Economic Commentary – Is The Economy Booming?

Economic reports coming in are good, and most media outlets have concluded that this is great news. Those conclusions may be premature; the more logical conclusion is that the good news is short-term and may very well be masking longer-term issues that still need to be resolved. Understanding this distinction is critical to making wise decisions.

Short-term Economic Outlook Is Good

The good news came in the form of upward revisions in fourth-quarter real GDP, upward movement in nominal GDP, and sustained corporate profits. Real 4th quarter 2023 GDP was revised up to a 3.4% annual rate instead of the previously reported 3.2% rate. Nominal GDP (real GDP plus inflation) rose at a 5.1% annual rate in the 4th quarter, representing a 5.9% increase from one year ago. Finally, corporate profits across the economy were up 4.1% in the 4th quarter, representing a 5.1% increase from one year ago. All the numbers are positive; it’s good news, and the stock market reflects that, with the Dow and S&P 500 closing at all-time highs at the end of March.

For those tempted toward market timing, do the new highs mean a correction or retrenchment is right around the corner? Does that mean you should immediately sell stocks to avoid a drop? The answer to both is no. Nothing about hitting highs means a drop is inevitable, nor does it mean we’re heading into a correction if one occurs.

Markets routinely hit highs, flutter around a bit, and then hit new highs. Of course, the same is true for market drops; they drop, flutter around with some improvements, and then drop again. The pattern over short periods of time is absolutely unpredictable.

What is predictable is that stock markets are strongly related to the economy as measured by the corporate profits of all publicly traded companies. That, after all, is what a stock price is – a measure of the present value of a company’s future profits. The “market” is the sum total of all those stock prices, which measure the present value of all publicly traded companies’ profits.

The current economic improvements and market upticks reflect the very real fact that the post-COVID stimulus is still percolating through the system, as is the flood of money from quantitative easing, and the recent $1.2 trillion spending bill offers a bit more stimulus. All of this is short-term! We don’t know how short-term, and we don’t know yet what will happen when the short-term ends.

Inflation Is Still Smoldering

That brings us to the other economic news, which was also released in late March. Inflation reports again showed higher than desired inflation levels. One of the Fed’s median price indices showed prices were 4.6% higher than one year ago. Core inflation rose, and “Supercore” CPI is up 4.3% for the last twelve months; more worrisome, though, it has increased 7% on an annualized basis in just the last three months.

The Fed affirmed recently its earlier projection that it will institute three 0.25% rate cuts in 2024. That also is received as good news, and it will be if the Fed can actually do that without reigniting inflation.

The inflation numbers above clearly show inflation is higher than the Fed’s 2% annual goal, which is their stated inflation policy guide. With all the different measures of inflation – the Cleveland index, core, supercore, etc., it is difficult to know whether inflation has been tamed. Interestingly, none of the measures shows inflation running at 2% or less. Every one of them is above the 2% target – some by a lot and others only slightly.

Fighting a forest fire offers a great analogy. We’ve all seen pictures of burned forests – black stubs of trees seemingly burned to a crisp – while firefighters still throw water on them. It seems like a waste of water at first, but we know that there may still be fire beneath the surface, and if the firefighters leave too soon, the fire will rekindle and could quickly get out of control.

Inflation acts similarly, and our experience under Fed Chairman Arthur Burns in the 70s demonstrates that danger; on multiple occasions, the 70s Fed declared inflation conquered and mission accomplished, only to see it reignite.

Even as the Fed reaffirms its intended rate cuts, it acknowledges this potential danger. Fed minutes are notoriously opaque, but small changes in language often signify significant changes in thinking. Such changes are exactly what we read in the March 20th minutes. Concerns were further reinforced in a recent press conference when Fed Chairman Powell would not confirm when the Fed would start scaling back the rate of quantitative tightening.

Still Unchartered Territory

The “good” short-term news summarizes that the economy continues to grow, corporate profits are holding up, stimulus continues to have a reinforcing effect, and the inflation rate has dropped from the recent annual high of 9% (reported in June 2022). The Fed has made progress, but the anticipated and hoped-for soft landing has not yet occurred. The risk is that the Fed will let inflation surge and unanticipated interest rate increases will push us into recession. The additional risk is that continued large deficit spending will necessitate tax increases that are also recessionary.

We are walking a thin line over unchartered territory. The comparison of a soft landing to a hard landing is useful, but it can be misleading and perhaps even scary. A soft landing represents conquering inflation without a recession. That does not mean a hard landing is a severe recession. The odds are strong that we will avoid a severe recession at this point. In this case, a “hard” landing doesn’t mean the plane crashed on the runway. It would most likely mean a mild recession later in the year.

Portfolio Implications

The current economic environment argue for a continued commitment to a long-term allocation strategy which also reflects any need for liquidity to fund anticipated withdrawals. The environment does not suggest you should tactically move more into stocks, lighten stocks or move to the sidelines. Market volatility has only increased in recent years, and there is little chance of successfully timing economic or market shifts by moving into or out of some category.

That does not mean prudent steps are not necessary. To the contrary, now is the time to review portfolios to see if the economic and stock market recovery to date has increased your stock holdings above their target allocation. If so, this is exactly the sort of environment in which rebalancing demonstrates its value.

This, of course, assumes you have a strategic allocation. For example, if, generally speaking, you’ve targeted a 40% stock portfolio, you might find that your stocks now represent 50%. Again, this is an arbitrary example, but it illustrates what market rallies can do. If stocks rise significantly, they become a larger share of your portfolio. You need to take action to return to the original target by selling off the excess and investing those proceeds into the bond portion of the portfolio.

This seems counter-intuitive because you’re selling the “winners” (stocks) and buying into the “losers” (bonds in this example). But it is exactly the right move to maintain your asset allocation’s integrity and control risk. If you let stocks become too large a share of your total portfolio, you have increased the portfolio’s risk.

As we’ve written before, this is also a good time to keep your bonds a bit more on the short-term side than the long-term side. As interest rates rose over the last year, long-term bonds were hard hit, and favoring short-term bonds limited the damage. When interest rates begin to fall, long-term bonds will experience some gains. The question is whether or not we’re at that tipping point yet. The Fed is signaling that it wants to reduce interest rates later in 2024, but our concerns from above argue for taking a bit of a wait-and-see attitude on this.

No specific formula can be established in this commentary. The best practice now is to review your portfolio along the lines above and determine if you should make any adjustments. This is standard practice at First Financial and has been ongoing as we moved into, through, and out of the COVID economic shutdown.

Executive Summary

Economic reports coming in are good, and many are tempted to conclude that this is great news. However, those conclusions may be premature, as other data points suggest that longer-term issues still need to be addressed. As much as we all want the Fed to execute a soft landing as it fights inflation, there may still be some pain points. As a result, now may be the time to make some adjustments in portfolios.