Big Picture Review
The question on the minds of most investors has been the same one for many quarters: What is the Fed’s next move? After hiking its benchmark federal funds rate at an aggressive pace in 2022 and more moderate pace in the first half of 2023, the Federal Reserve has begun to tap the brakes on its acceleration. While inflation is not back to its preferred 2% level, Chairman Powell commented at the most recent post-Federal Open Market Committee meeting in September: “We’ve raised our policy interest rate by 5¼ percentage points and have continued to reduce our securities holdings at a brisk pace. We’ve covered a lot of ground, and the full effects of our tightening have yet to be felt. Today, we decided to leave our policy interest rate unchanged and to continue to reduce our securities holdings. Looking ahead, we’re in a position to proceed carefully in determining the extent of additional policy firming that may be appropriate.” Could the Fed achieve the best outcome known as a “soft landing” where the economy and inflation cool but unemployment does not heat up too much? Or will the cumulative effect of 18 months of interest rate hikes be too much for the economy to bear? There are signs pointing in both directions.
The labor market is in good shape. The national unemployment rate for September came in at 3.8% and has been under 4% since February 2022. According to the latest Fed summary of economic projections, the longer run rate they are expecting is only 4% absent unforeseen shocks to the economy. Companies remain somewhat reluctant to let go of individuals knowing how hard it was to staff higher following the pandemic. The labor force participation rate is now above the pre-pandemic level for individuals 25 to 54 years old who represent the prime working age cohort. The number of available jobs as measured by the Bureau of Labor Statistics’ Jobs Openings and Labor Turnover Survey (JOLTS) jumped to 9.6 million in August from a revised 8.9 million is July due to more postings in finance and insurance, education and non-durable goods manufacturing. U.S. Census Bureau data showed that in the first half of this year, applications to start a business likely to hire employees outpaced last year’s first half by more than 7% with the application surge broad-based across most industry sectors.
Inflation is coming down. Monthly core inflation, as measured by the Fed’s preferred personal consumption expenditures (PCE) excluding food and energy, rose 3.9% at an annual rate in August, down from the 4.3% pace in July. The Fed’s summary of economy projections shows a median figure for total PCE of 3.3% this year, falling to 2.5% next year and then down to 2.0% by 2026. The University of Michigan consumer survey for September showed that individuals were expecting inflation over the next 5-10 years to be 2.8%, lower than the 1-year expectation of 3.2% suggesting that longer-term anticipations remain well-anchored. Shelter costs, which represent such a large portion of the consumer price index, are beginning to reflect the tough environment for residential real estate. Real time data was showing since last year that higher mortgage rates combined with limited supply was providing a stiff headwind for homebuyers yet monthly government data was not showing these cracks due to its tabulation procedures.
The trend in GDP has risen. From a measly 0.7% growth in the fourth quarter of last year, the U.S. economy grew 1.7% annualized in the first quarter, 2.4% during the second quarter and expectations are for a 2.4% pace during the quarter just ended. The Fed raised its median GDP figure from 1.0% growth this year to 2.1% in its latest projections. This is one of the stronger growth profiles when compared to other developed nations with Western Europe expected to only grow 0.6% this year with 6.2% unemployment.
While the positives remain strong, there are notable hurdles to overcome. For the first time in its history, the United Auto Workers (UAW) union has begun striking the nation’s three automakers all at the same time. Economists estimate that as many as 700,000 jobs could ultimately be affected when components manufactured by suppliers are by default rendered moot with no vehicles to build. While the strike could end by the time of this publication, the forgone spending will never be made up. What must be somewhat worrying for management is that recent strikes against the United Parcel Service and Hollywood studios by writers have led to the workers securing key demands concerning pay and job security. The threat of an airline pilots strike spurred big wins for them from the nation’s largest air carriers. While unions never went away, their numbers and leverage have certainly waned over the past few decades with about 6% of the U.S. private workforce unionized versus 17% four decades ago. Given that fact, recent gains are eye-opening.
