February Investment Comments
Last summer, there was a brief wave of optimism among investors that the Federal Reserve’s pattern of interest rate hikes would be short-lived. It was illogical given rampant inflation, but investors could let their imaginations wander during the lengthy eight-week lull between the Fed’s July meeting and its September meeting. However, midway through the lull the Fed became concerned investors weren’t getting the message, using the annual “Jackson Hole (WY)” monetary policy conference in late August to reiterate its determination to raise rates until inflation is back to its 2% objective. Investors got the message and stock and bond prices wilted for about a month and a half afterward.
A greater disconnect between markets and the Fed emerged after markets bottomed in mid-October, persisting even in the face of two more Fed meetings that resulted in rate hikes. Notes from its November meeting indicate Fed governors raised their terminal Fed Funds rate in this tightening cycle compared to their consensus after the previous meeting. Markets initially flinched on this news, but quickly resumed their ascent.
Fed governors are trying to demonstrate their seriousness in tackling inflation by raising rates to slow the economy, yet markets don’t seem to be believing them anymore. Since reaching its 2022 low on October 13, the S&P 500 is up almost 15%, retracing about 40% of its losses. Similarly, yields on 10-year Treasuries have retraced about 30% of the rise since reaching their 2022 peak of 4.33%.
What could explain these disconnects? One explanation is that we could be nearing the end of the line in terms of rate hikes, which is what the stock and bond markets appear to be counting on. There is some logic to this thinking. The Fed Funds Rate is currently 4.25%-4.50%, which leaves only two more hikes before reaching the 5% level that many believe will be the maximum rate for this cycle. Even if the Fed Funds rate ultimately goes to 5.25%-5.50% as some expect, this level would be reached by early May.
Private economists and the Fed are similarly disconnected. Over half of private economists in a Wall Street Journal survey indicated they expect the Fed to actually cut interest rates this year while no Fed governor endorsed that view in the November minutes released after the December meeting. In this case, we would side with the Fed. First of all, the Fed is the body directly in charge of short-term interest rates. Second, Fed governors are mindful of not repeating the 1970s mistake of retreating from the inflation fight too soon. It wouldn’t be surprising to see them hold rates higher a little longer than customary, and Fed governors have hinted as much.
While not as premature as market optimism this summer, recent hopefulness strikes us as too much too soon considering that the effects of the Fed’s six rate hikes are only starting to be felt. We surmise the reason for the delayed effect is that rates only exceeded long-term inflation in late July, meaning that monetary policy was still “accommodative” up to that point. Given that it takes 6-9 months for policy changes to affect the economy, we should be noticing the impact around now.
There are signs the Fed has indeed had an impact on the economy. Consumer inflation has been declining for six straight months after reaching its year-over-year peak of 9.1% in June. In addition to tightening monetary policy, contributing factors include normalizing supply chains and falling energy prices due to weak global growth.
Retail sales grew during 2022, tracking the rate of inflation such that unit growth was slightly negative. November and December retail sales shrank in dollar terms, and likely worse in terms of units sold. Some of this is the consequence of strong October sales when many retailers offered deals to clear excess inventory. Wages have risen, but not up to the rate of inflation. Consumers have supported spending by dipping into savings, but there is a limit to how long that can continue.
The Purchasing Managers Index registered contraction in both the manufacturing and service sectors in December. Actual industrial production has weakened as well. It is a bit soon to break glass and pull the alarm, but recent indicators reflect a steady softening that has been going on for months.
Some investors and the media point to solid job growth as a sign the economy is still strong. This view is overly optimistic because employment is a lagging indicator. Companies cut jobs after seeing lower sales, not in anticipation of them. However, one nugget from the recent employment report is that wage gains continue to decelerate, a hopeful sign if we are going to get inflation under control.
When evaluating information that seems out of step with reality, one helpful exercise is to consider what would have to happen for that viewpoint to be correct. In other words, don’t discount the possibility that a seemingly disconnected view might turn out to be correct. Stock prices and bond yield behavior last year were consistent with a recession. 61% of economists in a Wall Street Journal survey expect a recession this year, but a mild one with the weakest period being the second quarter. If they are correct, we are not far away from that point and the recent market optimism starts to make sense. Investors may have accepted and priced in the odds of a recession and are now looking 6-9 months ahead to the early stages of an economic recovery. In this view, they would be looking past the remaining interest rate hikes because they have accepted the outcome, recession. They aren’t ignoring the Fed, they are just looking farther ahead. But it is all predicated on a moderating inflation rate that allows the Fed to pause its rate hikes rather than persistent inflation that forces the Fed to raise rates higher than anticipated by investors, economists, and even the Fed itself. Investors should remain buckled in because the ride will be bumpy as the mix of economic news turns negative. It is also important to look for opportunities to prepare for the eventual upturn in the economy.
Scott D. Horsburgh, CFA