By Dr. Charles Lieberman, Co-Founder & Chief Investment Officer
The economy may have picked up some steam recently, although a strengthening of growth is actually unsustainable. Increasingly, the upside to growth will be limited by the scarcity of labor. More significantly, recession prospects have been pushed even further into the future, which jeopardizes the Fed’s hope of bringing inflation closer to its 2% objective.
For nearly two years, we have been in the camp that a recession was inevitable, but it was nonetheless beyond our radar range. That remains our view. Forecasting a recession is rather easy, since every economic expansion has been followed by recession. But as the economics joke advises, give them a forecast, give them a date, but never give them both. The latest data provides strong support for our view that solid economic growth will continue. Most everyone can and should regard that forecast as good news. More worrisome is the data showing a bit more wage inflation. A rise in wage inflation presents a significant risk for policymakers. Many hoped that the Fed’s rate hikes might temper inflation enough to avoid a recession, the so-called soft-landing scenario. But the data provide more support for the no landing scenario, at least right now. Thus, we see little opportunity for the Fed to lower interest rates anytime soon.
The thesis embedded in the bond market, and highly visible due to the inverted yield curve, is that economic growth will slow dramatically, most likely resulting in recession, that will enable or force the Fed to lower interest rates at a rapid clip beginning in the near future. The bond market has been priced that way for almost two years. It’s been wrong. This is the essence of the October 20, 2023 essay we wrote for Barron’s. But investors haven’t given up on that thesis. Instead, they’ve simply pushed it further into the future. We expect that to continue.
The Fed has also shared that incorrect belief, although it has been very careful to retain maximum flexibility with policy, because they have seen this kind of expectation fail in the past. In the early 1980s, the Fed hiked interest rates to contain inflation and then lowered interest rates as their policies seemed to be working. But when growth and inflation both picked up in response to the decline in interest rates, the Fed had to resume rate hikes and were forced to push rates even higher to bring down inflation. A premature easing of policy led to a quick reversal that was even more damaging to the economy. Since the Fed hasn’t forgotten that experience, Fed officials warn against declaring victory against inflation prematurely before it is truly and visibly vanquished, even as they hope some modest rate reductions may become feasible this year, as they’ve built into their economic projections. But those policy aspirations remain, as always, data dependent.
The above suggests that even modest rate reductions are not yet justified. By some select measures, such as comparing the overnight cost of money to the six-month annualized rate of inflation reported by the PCE deflator, a 2% real rate is already down to historical averages for overnight money. Since some Fed officials think the sustainable real rate has declined to as little as 0.5%, they also think policy is restrictive, so a modest reduction in policy rates would now be appropriate. In our view, that’s possible but not overly likely, and increasingly at odds with the economy’s performance. Long-term rates, such as 10-year Treasury yields, have declined sufficiently to provide sufficiently low financing costs to encourage spending and investment. We already see a clear uptick in housing demand, for example. So, we think the Fed will refrain from lowering rates in the near future and as long as growth remains solid. And we doubt that inflation will continue to moderate. This scenario implies that the Fed will keep policy on hold while it waits to see if inflation moderates further.
Our economic outlook remains positive for equities and more complicated for fixed-income. Solid growth and modest changes in inflation (either up or down) is a very benign environment for stocks. Corporate profits should rebound and set new highs, even as interest rates remain sufficiently well behaved to avoid undermining equities. As always, stocks react to every bit of incoming news, often overreacting, but the general trend should remain positive. Bond yields are likely too low for the prevailing level of inflation, but expectations for slower growth and moderating inflation will mitigate any sell offs in response to unfavorable data. So, we think bonds are likely to hold their value, enabling investors to earn their coupons. The economic environment implies that it is a good time to remain invested.
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