On the Road Again

By Dr. Charles Lieberman, Co-Founder & Chief Investment Officer

Economic growth is holding up quite well, as the labor market plows ahead.  After pausing rate hikes at the last meeting, we expect the Fed to resume with another 25-basis points increase at its next meeting on July 25-26.  Higher interest rates are a headwind to growth, but only a modest one so far and they are overshadowed by solid spending in a variety of economic sectors.  A number of additional rate hikes may be needed before the Fed brings inflation back to its 2% objective.

No doubt, higher interest rates slow economic growth.  But how high do rates have to go to cause a recession or to bring inflation back to the Fed’s target?  We don’t know, nor does the Fed.  And can the Fed get to 2% inflation without precipitating a recession?  Theoretically yes, but that requires a level of precision with policy that is widely regarded as extremely difficult to achieve.  What we do know is that the economy is holding up very well despite the Fed’s aggressive rate hikes through May, so more rate hikes will be coming, including at the Fed’s very next meeting later this month.

Economic weakness is limited to a small number of sectors.  Export demand is mixed, as some of our key foreign customers suffer from weak economic growth.  Housing, the most interest-rate sensitive sector within our own economy, declined sharply last year in response to the Fed-engineered rise in rates, which some people extrapolate into the future.  And some people and companies are struggling with higher inflation.  Some judge that the pool of excess savings that was funded by the government’s numerous programs during the pandemic is almost gone.  The resumption of student loan payments will cut into household spending, albeit just slightly.  And banks have turned a bit more cautious about lending in the wake of the failure of Silicon Valley Bank.  None of these is powerful enough or large enough to push the economy into a downturn. 

The strength in the economy is coming from a variety of places.  Housing is already rebounding after its soft spell, reflecting the dramatic shortage across the nation.  Demand for goods surged during the pandemic, even as demand for services declined sharply.  They have since reversed positions.  Demand for goods is quite soft, except for autos, while business just can’t keep up with the surge in demand for services.  (Check out airline ticket, hotel rooms or restaurant prices.)  So, firms keep hiring and that provides households with more income that they are happy to spend.  Significantly, household income is running slightly ahead of spending, so the savings rate has actually increased a little this year, leaving consumers with greater capacity to fund spending.

Two key industries, aircraft and autos, are still very much in recovery mode.  Boeing, the nation’s largest exporter, is still seeing tremendous demand for new planes and its order book stretches out over five years.  But it is more important that the company is ramping up current production, as supply chain disruptions ease and airlines are anxious to take deliveries.  The Chinese, who have declined to take deliveries for political reasons, have already placed almost their entire fleet back into service, including the 737s that were grounded for “safety” reasons.  They will need more aircraft soon.  Similarly, auto production was severely hampered by supply chain disruptions and the situation has improved considerably.  Production is rising, but has a way to go to meet demand and refill dealer lots with inventory.

Government spending will be another source of some strength.  The mis-named Inflation Reduction Act is subsidizing investment in green infrastructure.  Along with the government’s efforts to on shore manufacturing, capital investment is likely to perform well.  And governments are also spending to improve our nation’s deteriorated infrastructure.

The U.S. unemployment rate has been oscillating around 3.5% for more than a full year, despite very strong job growth.  The saving grace has been the rebound in labor force participation, which added over 1 million people to the workforce in search of jobs.  Without this influx, the U.S. unemployment rate would be below 3.0% and wage inflation would likely be rampant.  The Fed is surely watching this data closely to see if it can continue, or if labor scarcity worsens even further.  It is critical to making progress on reducing inflation.

There has been some tempering of expectations for reducing inflation.  Fed Chair Powell recently stated publicly that he doesn’t expect inflation to revert to the Fed’s 2% target until 2025.  But it won’t be possible for the Fed to avoid rate hikes for such a long time while it waits for such an outcome unless growth slows visibly or inflation moderates more.  Indeed, the latest minutes indicate that a substantial majority of the FOMC expects two rate hikes this year, no reductions in the visible future and imply a hike at the July meeting.  The case for this playbook seems quite strong.  But more rate hikes are also possible, especially if inflation fails to moderate on a path to meet Powell’s low expectations.

Investors appear to be coming to similar conclusions, albeit reluctantly.  While news headlines continue to report that the pace of job growth is slowing, which is factually correct, interest rates having been working their way higher.  Treasury yields are now close to their recent highs, but likely still need to move upward to provide investors with real returns.  Stocks, after falling sharply last year to discount the impending recession that didn’t happen, are holding up quite well, at least superficially.  But they are a tale of two cities.  The large cap tech and consumer stocks, the magnificent seven, have rallied strongly in 2023, while the rest of the market has languished.  So, is the stock market cheap or expensive?  I think the answer is yes.  It is both, depending on where you look.  There is certainly value to be found with plenty of cheap securities, if the market ever can divert its attention from the magnificent seven.  But eventually, that should happen.

The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.