Market and economic expectations have shifted 180 degrees since the start of the year when many investors expected a recession and prolonged bear market. Ongoing economic growth, low unemployment, improving price pressures, and slowing Fed rate hikes have spurred a strong market rally, especially across sectors that struggled last year. While the economic situation is far from perfect and investors should always be prepared for uncertainty, it’s also important to recognize the positive trends that are raising the odds of a “soft landing.” Below we will discuss what factors are driving these changes in investor expectations?
2 Inflation is Improving Across Many Measures
Perhaps the most important are the many signs that inflation is improving. Recent data for both consumer and producer prices show meaningful signs of deceleration toward Fed targets. The Consumer Price Index (CPI) has slowed from a peak year-over-year rate of 9.1% a year ago to only 3% today. Similarly, the monthly rate of 0.2% for headline inflation represents an annualized rate of 2.2% – very close to the Fed’s 2% target. Core inflation remains elevated at 4.8% when comparing prices this year to last year. However, the monthly pace slowed in June to only a 1.9% annualized pace. These are all positive signs and suggest that while prices could remain high, there is already far less upward pressure.
Producer prices show even greater improvements. Headline Producer Price Index figures (for “final demand”) show a year-over-year change of only 0.1% in June. Core PPI rose 2.4% compared to last year, but only grew 0.1% month-over-month. Other measures showed sharper improvements and even deflationary trends, especially among “intermediate demand” which represents industries buying the inputs they need. These data suggest that prices are declining throughout the supply chain, creating additional hope that these gains will eventually be passed on to consumers.
Of course, there are always caveats. On a technical basis, the year-over-year comparisons will likely worsen next month. This is because the peak rate of inflation occurred exactly a year ago so future comparisons will become more difficult. This means that, going forward, it will be more important to focus on the current pace of inflation rather than how prices compare to last year. Additionally, many of the headline improvements have been in volatile areas like energy, which can always fluctuate. Finally, shelter prices (rent and “owners’ equivalent rent”) declined in June but the pace of improvement has been quite slow so far, and it’s difficult to know whether this will be sustained.
3 The Federal Reserve’s Rate Projections
For the Fed, which has been grappling with the largest inflation shock since the 1970s and early 1980s, these data could not have come at a better time. The Fed decided to skip a rate hike in June in order to “allow them more time to assess the economy’s progress toward the Committee’s goals of maximum employment and price stability,” according to the latest FOMC meeting minutes. In other words, the Fed had already decided to slow the pace of rate hikes from 25 basis points every meeting to perhaps every other meeting
The accompanying chart shows that Fed officials expected to raise rates two more times later this year (i.e., an additional 0.5%). At the moment, markets are anticipating only one additional hike. This disconnect between the Fed and markets has driven volatility over the past year, with the Fed staying firm and markets adjusting to meet monetary policy. In general, a slower pace of rate hikes, if justified by the economic data, has been cheered by markets as this year’s S&P 500 return of 17% shows.
4 Wage Growth Remains Strong
The Fed’s challenge since they began raising rates in March 2022 has been to strike a balance between beating inflation and preventing a recession, i.e., achieving a so-called “soft landing.” The absence of a recession so far, alongside these inflation data, is positive and a big reason for this year’s market rally. Current consensus forecasts by economists still call for flat GDP growth in the third quarter and slightly negative growth in the fourth before rebounding next year. Over the past twelve months, these forecasts have been revised upward with recession forecasts continually pushed back.
What has helped is the strength of the labor market. The latest report from the Bureau of Labor Statistics shows that 209,000 net new jobs were added in June, a slower but still very healthy number. Unemployment continues to hover around 3.6%, near historic lows. Wage growth is strong with average hourly earnings rising 4.7% on a year-over-year basis. Despite earlier layoffs in tech, there are still 9.8 million job openings, or about 1.6 openings per unemployed person, which suggests that many businesses would like to hire if only they could find qualified workers.
Theoretically, higher wages should make inflation stickier as consumers spend more and the cost of doing business rises. Thus, higher wages in a disinflationary environment are somewhat surprising given that economic theory typically assumes that there is a tradeoff between inflation and jobs. Additionally, perhaps an even bigger fear investors faced last year was around the possibility of stagflation – a period of poor growth in which inflation remains stubbornly high. While it’s too early to declare victory, updated expectations by investors and economists suggest that these scenarios are now less likely.
