The second quarter of 2023 brought the first pause by the Federal Reserve in its blistering campaign of rate hikes that began in March of last year and has taken interest rates to a 16-year high. Following ten consecutive increases in the fed funds target rate, which soared from a range of 0.00%-0.25% in early 2022 to a current range of 5.00%-5.25%, the 12 FOMC (Federal Open Market Committee) voting members agreed unanimously in June to halt further increases until they can gauge the impact of their monetary policy on the economy, and more specifically, inflation. As measured by the CPI (Consumer Price Index), inflation has dropped from about 9% at its peak last year to about 4% year-over-year in May. However, 4% is not 2%, the Fed’s stated inflation goal. After the June FOMC meeting, Chairman Powell said they will continue monitoring the data and likely raise rates again this year.
Investors appeared nonplussed by Powell’s comments, taking comfort in an economy that is stubbornly refusing to capitulate to the R word. Economic growth, as measured by real (after-inflation) GDP (Gross Domestic Product), grew 2% annualized in Q1 after being revised upward from an earlier 1.3% estimate. The Atlanta Fed GDPNow model estimates Q2 real GDP growth at 2.2%, up from its 1.9% estimate on 05/26. Shares of the largest companies soared during the 2nd quarter with the S&P 500 registering noteworthy gains of 8.74%. For the year’s first half, the S&P 500 delivered an over-the-top 16.89% return. Small and mid-sized domestic companies and international markets produced mixed results during both periods.
Market interest rates, which dropped in late March in a knee-jerk, flight-to-safety reaction from the banking crisis, stabilized and headed upward again in Q2. This put downward pressure on bond prices resulting in quarterly total returns of -0.62% & -0.08% respectively from our two short-term bond benchmarks, the Bloomberg 1-5 Year Govt/Credit and 1-5 Year Credit indexes. Over the year’s first half those benchmarks returned 1.19% and 1.65% respectively. Total return measures interest earned plus or minus price changes. The inverted yield curve, with short-term rates above longer-term yields, widened recently. The level of the inversion varies from 148 basis points (1.48%) for the 3-month T-Bill to 105 basis points (1.05%) for the 2-year Treasury note, both as compared with the 10-year Treasury note. A widening inversion suggests the Treasury market believes the probability of a hard landing is increasing or is a response to over $1 trillion in new supply about to hit the bond market as the U.S. Treasury replenishes is coffers, or both.
On the other hand, the equity market has been rallying in the belief that inflation has peaked, the Fed is almost done tightening credit, we will avoid a severe recession, and earnings will improve in 2024. Stock and bond markets are forward-looking and currently the forecast is cloudy as usual. As examples of the differing viewpoints on the economic picture, consider the following. The nation’s labor market continues to be very strong, producing job gains well above pre-pandemic averages. According to the JOLTS report (Job Openings and Labor Turnover Survey) there are only 6 workers seeking employment for every 10 job openings. However, the Conference Board’s Leading Economic Index (LEI), which historically has been a reliable recession indicator, dropped for the 14th consecutive month in May. In its recent press release the Board stated “…Rising interest rates paired with persistent inflation will continue to further dampen economic activity. While we revised our Q2 GDP forecast from negative to slight growth, we project that the US economy will contract over the Q3 2023 to Q1 2024 period…”.
Consumer spending hit a speed bump in May, up 0.1% and was flat adjusted for inflation. U.S. existing home prices dropped year-over-year in May by 3.1%, the most in 11 years as rising mortgage rates took their toll on home values. Sales of existing homes, while up slightly over April, have fallen 20.2% year-over-year. Higher mortgage rates have pushed many buyers out of the market and caused homeowners with existing low rates to sit tight. The flip side of higher interest rates is that investors who need the income and relative stability of high-quality, fixed-income securities are finally seeing yields above long-term inflation rates and closer to long-term interest rate averages. It has been a long time coming and well received.
The Fed’s preferred inflation gauge, the PCE (Personal Consumption Expenditures Price Index) rose 3.8% year-over-year in May, the lowest level in two years, and the more closely watched, core PCE (excluding volatile food and energy) increased 4.6%, both still well above the Fed’s tolerance.
Investor confidence increased in May for the sixth consecutive month as clouds overhanging the market seemed less threatening. The banking crisis was resolved although most bank stocks remain depressed. The economic outlook appears less bleak with each successive positive GDP number. The Federal Reserve seems closer to the end of its monetary tightening campaign, although it says another hike or two may be inevitable before year-end. “The reason… (is) if you look at the data over the last quarter, what you see is stronger than expected growth, tighter than expected labor markets, and higher than expected inflation,” said Powell in recent comments.
So, will the Fed make good on its prediction that more rate hikes are in the cards for this year, or will it read the inflation tea leaves and surprise everyone with a continued pause and a higher for longer posture? One thing is certain, and that is no one knows, not even the Fed. The Federal Reserve’s mission is to manage the nation’s money supply to achieve stable inflation, full employment, and moderate interest rates, no small order indeed. It is doing everything in its power to bring inflation down while trying to avoid a deep recession resulting in massive layoffs and severe economic pain. Inflation is coming down, but will it get back to 2% soon? The equity market acts as if it thinks inflation is improving more than the Fed is letting on. The bond market, not so much. Even if there are no more rate hikes, that doesn’t mean the Fed will pivot to cutting rates anytime soon, so it may be higher for longer.
The year’s first half, once again, produced a smorgasbord of concerns over which an investor could become distracted including the Russia-Ukraine war, the banking crisis, the debt-default crisis, inflation, interest rates and more. The crisis-obsessed financial media believes its Earthly mission is to get you focused on the crisis du jour because that increases TV viewing, radio listening, newspaper reading and social media clicks, all of which increases the industry’s ad revenue. It is a classic cause-effect business model and not in your best interest. Successful, goals-focused investors ignore the news and understand the difference between investing and speculating. Many, with the help of experienced financial advisors, construct broadly diversified, low-cost, tax-efficient, risk-appropriate portfolios designed to help fund their life’s goals which are contained within an intelligent financial plan. They then get on with the business of life.
Best wishes for a safe and fun-filled summer.
Samuel J. Taylor, CIMA®, AIF®, CRPC®
Wealthview Capital, LLC