The Economy Reaches an Inflection Point
- The soft landing debate
- Inflation pauses
- The Fed also pauses, but still talks tough
- Recession still possible
The financial media cannot stop talking about US prospects for a “soft landing” – a resolution of our current inflation woes without a recession. While it is human nature to wish for ideal outcomes, it remains true that defeat of inflation on the scale we have recently experienced rarely occurs without the collateral damage of a recession. It is also true that talk of soft landings often reaches a crescendo right before a tougher reality sets in.
We believe that inflation has topped and that central banks, including the Federal Reserve, have reached the end of a dramatic period of steep rate increases. The most recent measure of US CPI indicates that inflation has broken to the downside and the median of consensus estimates for US growth in the fourth quarter of 2023 is now below 1%. Employment remains strong, with unemployment running at just 3.9%, however some recent indicators suggest a sudden softening in the labor market. These facts taken together indicate that the US economy has reached an inflection point. We appear to be past peak inflation and past a peak for rate increases. Whether developments from here will result in a hard or soft landing remains debatable.
The Leading Economic Index was down again in October. It has been in decline for some 19 months now and is now down a cumulative 11.7%. Based this index’s predictive history, the US should be in recession by now. And yet, US Real GDP came in at a strong 5.2% in the third quarter.
Soft landings are rare. We count one in the past 40 years, and that took place in the mid 1990’s. More typically, once the Fed embarks on a program of higher rates and monetary constraint, recessions follow. This is not a coincidence. Inflation is a by-product of an imbalance between supply and demand. When demand outraces supply, higher prices result. This effect can be aggravated by an excess of liquidity, or cash, such as that produced by the overly aggressive fiscal and monetary stimulus that followed the COVID recession. Rising interest rates do not, by themselves, reduce inflation. Rising interest rates increase the cost of credit thereby constraining demand, especially for items we typically finance. A general reduction in aggregate demand will reduce economic growth and such a pullback forms a recession. Reduced demand will, in turn, allow prices to moderate. Recessions cure inflation, whether policy actions do or not. Older readers will recall that Paul Volker’s Federal Reserve was able to tame the raging inflation of the 1970s with a string of very sharp rate increases that fostered back-to-back recessions in the early 1980s.
Rare does not mean impossible. Inflation has already come down from 9% to about 3% without a recession. Furthermore, while historical patterns do suggest certain future outcomes, each cycle writes its own history, and the present context is quite unique. A global pandemic, addressed with massive fiscal and monetary stimulus, followed by rampant inflation, and the fastest and steepest rate increases in a generation is not a common scenario. The strongest evidence of the resilience of this economy is found in two measures. First, employment remains quite strong, and the US consumer has kept right on spending. However, the number of people claiming unemployment insurance rose sharply last month to the highest level seen in three months. Measures of employment at the state level are also showing signs of softening. It may not take as much of a change in unemployment as we generally assume to signal the onset of recession. According to the “Sahm Rule” once the unemployment rate increases 0.5% from its prior low, based on its three-month moving average, recession typically follows. Even a casual review of unemployment history shows that once unemployment moves up slightly, it usually moves up significantly. Real US GDP was strong for the third quarter of 2023, however, estimates for the fourth quarter are running below 1%. This economy has powered ahead through sharp rate increases, a war in Ukraine, and renewed fighting in Gaza, yet current leading indicators presage weakness ahead.
So, what are investors and decision makers to watch for? If the last few percentage points of inflation come down gradually, the Fed remains patient, and the US consumer holds up, a soft landing may still be possible. However, if the jobless rate jumps by just half a percentage point, and holds there or increases further, batten down the hatches.
- +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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This information is for informational purposes only and does not constitute investment advice.
GDP – Bureau of Economic Analysis
Employment & Inflation – Bureau of Labor Statistics
Interest Rates – Federal Reserve
P/E S&P 500 – multpl.com
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