01/17/2023 | News release | Distributed by Public on 01/17/2023 10:18
Since last March, the Fed has raised rates more aggressively than at any point in the past forty years. The latest economic data shows that the economy is slowing materially without causing rising unemployment-an impressive feat and begging the question, has the Fed done enough?
Financial markets think we are near peak rates and expect rates to fall in late spring-and if all goes right, perhaps the Fed can achieve a "soft landing" whereby inflation continues to fall without a big rise in unemployment. In contrast, Fed says that it thinks rates need to stay higher for longer, creating a disconnect with markets.
Who is right? Will rates start to fall by summer? And can the economy really achieve a soft landing? Those are the big questions for financial markets as we enter the new year. The answers aren't as simple as financial headlines might have you believe.
Encouraging News!
Economic reports in November and December brought encouraging news, and financial markets rebounded with an optimistic "yes!" to those questions. After such an aggressive increase in rates, it's clear that higher rates are having an impact.
Headline inflation peaked at over 9% in June and is now 6.5%. While companies are still hiring, the labor market is cooling, with important indicators like wage growth slowing to 4.6%. Broader economic activity is slowing, too, with sectors like housing, construction, and transportation arguably touching recession already. Banks have also tightened their lending conditions significantly, showing caution about the future.
In relief, the S&P 500 stock index is up about 10% off its October lows, and bond prices have rebounded as well (driving yields lower as prices rise). Investors are encouraged that the Fed should be able to slow the pace of rate increases (we agree) and even perhaps begin to LOWER rates starting late spring or summer as the economy slows further (we are more skeptical that they can).
A Clear Disconnect
There's a clear disconnect between expectations of financial markets and the Fed's public guidance. The Fed keeps saying that they do not expect to lower rates this year. Why? In short, as we articulate it, inflation risk is still embedded in the economic system.
The risk of inflation still lingers when you consider three things:
For these reasons, we think the Fed will have to convince the public that it is committed to "higher rates for longer" than current financial markets hope. In a sense, the IMPRESSION of commitment is more important than a change in policy itself. Markets must believe the Fed is committed to taming inflation for the policy to work. If the Fed stops too early, the risk that inflation surges again (a lesson during the 1970s) is significant, in our view.
Overshooting the Goal
History teaches us that the Fed usually overshoots-i.e., it raises rates higher than necessary in hindsight and drives the economy into recession. We wrote about this here. The key reason for this outcome is due to the lag effect of higher rates. It takes time for higher rates to pass deeply into economic activity. Stopping too soon risks not solving the problem of inflation.
As we saw last summer, financial markets began pricing in a higher probability of recession this year. The yield curve of bond markets continues to invert, and other leading economic indicators have been slowing since last spring. These have been good indicators of recession historically, occurring generally within a year.
Our Outlook
Our research shows that in periods when rates and inflation are low but start to rise, stocks and bonds tend to do poorly. Stocks broadly don't become more attractive until the Fed stops raising rates, in our view. Accordingly, over 12 months ago, we started adding more defensive allocations to equity exposure in client portfolios, where appropriate.
Our own market outlook continues to be:
Bottom Line
The bottom line to us as we begin the new year is that higher rates are beginning to take effect, but we are not out of the woods yet. During 2022, we de-risked equity allocations as appropriate continue to expect financial markets to remain volatile, which we will look to exploit opportunistically.
For further details on our research decisions for business owners, family foundations, and retirement, see the concluding sections here or here.