Economic Outlook

• +150,000 jobs in October
• Unemployment at 3.9%

Payrolls rose 150,000 in October and unemployment ticked up to 3.9%, not very much higher than where it has been since March of last year. However, the unemployment rate is now 0.5% higher than its prior low. If unemployment holds at this level or rises further, it will have satisfied at least one statistical predictor of recession (see Sahm Rule, above). Monthly payroll additions have noticeably softened since the prior three-month average increase was over 200,000 jobs. Jobless claims jumped up in early November, however, it is too early to discern a durable trend in that increase. State employment data also suggest some softening in the labor market.

• All items CPI was flat in October
• Core CPI at 4.0% and trending down
• Fed still seeking 2.0% inflation

The “all items” CPI index was unchanged last month and stood at 3.2% for the 12 months ending in October. The trend in both measures is noticeably down, but not yet at the 2% sought by policymakers at the Federal Reserve. A decline in gasoline prices helped offset increases in food costs. Housing, gas, and electricity also moved up. The inflation picture is improving; however, the Fed is still pursuing its 2% target. The costs of commodities and durable goods are moderating faster than food and most services.

• Fed on indefinite hold
• Fed still shrining its balance sheet

The Fed Open Market Committee met on October 31 and November 1. They once again held steady on their target for overnight interest rates. The upper bound of that target remains at 5.50%, up from virtually zero post pandemic, and the highest it has been for most of this century.

The Fed will continue to reduce its bond holdings, which has the effect of reducing liquidity in the economy at a rate of $95 billion per month. While rates may be on hold, the reduction in bond holdings on the Fed balance sheet continues, so monetary conditions continue to tighten even as the rate “pause” dominates the headlines. The 10-year Treasury note currently yields 4.22%, so the yield curve continues to be significantly inverted, after flattening slightly last month. Real rates (yield minus inflation) are now positive across much of the yield curve, so even without further increases, interest rates remain quite restrictive. During most of the low-rate environment that preceded the current tightening, real rates remained negative. With normal lags, these rates should continue to dampen both growth and inflation for months to come.

• S&P 500 showing some strength approaching year-end
• Very narrow market leadership
• Duration in bonds becoming attractive

The S&P 500 is up 18.5% YTD at this writing and was up 8.7% in November. However, the great majority of the index return continues to be concentrated in a short list of very large technology companies. Over 10% of the YTD return comes from one stock. Just seven technology mega-caps comprise fully 28% of the index’s capitalization and a much larger percentage of its recent move upward. Take out those names and the remainder of the market is not beating money market rates of return. 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. 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 tends to dilute 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 those leaders. It would be a healthy development if this market were to begin to spread its gains across more industries and across market caps.

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, and they do so in direct proportion to their duration. Longer bonds are more sensitive to interest rate moves than bonds with shorter maturities. In a year like this year, it has been almost impossible to shorten duration enough to escape the negative effects of one 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 anticipate a different rate environment in the future. The Fed has stopped raising rates. We believe the current “pause” is permanent. If that is the case, investors with longer investment horizons may want to rebalance toward more intermediate-term bonds to lock in the currently attractive yields. Typically, 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 current rates before the environment changes. In six to twelve months, we could be operating in a quite different (read lower) rate environment.

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