Also, inflation may be coming down, but the low hanging fruit has certainly been picked. Some of the surge in 2022 prices was due to a global supply chain that remained wobbly post-pandemic. As those channels were repaired, goods flowed more freely and upcharges to get items to their intended destinations faded. But just because products flowed more smoothly does not mean that services are less expensive. Financial and legal fees remain sticky. Airline fares have receded somewhat but still remain higher than pre-pandemic prices on many routes. Health care will likely see a boost to prices as more delayed procedures are carried out. These costs are “sticky” because they do not often go on sale as 2-for-1 deals. Thus, it is much harder for the Fed to influence them and remain a barrier to reaching their desired 2% inflation target.
Moreover, the best days of GDP growth may be numbered. The consensus expectation for 2024 growth is only 0.9%, less than half what is expected for this year. The trade-weighted dollar has been rising since mid-July making U.S. good more expensive for foreign buyers. That plus a higher interest rate environment could weigh upon business investment thereby crimping two components of GDP. Annual revisions are showing that consumers have a shorter spending runway than previously believed. The resumption of student-loan repayments is likely to affect over 40 million borrowers. With consumption comprising about two-thirds of GDP, if that pillar were to waver, then GDP projections would certainly fall.
So where does this leave today’s consumer, trader and market watcher? Basically, where we started, waiting on what’s the Fed’s next move. According to the futures markets, the chance of a hike in November is about 33% and has hovered around that figure for weeks. Atlanta Fed President Raphael Bostic recently cryptically commented: “I am not in a hurry to raise, but I am not in a hurry to reduce either.” The “higher for longer” mantra is something the markets will likely have to absorb because the economy is not leaning towards a clearcut direction. Stay tuned.
Market Analysis & Outlook
Markets started the third quarter on a positive note but turned decidedly negative as the months progressed. The S&P 500 returned 3.2% on a total return basis in July following on the heels of a superb 6.6% gain in June. By September, however, as the prospect of higher rates for longer than expected began to bite, the index tumbled 4.8% following a 1.6% pullback in August. The pain was especially felt by small cap stocks as measured by the Russell 2000 which saw declines of 5.0% and 5.9% in August and September, respectively. The tech-heavy Nasdaq Composite remained the year-to-date market leader, but the heady gains from this group during the first half of the year were not replicated during the third quarter.
Investors are beginning to wonder if the tide has turned for this year. Through the first nine months of the year, the S&P 500 is up 11.7% which is a nice turnaround from the 18.1% loss for all of 2022. Moreover, last year seemed to be an anomaly after gains of 28.7% in 2021, 18.4% in 2020 and 31.5% in 2019. But none of those previous years has faced the same type of interest rate environment. The 10-year Treasury note reached a yield of approximately 2.78% in late January 2019. It did not reach that level again until April of 2022 after the Fed began implementing its rate hike agenda and, beginning in the summer of last year, including allowing $60 billion in Treasurys and $35 billion in mortgage-backed and agency securities to mature each month without replacing them.
The phrase many investors repeated over the years prior to 2022 was TINA—there is no alternative—referring to being “forced” to invest in equities because no other asset class came close to matching the expected returns. Today’s phrase is TARA—there are reasonable alternatives. Short-term maturities can now be had from the federal government for over 5%. For example, the current yield on a 2-year note is 5.146%. From March of 2020 through September of 2021, that yield did not go above 0.277%. Households, pension funds, hedge funds and other sophisticated and not sophisticated investors can capture yields which have not been seen since before the global financial crisis.
The bond market seems to be going through a period of readjustment. Last year, the price of bonds and stocks both fell as rates rose. In the decade prior, a decline in the stock market could be hedged by purchasing Treasurys. This year, some investors thought that historical negative correlation would return, but it has not so far. Why not? Daleep Singh, chief global economist at PGIM Fixed Income and former executive at the New York Fed, offers an explanation: “The compensation required to underwrite potentially the new structural regime with more volatile growth and inflation and fewer predictable sources of demand to absorb record amounts of government debt issuance has clearly risen.” What does that mean? The bond market is repricing uncertainty.
