Key takeaways:
- In a further hawkish turn, the Fed has promised to prioritize inflation above all else, including employment and housing prices.
- The economy continues to decelerate, with lower fiscal spending, a strong dollar, significantly higher mortgage rates and economic weakness abroad.
- Shorter-term Inflation pressures appear to be easing, while the stickier elements of inflation will take some time to work through the economy.
- Equity and bond market valuations are approaching attractive levels, which should set investors up for better long-term returns going forward.
Market Update:
The economy decelerated and financial conditions tightened during the third quarter, making for a challenging time for financial markets. While inflation numbers appear to have peaked during the period, the outlook for prices remains uncertain, driven by the continued war in Ukraine, draconian Chinese COVID policy, and a tight US labor market. The Fed reacted with a steadfast commitment to prioritize inflation above all else, further reducing its balance sheet, hiking interest rates, and indicating it would continue its aggressive tightening for the foreseeable future. Amid this backdrop and with slowing global growth, a surging US dollar and ongoing fiscal drag, recession concerns gripped markets. By the end of the quarter, valuations in both bond and equities were approaching attractive levels (albeit with some question about future earnings). While the Fed has more work to do, we believe the improving inflation picture and underlying economic resiliency will make for less volatility going forward.
By the beginning of Q4, the economic surge from the effects of massive fiscal stimulus and post-pandemic economic reopening had been replaced by several major economic headwinds. After nearly $6 trillion of fiscal spending during the pandemic years, the federal budget deficit fell to less than $1 trillion during the fiscal year ending September 2022. In the long term, lower deficits are positive for the US debt situation, but do restrict the flow of money to American families that has supported consumer spending during the recovery. Additionally, mortgage rates have more than doubled this year, following several years of escalating home prices, putting a chill on the housing market. Home building and sales, and the consumption associated new home purchases have all suffered as a result. Higher interest rates have also contributed to a strong dollar, up nearly 20% against major trading partners in the past year. Coupled with economic weakness abroad, this will have the effect of slowing US exports and boosting imports, further dampening economic growth. As a result, real GDP growth is expected to slow considerably into 2023, with the odds of recession growing by mid-year.
Despite two quarters of negative GDP growth, the National Bureau of Economic Research has not officially declared a recession, in large part because of strength in the labor market. After some slowing over the summer, there remain two job openings for every unemployed worker while quits remain high and employers are reluctant to lay off workers. Demographic factors like lower legal immigration in recent years and high baby boomer retirements have amplified this effect on the supply side of the labor market. We would expect this to resolve itself in the coming year as businesses are forced to justify hiring and wage increases in the face of diminishing revenues. In the meantime, however, unemployment will likely remain at historic lows through the end of this year.
Inflation has been the bugbear that has kept markets on edge most of the year, with year-over-year consumer price inflation peaking at 9.1% in June. Prices have mellowed a bit since then to 8.5% (YOY) in July and 8.2% in August, with month-over-month readings essentially flat during the period. In good news, the so-called transient elements of inflation – energy prices, commodities prices, dry shipping costs, supply chain indices, and so on – have all eased significantly since earlier this year. On the other hand, the stickier contributors to inflation (elements that take longer to work their way through the economy) continue to rise. These include things like rent costs and wage growth, which are expected to moderate as the housing market cools and the labor market comes back into balance. Inflation expectations over the next five years remain well anchored between 2.5% and 3%, indicating that markets and consumers still expect the Fed (and the decelerating economy) to arrest the current spike in prices. This should put the Fed in a good position to slow or even pause the rate of interest rate hikes in 2023. (Currently, the Fed expects cumulative further increases of 1.25% this year and .25% next year and is maintaining an exceptionally hawkish stance).