Economic Monitor: Hitting the Brakes
BY: Mark Drachenberg
Planned slowdown or emergency stop?
Ultimately, if you’re driving the car, the answer to that question will determine the safety of your passengers, cargo, and those individuals and things around you that aren’t under your direct control. When I was learning how to drive, my instructor always emphasized keeping a safe distance between me and the car ahead of me, planning ahead to stop, and to not slam on the brakes. He taught me to apply pressure to the brakes to slow down (having given myself enough space) as I approached my stop, and then finally to ease off the brakes to try and come to a smooth stop.
What does this have to do with economics and investing? Well, Fed Chairman Powell is driving the bus and is applying the brakes to an overheated (overstimulated might be a better way to put it) economy, and so far, he has not been gently applying the brakes, but his efforts are closer to slamming on them.
Is it working? Are the Fed’s efforts going to harm investors and the economy (passengers and cargo)? What about other collateral damage (the rest of the world)? Certainly, the efforts are not meant to totally stop the economy, but to slow it down to a more manageable (and sustainable) level. We can see some of the effects of their efforts (higher interest rates, slowing in the housing sector, slowing manufacturing) that all lead to a slowing economy, but is it enough or has too much damage been done already?
Financial Markets
Have we started a trend? November, like October, and like July earlier this year, saw the markets rally. Unlike July, however, it feels like this is the start of something more sustainable as the Fed has indicated that they are likely to start slowing the pace of raising interest rates and are certainly nearer to the peak in rates than we were in July. The Dow Jones Industrial Average was on the verge of entering positive territory for the year as it gained 6.04% in November. The S&P 500 added 5.59% but due to its heavier tech exposure and being cap weighted, it is still down over 13% on the year. The EAFE was the big gainer on the month, as it added 11.09% in November. Even bonds finally got in on the act, as the Bloomberg US Aggregate Bond Index gained 3.68% during the month, although it remains down 12.62% on the year. While things appear to be on the upswing, the markets will likely face some pressure in the new year, barring the Fed truly engineering a soft landing. The brakes are being pumped too hard at this point and the likely scenario is a recession during the second half of 2023.
The Economy
While we are not in a recession at this point, several factors are pointing in that direction. Manufacturing data shows that things have softened and likely will continue to soften in coming months. Consumer sentiment has fallen dramatically over the past several months although that could be due in part to pessimism over the mid-term elections. The yield curve has, or is, inverted at several points and, while not a guaranteed precursor to a recession, the level and consistency of the inversion sure are pointing that way.
On the other side of the ledger shows consumer spending remaining strong, including through the early holiday shopping period. A rail strike appears to have been averted or at least delayed, helping to ensure that holiday gifts are delivered, and manufacturing continues. Even the mid-term election results offer some bright spots, such as no major new spending packages or tax increases for the next couple of years.
Finally, while the unemployment data is discussed more below, the fact that jobs are still available and wages are rising is good for individuals and families but, less so the Fed, who is trying to slow the economy further.
GDP (Gross Domestic Product) – GDP rose in the third quarter at an annualized rate of 2.6% after falling 0.6% in the second quarter and 1.6% in the first quarter. All numbers may be revised in coming days, as the government evaluates the data further. Full year estimates have been all over the map but are currently running in the positive 1% to 2% range. The key question is whether a recession arrives in 2023 or not? Chances are one will unless the Fed can pull off a soft landing by easing off the brakes a bit in the next few months and the economy can be resilient enough to ride through the slowdown without contracting.
Inflation – Inflation moderated slightly more than expected to 7.7% in October, as the rate rose 0.4% during the month. While not enough to cause the Fed to ease up on the brakes yet, it was enough to at least start the discussion about when to do so. While it is likely that inflation is starting to moderate, until the rate falls below the Fed Funds Rate set by the Fed, do not be surprised to see the Fed continue to move rates higher.
Unemployment – The labor market remains stronger than the Fed wants, as November saw another jump in employment. Nonfarm payrolls increased by 263,000 during the month while the unemployment rate stayed at 3.7%. Wages continue to bump higher, although they continue to run below the rate of inflation. November saw an increase in average hourly earnings by 0.6%, while wages have risen 5.1% over the past year (well below the rate of inflation). The healthy jobs market continues to be a large part of why we have not “officially” entered a recession and why the Fed continues to slam on the brakes.
The Fed Watch
As is usual for the Fed these days, the message can be quite confusing. One day, one Fed official will give a speech indicating that they need to keep slamming on the brakes by raising interest rates further, only to be contradicted by another Fed official indicating that the Fed is ready, or should be ready, to slow or even pause in hiking rates. Even Chairman Powell contradicts things from time to time. Evidence of this is the statement that was released when rates were raised in November, which seemed to indicate a slowing in rate hikes, which was interpreted to mean that the end of the hikes might be in sight. But, shortly thereafter, Chairman Powell stated that the Fed could slow their level of hikes but also take rates higher than previously planned.
While there has been uncertainty, recent comments by Chairman Powell and other Fed officials, are showing more consistency and seem to indicate that the Fed will likely slow rate hikes and potentially pause at some point in the first half of 2023. They will, however, raise rates by 50 basis points in December barring new data that causes them to raise rates by more than that amount. The markets like what they are hearing from the Fed right now and that has helped the markets rally. This is not the end of the story, however, and keeping an eye on how strongly the Fed applies the brakes will give a strong indication of potential danger on the economic horizon.
Outlook/Summary
The story just does not change, and neither will this outlook. Opportunities always present themselves in times of major market movements and this time is no different. New opportunities exist in the fixed income markets due to the rise in interest rates and the ability to start enjoying some yield again. The time to extend durations may be soon upon us and the potential for capital gains could present itself should the Fed pause or even cut rates at some point down the road (probably 6-12 months from now at a minimum).
On the equity side, it still pays to be defensive with a value tilt, although many traditional growth investments are trading at valuations not seen in quite some time. We will remain diversified, keeping a focus on downside protection, but ready to take advantage of opportunities as they present themselves. Our eyes, like everyone else’s, are on the Fed, the economy, and other news, to make informed decisions. To discuss your portfolio, please call the Wealth Management department of the State Bank of Cross Plains at (608)826-3570. We look forward to speaking with you soon.
Market/Economic Data
As of November 30th, 2022…. (Unemployment data is through November for national, October (preliminary) for both Wisconsin and Madison, inflation data through October):
Index | Month Return | YTD Return | Index | Month Return | YTD Return or Current |
---|---|---|---|---|---|
DJIA Industrials | 6.04 | -2.89 | EAFE | 11.09 | -16.78 |
S&P 500 | 5.59 | -13.10 | Bloom US Agg | 3.68 | -12.62 |
S&P 500 Equal Weight | 6.70 | -7.07 | Inflation (CPI All-items) | 0.40 | 7.70% annual |
S&P 400 | 6.12 | -7.96 | U.S. Unemp. | n/a | 3.7% |
S&P 600 | 4.17 | -10.06 | Wisconsin Unem. | n/a | 3.3% |
NASDAQ | 4.51 | -26.13 | Madison Unemp. | n/a | 2.2% |
Thank you for your business – we look forward to speaking with you soon. (Note – this commentary used various articles from JP Morgan, Morningstar, the Wall Street Journal, Investor’s Business Daily, Northern Trust, CNNMoney.com, msn.com, Kiplingers.com, nytimes.com, Fidelity Investments, American Funds, LPL Financial and other tools as sources of information