BY: Jim McElroy
Should Auld Misgivings Be Forgot and Never Brought to Mind…?
As we close the door on 2023, the mood in the markets seems to be one of optimism and good cheer. The S&P 500 is up for the year and long-term interest rates appear to be on the decline. This is in sharp contrast to the way we began 2023. At that time, we were in an equity bear market, inflation had hit a forty year high, the Fed had raised short term interest rates from near zero to 3.75% and was darkly hinting that more was on the way. By the end of July, the overnight rate had reached a range between 5.25% and 5.50%. All that, of course, changed in December, following the Fed’s seeming about-face on inflation and interest rates. Now, in spite of all the skepticism and doubt with which history has equipped us, the market seems willing to believe that the Fed has managed, so far, to conjure up the semblance of a soft landing, defined as disinflation without a recession. The active modifier, of course, is “so far”.
The Fed does deserve some credit. The latest Core Personal Consumption Expenditures index — the Fed’s preferred inflation measure — increased at a 3.16% rate from year ago levels, a significant decline from the forty-year record of 5.57% set in February of 2022, but still above the Fed’s stated target of 2%. More importantly, however, the monthly rates have been declining towards the Fed’s target: the increase from October to November came in at .058% (an annualized rate of .7%), .3% below the Fed’s annual target. The more common inflation measure, the Consumer Price Index for all items, has also declined, though it still remains above pre-pandemic levels. Meanwhile, the unemployment rate for November posted a still low 3.7% and third quarter real GDP registered a healthy 5.2%. Overall, market interest rates have declined since mid-October — the Ten-Year UST from about 5% to near 4% — due as much from disinflation as from a market reduction in the inflation premium. The risk spread on corporate debt, defined as the yield on corporate bonds (in this case, 10 year AAA corporates) minus the yield on like maturity U.S. Treasuries, has remained subdued for most of the year — a high of 1.18% and a current low of just under .70% — suggesting a lack of concern for recessionary defaults. All these reassuring statistics were what led the Fed to a decided shift in emphasis: in comments following the December FOMC meeting, Chairman Powell declined to make his now customary suggestion of likely rate hikes in the future and instead mentioned that three rate cuts had been “penciled in” for 2024.
The immediate response of the stock and bond markets to the Fed’s unexpected change of opinion was predictable: the Dow Industrials set a record high and the yield on 10 Year U.S. Treasuries dropped below 4%. However, a closer analysis of the working papers for the December meeting – the Statement of Economic Projections, a compilation of opinions and assumptions by Federal Reserve Board members and Federal Reserve bank presidents — reveals that little had changed from the prior meeting. There was an acknowledgement that inflation had eased somewhat over the past year, that expectations for GDP growth in 2024 had declined slightly from 1.5% to 1.4% and, in a subtle change in wording, that the likelihood of additional rate hikes in the current cycle had been revised downward. The message that the Fed appears to be sending is that after over a year of the steepest rate tightening in forty years, it has decided to pause its efforts in order to consider the results of its prior actions. Given the multiple uncertainties of unforeseen future events and indefinite time lags between Fed actions and subsequent economic results, this seems to us a wise course. A pause does not preclude the possibility of more rate hikes if inflation quickens, or more drastic loosening measures if unemployment suddenly accelerates. For now, though, the Fed has declared a truce and the markets have responded accordingly.
We are heartened by the Fed’s success so far in reducing inflation without wrecking the economy. But, at the risk of inserting a discordant note to New Year’s celebrations, we wonder if the possibility of a hard landing or higher inflation has really disappeared. The yield curve is still inverted, short term interest rates at 5.25%-5.50% are still restrictive, rate cuts are still dependent on progress on inflation, and inflation, while having eased on a monthly basis, is still vulnerable to volatile demand and supply constraints. On the subject of possible demand and supply constraints, we have only to look at the escalating crisis in the Middle East to recall that a curtailed oil supply will have a massive impact on consumer prices and inflation. And although the Fed did exchange its “Grinch” clothes for the white beard and red wardrobe of Santa Claus at its December meeting, it has not declared victory and has not retired.
The likelihood of the Fed’s continued activity in 2024 should not be cause for alarm, but certainly should temper overly optimistic expectations. There are substantial pitfalls ahead for the economy when the Fed actually begins reducing overnight rates: too much or too little, too soon or too late, each can have outsized consequences for inflation, unemployment and the financial markets. The market is already predicting three to four rate cuts of .25% to .50% in 2024, the first such cut to occur in March; there will be negative market repercussions if this doesn’t happen. We should also remember that there is always a political dimension to the Fed’s maneuvering: with the presidential election only ten months away, the last thing the Fed wants is media and public suspicion that it is interfering with the political process. We should anticipate that the Fed’s timing in 2024 might be less than optimal.
The outlook for 2024, like every new year in late December and early January, is full of promise and foreboding and as clear as muddy water. The “promise” resides in the hope that inflation will continue to decline in the face of steady or improving economic conditions; if this case, the best returns over the next three months will come from equities and especially from the riskier members of the equity asset class (i.e. small cap stocks and stocks of lower quality cyclical companies). The “foreboding” resides in the fear that inflation may reverse itself and accelerate, or that it may continue to decline, but accompanied by rumors of a hard landing. We expect a good bit of volatility in the months ahead as the market adjusts to changes in expectations and the Fed responds to progress or backsliding on inflation, GDP and employment. In such volatile markets, we believe that patience and a consistent adherence to the asset allocations that are appropriate to individual investment objectives will produce the most satisfactory results for investors.
Last year at this time, we were skeptical that the Fed would be able to orchestrate a soft landing and suggested that 2023 would be a turbulent year for investors, particularly in the first half of the year. We had misgivings and we were partially right. It was a volatile year: overnight rates climbed from 3.75% to 5.25%; the yield on Ten Year US Treasuries fluctuated between 3.30% and 4.93%, but finished the year at 3.8%, about the same level at which it began; and in a show of positive volatility, the S&P 500 finished 2023 up 24.2%, within .6% of its all-time high. We are not ready to forget our misgivings from last year — we are still skeptical of the Fed’s ability to fine tune an economy that has historically resisted fine tuning — but the Fed so far has made few mistakes. The next few months should clarify the direction of the economy and the markets. In the meantime, we wish you a happy and prosperous New Year.
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This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing.