5 Positioning Portfolios Going Forward
Following the dramatic outperformance by the ‘Magnificent 7′ tech giants with outsized exposure to the A.I boom, we are cautious not to chase performance into technology at this point. In fact, we believe that risk assets are likely to take a breather in Q3 and for the drivers of return to broaden into year-to-date laggards.
But, a broadening on the market does not mean we’re out of the woods yet. True, the worst case scenario emanating from the bank failures appear to be off the table. However, we believe the markets strength was partially propped up by one-time infusions of liquidity in the form of the Fed’s emergency bank lending program and a draw down of the Treasury General Account balance drawdown-dynamics which are now reversing. Between March and June, these liquidity infusions more than offset the Fed’s on-going quantitative tightening program. But, with those infusions behind us and with commercial bank reserves at the Fed falling again, the market is likely to run into some indigestion later in Q3. This leads Atticus’ Investment Committee to remain careful, limiting over exposure to liquidity sensitive assets like emerging market stocks and companies with lower credit quality.
Nevertheless, we do see the odds of recession lower than four months ago. This reflects the lingering power of ‘revenge spending’ by consumers fueled by post-pandemic pent-up demand and excess savings. But the economy’s resilience may also make the endgame battle against inflation trickier than the 9% to 3% free fall in CPI during the last 12 months. Considering the Fed’s commitment to flexing its rate-hiking and QT muscles, we would look to increasing exposure to floating rate Treasuries and TIPS, which we see as having higher than normal yields, complementing our other fixed income positions. This barbell strategy may help guard against the cumulative effects of Fed tightening, which if ultimately proves excessive versus an already weakened US economy, may usher in this long awaited for US recession.
The bottom line? The current economic environment is far from perfect but is still significantly better than what many had feared only six months ago. This is a reminder that consensus views are not always correct and can change rapidly as conditions shift. As such, it will be important to stay balanced as the inflation, Fed, and economic situations evolve.
THE VIEW FROM THE TOP
Market Commentary from Atticus Wealth Management
July 2023 – 3rd Quarter
1 2023 Mid-Year Overview & Factors Driving Expectations
Market and economic expectations have shifted 180 degrees since the start of the year when many investors expected a recession and prolonged bear market. Ongoing economic growth, low unemployment, improving price pressures, and slowing Fed rate hikes have spurred a strong market rally, especially across sectors that struggled last year. While the economic situation is far from perfect and investors should always be prepared for uncertainty, it’s also important to recognize the positive trends that are raising the odds of a “soft landing.” Below we will discuss what factors are driving these changes in investor expectations?
2 Inflation is Improving Across Many Measures
Perhaps the most important are the many signs that inflation is improving. Recent data for both consumer and producer prices show meaningful signs of deceleration toward Fed targets. The Consumer Price Index (CPI) has slowed from a peak year-over-year rate of 9.1% a year ago to only 3% today. Similarly, the monthly rate of 0.2% for headline inflation represents an annualized rate of 2.2% – very close to the Fed’s 2% target. Core inflation remains elevated at 4.8% when comparing prices this year to last year. However, the monthly pace slowed in June to only a 1.9% annualized pace. These are all positive signs and suggest that while prices could remain high, there is already far less upward pressure.
Producer prices show even greater improvements. Headline Producer Price Index figures (for “final demand”) show a year-over-year change of only 0.1% in June. Core PPI rose 2.4% compared to last year, but only grew 0.1% month-over-month. Other measures showed sharper improvements and even deflationary trends, especially among “intermediate demand” which represents industries buying the inputs they need. These data suggest that prices are declining throughout the supply chain, creating additional hope that these gains will eventually be passed on to consumers.
Of course, there are always caveats. On a technical basis, the year-over-year comparisons will likely worsen next month. This is because the peak rate of inflation occurred exactly a year ago so future comparisons will become more difficult. This means that, going forward, it will be more important to focus on the current pace of inflation rather than how prices compare to last year. Additionally, many of the headline improvements have been in volatile areas like energy, which can always fluctuate. Finally, shelter prices (rent and “owners’ equivalent rent”) declined in June but the pace of improvement has been quite slow so far, and it’s difficult to know whether this will be sustained.
