Economic Commentary – Where Are We Now

Where Are We Now

Thus far, 2023 has been a confusing year. Certainly, the geopolitical landscape has been difficult, but overlaid on those headlines are alternating reports of a looming recession or run-away inflation. So which is it: recession or inflation, or perhaps both? We thought some perspective might be helpful.

The Economy Is Still Growing

We’ll start with the easiest thing to measure. While the most recent GDP report doesn’t cause much excitement, it shouldn’t necessarily cause despair. The economy grew moderately in the second quarter and should close the calendar year with a roughly 2% annual growth rate. Some of the key components of that growth include:

These are just a few of the stats we could pull out, and they’ve now been bolstered by July reports of growth in industrial production (up 1%), increased housing starts (up 3.9%), and continued growth in retail sales (up 0.7%). All in all, they would suggest at least steady growth ahead. It won’t be anything like the economic growth rates we saw in the 1980s and 1990s, but we’re still in positive territory and likely to remain so through year-end.

All Eyes On The Fed

The challenge in all this is the Federal Reserve. The Fed has tremendous power in setting the federal funds rate, but it is difficult to wield that power effectively. It can sink or lift the economy; think of it as a sledgehammer, which is being used to finish nails on the molding in your house.

Tap the nail just right, and the molding is nailed in place and looks great; hit it too hard, and you’ve got splinters instead of molding and a gaping hole in the wall.

There is not much of an argument these days that the Fed let interest rates stay too low for too long, and it was slow to recognize that inflation was not “transitory,” as it had claimed back in late 2021. The money supply was increased dramatically to compensate for Covid shutdowns; excess money and low interest rates created an inflationary environment. While the Fed rightly recognizes that inflation must be decreased, it’s easier to say than to do.

This difficulty is particularly acute if the Fed is trying to prevent a recession. To go the extreme to illustrate the point, the Fed could whip inflation almost immediately if it pushed rates to 10% or more. Common sense tells us that would crater the economy for a while. That would not be a mild recession; it would be fairly severe.

Now, nobody is predicting that. We use the example to illustrate the decision the Fed must make. The decision of how much interest rates should be raised – and over what time period – to tame inflation without cratering the economy.

What Do We Think They Are Thinking?

Understanding what the Fed needs to do is different than understanding what the Fed is actually going to do. If the market “knew” with certainty that the Fed was going to raise rates substantially, stock prices would be bid downward to reflect the high likelihood of a recession. On the other hand, if the market “knew” with certainty that the Fed had conquered inflation and did not need to raise rates further, stock prices would be bid up substantially to reflect the likelihood that economic growth was going to accelerate.

The market “knows” that neither of those things is true. The Fed is somewhere in between, and everyone is trying to figure out what the Fed is thinking right now. Does the Fed think they can pause interest rate hikes, need to increase rates moderately once more, twice more, etc.?

This has always been a difficult assessment to make, and Federal Reserve Board Chairman have been renowned for seemingly talking in circles. They want to keep their options open.

The difficulty in assessing the Fed’s intended action has been complicated further by their switch from relying on a “scarce reserve” policy to an “abundant reserve” policy. This was a historic change; the implication is that Fed history is no longer as reliable a guide to the future. In essence, the Fed changed the rules of the game, so to speak. And therefore, introduced more uncertainty into the already uncertain job of predicting what the Fed will do in any given economic situation.

Will they raise rates more? Will they raise rates once or twice? Will they start lowering rates? Is the Fed looking at employment numbers or prices in determining whether an interest rate change is needed? Is the Fed considering the supply of money at all in its calculations? We used to have historical precedents for all those questions. Now, we don’t.

Weakness Vs Recession

The bottom line for us is that we do not believe inflation has been tamed; accordingly, we believe there will be more rate hikes – even if the Fed pauses that process for the next several meetings. There are certainly optimistic headlines announcing that inflation is down and the likelihood of recession is abating. While we aren’t pessimistic about the future, we’re not embracing an optimistic view either.

The underlying cause of inflation is always the amount of money in circulation relative to the demand for that money. Milton Friedman famously said that “inflation is always and everywhere a monetary phenomenon.” The money supply (measured by M2) was increased by roughly 40% to offset Covid shutdowns. Not all of that money made its way into the actual economy. Much of it remained in banks held as reserves. But that excess supply needs to be extracted before it makes its way into the economy, accelerating inflation. The Fed ultimately needs to orchestrate this: get money out of the system so there is enough to meet economic needs but not so much as to spike inflation again.

All fortune tellers are quacks, and all crystal balls are clouded, so anytime we make a prediction, it is, at best, an educated guestimate of what will happen over the course of the next several months.

As we look forward to the balance of this year and into 2024, we expect something between a continuation of tepid growth (weakness, if you will) and a mild recession. That doesn’t mean the stock market implodes. We feel the stock market is pricing in a very similar scenario. So, it probably won’t accelerate rapidly, but it probably won’t crater either.

Portfolio Implications

We could be wrong in what we just wrote. Remember, all eyes are on the Fed; they could make a mistake or a brilliant move. They seem to be on course to pausing rate increases and then returning to a couple of small rate increases.

Looking at the broad price of stocks, we wouldn’t say they are dramatically overvalued. An investor with a long-term focus can feel confident investing in stocks, expecting that the long-term will handsomely reward that strategy. However, an investor with a short-term focus (say, the portfolio will be needed for college expenses next year) should not feel confident that stock investments will be up when they need to withdraw the money.

As always, a portfolio’s goals and timeframe dictate the wisest strategy. And it is possible to have multiple goals seemingly contradicting one another. We have many clients who are investing money for college for their high school kids (short-term) and investing money for their own retirement (long-term). The solution to the apparent contradiction is treating this as two different portfolios with two goals and timeframes. Each one is structured differently than the other.

Broadly speaking, we diversify portfolios between a combination of cash, bonds, stocks, and real estate. We further diversify between domestic and international positions within stocks and bonds. Finally, we specifically diversify between categories of stocks and categories of bonds. How we put everything together depends on the portfolio’s goals and the timeframe until the money is needed.

Even in these uncertain times, short-term goals can be achieved with a prudent allocation emphasizing CDs and short-term bonds, with a smattering of stocks. Long-term goals can be achieved with an allocation emphasizing stocks and real estate, with enough bonds to mitigate volatility to each client’s tolerance level.

The key is to properly identify the goal and timeframe and stick with the strategy even if headlines and the Dow’s mood swings aren’t favorable. As much as it is a case of balancing growth with the preservation of principal, it is also a case of balancing logic and emotions.

Executive Summary

The economy is still growing, and inflation has been tamed a bit. The immediate prognosis is tepid growth for the balance of this year, with a slight chance of a mild recession in 2024. The stock market has already priced in that scenario, but the wild card remains the Fed and its actions in the months ahead. Trying to figure that out has become more difficult than usual, and there are serious challenges remaining in the fight to fully conquer inflation. The implications for investors depend on the goals and timeframes for each portfolio. More often than not, investors should have multiple portfolios with a unique strategy for each one.

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