Economic Outlook

• +209,000 jobs in June
• Unemployment holds at 3.6%

Payrolls rose 209,000 in June, and unemployment held at 3.6%, close to where it has been since March of last year. The monthly payroll additions have been moderating, and the average for the previous three months was 298,000. The number of openings per unemployed person is now down to 0.6; it had been well over 2 in the immediate aftermath of re-opening. The reported number of hours worked has come down, and wage inflation is moderating.

The “soft landing” argument sees monetary tightening impacting job openings without significantly increasing unemployment. However, it should be acknowledged that unemployment lags significantly behind changes in the direction of economic growth.

• CPI at 3.0% in June
• Fed still seeking 2.0%

The “all items” CPI index came in at 3.0% for the 12 months ending in June. That is the lowest reading since the COVID recession and significantly below the 9.1% posted one year ago. It remains above the target of 2% set by the Federal Reserve.  The “core” index (all items, less food and energy) rose 4.8%. It has declined at a slower pace than the broader measure. Energy came down 16.7% over the past year, and food prices declined 5.7%. Gasoline is 26.5% lower than one year ago, although it ticked up 1.0% last month. Shelter is up 7.8% year-over-year, bolstered by home prices and mortgage rates. Energy has provided a tailwind as prices have declined over the past year, but that could transform into a headwind if oil continues to climb, as it did last month.

• Yield curve deeply inverted
• Fed still draining liquidity from financial system
• One more hike in rates?

The FOMC met on July 25 and 26 and raised their target for overnight rates by 0.25% after having “paused” for one meeting in June. The upper bound of the target rate is now 5.50%, the highest it has been since 2001. The Fed will continue to reduce its bond holdings, which has the effect of reducing liquidity (money supply) in the economy at a rate of $95 billion per month. The 10-year Treasury note currently yields 3.96%, so the yield curve remains deeply inverted. The duration and extent of this yield inversion have set records. The difference in yield between the 2-year note and the 10-year has at times exceeded 1.00%, and the inversion has now lasted over one year. This has been one of the fastest and steepest instances of monetary tightening in Fed history. There is no FOMC meeting in August which means that the Fed will have two months of economic data to digest at their meeting in September.  Many analysts have expressed the view that the most recent rate increase will be their last for this cycle. We give even odds that they may go for one more hike, but their decision will really turn on the direction of economic indicators over the intervening weeks.

• S&P 500 up 19.8% YTD
• Very narrow market leadership
• Bond market impacted by rising rates

The S&P 500 has returned a remarkable 19.8% YTD at this writing. However, the great majority of that return is concentrated in a short list of very large technology companies. Just seven technology mega-caps comprise fully 28% of the index’s capitalization and a much larger percentage of its recent move upward. At times during this rally, these names have accounted for as much as 90% of the market index’s upward movement. Prudent investors and fiduciaries are not permitted to concentrate their investments in this same manner, and yet these benchmarks are routinely used to evaluate their performance. As an example, the manager of a diversified growth mutual fund is not allowed to invest more than 5% of the fund’s assets in any one company. Cap-weighted indexes like the S&P 500 have no such limitation. When the returns of the index are so concentrated in a short list of stocks, it is almost impossible for a manager of a diversified portfolio to keep up, since any diversification dilutes the returns of the market leaders. Such concentration can also pose risks for markets because indexes will suffer disproportionately should sentiment shift with respect to the market leaders. In the last couple of weeks, market gains have started to spread out beyond the short list of technology leaders. It would be a healthy development if that trend were to continue.

Bond investors have been challenged over the past year by a rising rate environment. When interest rates go up, the market value of bonds goes down—in direct relation to their duration. Longer bonds are more sensitive to interest rate moves than bonds with shorter maturities. In a year like this year, it was almost impossible to shorten duration enough to escape the negative effects of one of the fastest and steepest rate increases on record.  

The most “comfortable” investment this year has been cash. Many cash equivalents now pay over 5%. However, investors should begin to prepare for a different rate environment in the future. At some point, the Fed will stop raising rates. At that point, investors with longer investment horizons may wish to own more intermediate-term bonds. Once the Fed is finished raising rates, its next move is often a cut, either because the tightening has engendered a recession or because inflation subsides.  Either way, the longer-term investor may be wise to lock in some of the currently available rates before the environment changes. In six to twelve months, we could be operating in a very different rate environment.  

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