3 The Federal Reserve’s Rate Projections
For the Fed, which has been grappling with the largest inflation shock since the 1970s and early 1980s, these data could not have come at a better time. The Fed decided to skip a rate hike in June in order to “allow them more time to assess the economy’s progress toward the Committee’s goals of maximum employment and price stability,” according to the latest FOMC meeting minutes. In other words, the Fed had already decided to slow the pace of rate hikes from 25 basis points every meeting to perhaps every other meeting
The accompanying chart shows that Fed officials expected to raise rates two more times later this year (i.e., an additional 0.5%). At the moment, markets are anticipating only one additional hike. This disconnect between the Fed and markets has driven volatility over the past year, with the Fed staying firm and markets adjusting to meet monetary policy. In general, a slower pace of rate hikes, if justified by the economic data, has been cheered by markets as this year’s S&P 500 return of 17% shows.
4 Wage Growth Remains Strong
The Fed’s challenge since they began raising rates in March 2022 has been to strike a balance between beating inflation and preventing a recession, i.e., achieving a so-called “soft landing.” The absence of a recession so far, alongside these inflation data, is positive and a big reason for this year’s market rally. Current consensus forecasts by economists still call for flat GDP growth in the third quarter and slightly negative growth in the fourth before rebounding next year. Over the past twelve months, these forecasts have been revised upward with recession forecasts continually pushed back.
What has helped is the strength of the labor market. The latest report from the Bureau of Labor Statistics shows that 209,000 net new jobs were added in June, a slower but still very healthy number. Unemployment continues to hover around 3.6%, near historic lows. Wage growth is strong with average hourly earnings rising 4.7% on a year-over-year basis. Despite earlier layoffs in tech, there are still 9.8 million job openings, or about 1.6 openings per unemployed person, which suggests that many businesses would like to hire if only they could find qualified workers.
Theoretically, higher wages should make inflation stickier as consumers spend more and the cost of doing business rises. Thus, higher wages in a disinflationary environment are somewhat surprising given that economic theory typically assumes that there is a tradeoff between inflation and jobs. Additionally, perhaps an even bigger fear investors faced last year was around the possibility of stagflation – a period of poor growth in which inflation remains stubbornly high. While it’s too early to declare victory, updated expectations by investors and economists suggest that these scenarios are now less likely.
5 Positioning Portfolios Going Forward
Following the dramatic outperformance by the ‘Magnificent 7′ tech giants with outsized exposure to the A.I boom, we are cautious not to chase performance into technology at this point. In fact, we believe that risk assets are likely to take a breather in Q3 and for the drivers of return to broaden into year-to-date laggards.
But, a broadening on the market does not mean we’re out of the woods yet. True, the worst case scenario emanating from the bank failures appear to be off the table. However, we believe the markets strength was partially propped up by one-time infusions of liquidity in the form of the Fed’s emergency bank lending program and a draw down of the Treasury General Account balance drawdown-dynamics which are now reversing. Between March and June, these liquidity infusions more than offset the Fed’s on-going quantitative tightening program. But, with those infusions behind us and with commercial bank reserves at the Fed falling again, the market is likely to run into some indigestion later in Q3. This leads Atticus’ Investment Committee to remain careful, limiting over exposure to liquidity sensitive assets like emerging market stocks and companies with lower credit quality.
Nevertheless, we do see the odds of recession lower than four months ago. This reflects the lingering power of ‘revenge spending’ by consumers fueled by post-pandemic pent-up demand and excess savings. But the economy’s resilience may also make the endgame battle against inflation trickier than the 9% to 3% free fall in CPI during the last 12 months. Considering the Fed’s commitment to flexing its rate-hiking and QT muscles, we would look to increasing exposure to floating rate Treasuries and TIPS, which we see as having higher than normal yields, complementing our other fixed income positions. This barbell strategy may help guard against the cumulative effects of Fed tightening, which if ultimately proves excessive versus an already weakened US economy, may usher in this long awaited for US recession.
The bottom line? The current economic environment is far from perfect but is still significantly better than what many had feared only six months ago. This is a reminder that consensus views are not always correct and can change rapidly as conditions shift. As such, it will be important to stay balanced as the inflation, Fed, and economic situations evolve.