- Stocks were down slightly in August as investors weighed the prospects of an aggressive Federal Reserve hiking interest rates against corporate earnings that have been resilient and a healthy labor market.
- Fixed income experienced negative returns as interest rates rose in August, pushing bond prices lower.
- Inflation is finally showing signs of peaking and rolling over from 40-year high levels. The energy sector was the largest contributor to consumer prices declining as oil and gasoline prices have declined the past few months.
- The labor market continues to exhibit strength despite the two quarters of negative Gross Domestic Product (GDP) growth.
Stocks staged an impressive two-month rally with the S&P 500 Index advancing 17% from the mid-June low to the recent mid-August high. Stocks then traded lower the last two weeks of the month as investors tried to discern how the Federal Reserve will act now that it appears that inflation has peaked. Investors cheered the inflation reports from early-August that showed inflation might have finally peaked and will hopefully begin to trend lower from the 40-year high readings.
The labor market continues to show signs of strength with the most recent employment report showing employers added 528,000 new workers to payrolls, more than double the expectations. Also, the unemployment rate declined to a post-COVID low of 3.5%. We observe that there are over 11 million job openings that employers are attempting to fill.
Second quarter earnings season is nearly completed, and it shows corporations were able to post impressive results that beat expectations for both revenues (up nearly 14% YoY) and earnings (up nearly 9% YoY). We see that expectations for the second half of the year and 2023 exhibit steady growth during these unpredictable times. We believe this is too optimistic and believe expectations will need to come down due to the further slowing in the economy that we expect and the persistently high inflation.
No Fed Meeting, but Plenty of Commentary
There was no Federal Reserve (Fed) meeting in August, and the next one will not be until September 21st. But there were plenty of comments from the Federal Reserve for investors to parse through. These comments came from the Fed’s annual symposium at Jackson Hole where investors were looking for clues as to how much further the current hiking cycle must go. Fed Chairman Jerome Powell stated at this late-August gathering that the central bank will “use our tools forcefully” to bring inflation down from its highest level in over 40 years. He hinted that the Fed would continue to raise interest rates in a way that will cause “some pain” to the economy. We observed that parts of the economy are already slowing down, for example, housing activity has been slowing for a few months now due to higher mortgage rates. The Fed is essentially signaling that fighting inflation is more important than supporting growth at this point.
The graph below shows that the Fed’s preferred inflation measure, the Personal Consumption Expenditures (Core), has come down to 4.6% recently, but they indicated this will need to decline to a level near 2% before they let up against their fight with inflation. The good news is that the economy appears to be on solid ground now (labor market healthy, positive earnings growth), but we have concerns that the Fed will push too hard and tip the economy into a recession. Chairman Powell told us they do not want to repeat the mistakes of the 1970’s where they used an on-and-off approach to dealing with inflation. An examination of this period showed that the Fed let up in their fight against inflation in the late-70’s, only to see it roar back again in the early 80’s.
To summarize, the Fed’s approach needs to be restrictive enough, for long enough, to bring inflation down to their 2% target for Personal Consumption Expenditures. The economy is exhibiting pockets of strength and should be able to absorb modest amounts of additional hiking. Future interest rate hikes do not have to be as aggressive as the last two 0.75% hikes because they have already raised fed funds from near zero at the beginning of the year to the current level of 2.25% – 2.50%. We are expecting the Fed to hike interest rates at their September meeting, and a few more times after that, before pausing sometime early next year. It would not surprise us if they begin to cut interest rates in the second half of next year, if inflation comes down and the growth slows in the economy.
While corporate earnings remain strong and the labor market is healthy, we are concerned that the high level of inflation will take longer to moderate than originally anticipated. Based on the recent comments by the Fed, it appears clear that they intend to continue increasing interest rates until inflation is under control. While the Fed is trying to engineer a “soft-landing” for the economy we are becoming more concerned that they may in fact drive the economy into a shallow recession. Given this change in outlook we are planning to take advantage of the recent strength in the stock market to de-risk the portfolios by trimming some stock positions. We continue to have a positive long-term outlook for the economy and financial markets, but believe it is appropriate to de-risk the portfolios given all of the short to mid-term uncertainty. We will further detail these portfolio changes shortly in a separate communication piece.
As always, please do not hesitate to contact us if you have any questions and thank you for your continued trust and support.
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