This is not the global financial crisis/Brexit/pandemic Fed-bailout-white-knight rescue environment anymore. It is the Ukraine war/union strikes/decoupling supply chains you’re-on-your own world now. That is why we have seen over 60 basis point (0.6%) moves multiple times both up and down in the 10-year Treasury yield this year alone. This type of volatility is normally reserved for the stock market, but given the seismic effect of a global pandemic, it is not surprising that the largest and most liquid securities market in the world—U.S. government bonds—be duly affected.
These periods are exactly why we are managers who own diversified, balanced portfolios. We hinted at the risks in the last quarterly commentary writing: “Though the S&P as a whole has performed well, the narrowness of the leadership group has led to concern. The five largest names in the S&P 500 have decisivelyoutperformed the remaining 495.” The equal-weighted S&P 500 was up only a fraction compared to themarket-market capitalization weighted index at that time. Given that a typical holding period for most investors is longer than six months, short-term gains are nice, but it behooves investors to think about having exposure to a variety of sectors. Because if anything was learned from last year’s 33% decline in the Nasdaq composite, it is not wise to have all your eggs in one basket or, in financial terms, all your stocks in one sector. We use meaningful pullbacks to accumulate positions in companies that have strong balance sheets, solid cash flows and identifiable catalysts. We are industry-agnostic because whether we find opportunities in food distributors, banks, electrical equipment manufacturers or diverse chemical producers, the key is possessing an asset that will generate a return-per-unit risk that is superior to other alternatives.
And while some of the woes in the stock market can be blamed squarely on rise in yields, our client bond portfolios will benefit from taking advantage of what is being offered. Besides government yields, rates on all types of fixed income securities have risen meaning clients can lock-in attractive returns from high credit quality issuers. The bull market for bonds began in early 1982 when the 10-year Treasury was yielding over 14%. Subsequently it began a consistent, obdurate decline falling to approximately 0.5% in mid-2020. The Fed’s emergency response to the pandemic anchored that yield at low levels until the health emergency waned in the years that followed, and the hikes began early last spring. Now with yields higher and balance sheets of companies in good order, using client funds to lend to worthy borrowers makes sound financial sense. By laddering our bond purchases, we ensure that funds do not mature all at once. That could create a potentially challenging situation of getting all of the monies re-invested during a period of low rates.
As we enter the fourth quarter, investors have many items on their plate. Beyond the Fed, there remains the questions about job growth, the cost of federal deficit, the continued vitriolic political environment and ongoing war in Eastern Europe. With earnings season coming up, it will be confessional time for many companies who now realize that meeting 2023 goals may be out of reach and expectations need to be readjusted. On a positive note, we are entering what has traditionally been the most positive months for the markets. The 20-year average gain in the S&P 500 for October is 1.3%, 1.8% for November and 0.9% in December. Time will tell if 2023 will add to that tally or not, as past results are no guarantee of future performance. Nonetheless, markets often climb a wall of worry once uncertainty can be numerically computed.
We are not averse to taking sage advice from genii of the investing world including this blurb from Seth Klarman: “When all feels calm and prices surge, the market may feel safe; but in fact, they are dangerous because few investors are focusing on risk. When one feels in the pit of one’s stomach the fear that accompanies plunging market prices, risk-taking becomes considerably less risky, because risk if often priced into an asset’s lower market valuation. Investment success requires standing apart from the frenzy—the shortterm, relative performance game played by most investors.” The difference between embracing discomfort and catching a falling knife is often a fine line but that’s where true outperformance lies. We remain grateful for the trust you put in our management of your financial assets and look forward to a continued positive professional relationship.
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