 50 level – a sign of contraction in the sector. Three of the ten components in the index shifted from under to over 50 in January – new orders were impressive jumping from 47.4 to 57.1 – and production rose from 50.7 to 55.9. Employment increased from 44.8 to 48.1 but remains in contraction territory. See page 3. The ISM nonmanufacturing index will be released later this week.

Despite our concern about housing affordability and the inability of young adults to buy homes, homeownership rates increased in the third quarter of the year, with the overall reading rising 0.3 points to 65.3%. The largest increases were seen in the Northeast (61.4% to 62.5%) and the South (66.6% to 67.2%). Homeownership rates were flat in the West and down in the Midwest. Still, the most surprising and important fact seen in the survey was the 1.1% increase in homeownership for those under 35 years of age which rose to 37.5%. Homeownership remains highest for those 65 years of age or more at 77.9%, however the percentage was down from 78.6% in the second quarter. See page 4.

In general, we believe inflation worries are fading; however, the 0.5% increase in the PPI index in December was the largest monthly gain in five months. Still, this larger-than-expected monthly gain left the year-over-year unchanged at 3% YOY. The increase in December’s PPI final demand index can be traced to a 0.7% rise in the index for final demand services. Prices for final demand goods were unchanged in December, again indicating that tariffs on imported goods are not the source of inflation.

The deceleration in CPI and PPI indices has carried most inflation measures to a range of 2.7% to 3%. On one hand this range is well above the Fed’s 2% target, but it is also below the long-term average for inflation of 3.4% YOY. More importantly, it would be highly unusual to see any acceleration in inflation in coming months since oil prices continue to be negative YOY. Lower oil and energy prices provide a favorable backdrop for consumers and inflation.  See page 5.

Labor productivity increased by 4.9% (annualized) in the third quarter, after rising 4.1% in the second quarter. This acceleration was predictable since GDP accelerated to 4.4% in the third quarter after rising 2.8% in the second quarter. The US Bureau of Labor Statistics (BLS) calculates labor productivity index by dividing an index of output by an index of hours worked. Output can be measured in most industries, but for those industries where employees do not punch a clock, hours worked can only be estimated. As a result, we believe productivity numbers are unreliable. But it is clear to us that productivity did rise in the third quarter because nonfarm unit labor costs decelerated to 1.2% YOY from 2.0% YOY in the second quarter. Note that the BLS data on employment costs also shows compensation has been relatively stable at 3.5% YOY. Stable labor costs are good for corporate profit margins and for earnings growth. See page 6.

While the economy appears to be doing well, the risk is that the job market may be weakening for a variety of reasons. Unfortunately, BLS will not release January’s employment data this week. However, the January jobs report is always fraught with issues since the establishment survey undergoes an annual benchmarking process and seasonal adjustment factors are updated. The household survey is also adjusted for updated population estimates from the Census Bureau. All these factors make January data difficult to compare to previous months. It will be an important, but tricky month to analyze when we get the data. 

But if we were to choose one factor that is important for the equity market it would be earnings. The LSEG IBES consensus earnings estimate for 2025 rose $0.35 (more than offsetting last week’s $0.30 decline) to $271.92 this week and the 2026 estimate was unchanged at $313.04. The 2027 forecast rose $0.71 to $361.32. The S&P Dow Jones estimate for 2025 rose $1.81 to $265.41 and the 2026 estimate fell $0.02 to $310.24. Using IBES estimates this means the market is trading at 25.4 times 2025 estimates, 22.1 times 2026 estimates, and 19.1 times 2027 earnings. What is interesting about these PE multiples is that they have not changed much in the last two years (apart from the tariff panic in April 2025) even as equity prices continue to rise. In short, this is, and has been, an earnings-driven market. That is the best kind of bull market.

And though PE multiples are rich, the forward earnings yield of 4.65% and dividend yield of 1.14% compare well to a 10-year Treasury bond yield of 4.2%. Perhaps most importantly, 12-month trailing operating earnings are growing at 16.2% YOY, far better than the 75-year average of 8.1% YOY. See page 7.

All in all, we remain a buyer of weakness, and as this will be a midterm election year, one should expect several bumps in the road ahead. But if the economy and earnings continue to grow, and we expect they will, we expect the long-term bull market will remain intact.

Gail Dudack

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