BY: Jim McElroy
Same Song, Second (or Third or Fourth) Verse
There’s a certain sameness to the current market environment. It seems that we’ve been facing a familiar dynamic tension for most of the past year: GDP is thankfully still positive — no recession yet, and the unemployment rate is low —but inflation is higher than the Fed would prefer and there’s scant optimism that interest rates will drop before the end of the year. The latest news from the Fed is that overnight rates will remain in a 5.25%-5.50% range, that another hike may be necessary before year-end and that rates will remain elevated indefinitely. The inverted yield curve remains in place (short rates higher than long rates). Meanwhile, the stock market, though down almost 7% from its high this past summer, is still positive for the year and still in bull market mode. Don’t get us wrong: this is much better than the alternative of a deep recession, hyper-inflation, sky-high interest rates or a bear market in stocks. It’s just that we thought that by now, the Fed would have been able to declare victory over inflation, either because it had precipitated an economic recession (not good) or had managed that rarest of all central bank tricks, a soft landing. Both the good and bad paths to victory over inflation remain possible, but it appears that more time and patience are needed before the issue will be resolved.
Currently (dare we say it), conditions suggest the possibility of a soft landing. In broad terms, the hallmarks of a soft landing include an annual rate of inflation (core PCE, the Fed’s preferred measure) of about 2%, an unemployment rate near 4% (no more than 5%), and a still positive GDP. The latest monthly readings (June and July) for core annualized PCE inflation registered 2.6%, well below the cyclical peak of 7.8% set in June of 2022, which was itself the highest reading in over 22 years. We should also note that the general trend of monthly core PCE inflation has been slowly declining since the beginning of the year. GDP growth, following the anomalous pandemic-driven gyrations of the second and third quarters of 2022, has been slowly moving towards a more normal range of between 1% and 2.5% (annualized). The latest reading for the second quarter GDP was a positive 2.1% and average estimates for the current quarter were approximately 1.9%. The unemployment rate, after taking a hit from the pandemic and then rallying during the post-pandemic period, currently stands at a healthy 3.1%. A soft landing could happen — the continuing bull market in stocks suggests at least a non-negative weight to that possibility —but it will require more than a modicum of sound judgment and luck on the part of the Federal Reserve over the next few quarters to make this possibility a reality.
The Fed’s mandate, as defined by Congress, is to maintain both price stability and full employment. There is a sweet spot where both goals can be achieved simultaneously, but it’s a very small spot, and there’s little margin for error. The Fed’s only tools for hitting this sweet spot are monetary policy and the setting of overnight rates. And even with these, there are significant and variable time lags between implementation and results. The other tools for striking the perfect balance — long-term interest rates, consumer confidence, oil prices, corporate hiring decisions … the list goes on —for these, the Fed can only serve as an influencer. It’s little wonder that hitting the sweet spot or engineering a soft landing, is such a rare occurrence.
In the Fed’s latest communication, Chairman Powell said he was not displeased with the progress the Fed has made in meeting the two Congressional mandates of price stability and full employment. He also referenced the holy grail of Fed aspirations and seemed to suggest that it was a possibility: “A soft landing is not a baseline expectation, but I’ve always thought that it was a plausible outcome and there’s a path to it.” Most troubling to the markets was the suggestion that more rate increases might be necessary in 2024 and that rates might remain high for longer than originally thought. Though only an influencer, the Fed has a powerful and very loud voice: following its recent statements, the stock market hiccupped and long-term interest rates moved higher.
The current level of interest rates is certainly elevated when compared with comparable rates over the last ten or so years. But, over most of this period, the Fed had a very different objective than it has now. In the six years following the Great Recession (2008 through the second quarter of 2009), the Fed, as well as most central banks, was more concerned with deflation and economic depression than with high inflation. For six years, the Fed held overnight rates at near zero levels, while ten-year Treasuries, for the most part, traded at yields between 1.5% and 3%. In early 2016, the Fed decided that the risk of deflation had diminished and focused its attention on preempting inflation: for the next three years, overnight rates climbed from near zero to 2.5%, while ten-year Treasuries continued to trade below 3%. When the pandemic struck in early 2020, both the Fed and fixed income markets returned to a deflationary regimen: overnight rates dropped to near zero and ten-year Treasuries dropped to below 1%. Then the pandemic ended, inflation roared back,ten-year Treasuries climbed to 4.5%, and the Fed held rates near zero for eighteen months, leaving itself with a pricey and inflated egg on its face. Since then, the Fed has moved aggressively and has had some success in moderating inflation.
There seem to us to be at least three paths that the economy and the markets could take in the next few quarters. We’ve already mentioned two: a soft landing and a hard landing. A third path might be called a “non-landing” (or an indefinitely postponed landing). Unfortunately, “postponed” does not mean it doesn’t happen but that the eventual reckoning is much more painful. This was the case during the 1970s and early 1980s when inflation remained stubbornly high through three different Fed Chairmen and despite four recessions. The term “stagflation” was coined during this period: inflation drove up wages and salaries due to cost-of-living adjustments (COLAs), which drove up consumer demand, which drove up inflation, etc., all with no increase in real economic growth or productivity. The third Fed Chairman (Paul Volcker)ended this pernicious cycle with double-digit T-Bill and bond rates and a steeply inverted yield curve (4.1% difference between Fed funds and ten-year Treasuries). So, there are worse things than a hard landing.
For now, we hope for a soft landing but remain prepared for the harder alternative. The equity risk premium — S&P 500 expected earnings divided by price, minus the yield on ten-year government bonds — at 0.91% is not sufficiently high to justify overweighting the stock market. And bond rates are finally approaching attractive levels (ten-year Treasuries at 4.57%), especially if a hard landing is in our immediate future. We said earlier that there’s a certain sameness to this quarter when compared with the previous three months. Consequently, our message for the fourth quarter is much the same as it was for the last quarter: be cautious, keep a neutral stance to equities and rebalance any overweighted stock positions into what are likely to be underweighted asset classes, namely fixed income and cash.
Not Investment Advice or an Offer
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.
