Key takeaways:
- Even as the economy decelerates, it’s still too hot to cut rates.
- Since the Fed pivot last November, inflation and the job market have continued to surprise on the upside.
- The Fed backed off its June rate cut message in favor of higher-for-longer guidance, which we expect will contribute to volatility going forward.
- Rain portfolios remained competitive against their benchmarks in the first quarter and are well prepared to weather economic deceleration this year, emphasizing the income and safety of bonds and Low Correlation Growth strategies to buffer equity volatility.
Market Update:
More than fifty years ago, Niel Armstrong demonstrated that soft landings are hard. As the Apollo 11 lunar module navigated toward the Sea of Tranquility, NASA’s designated landing spot on the moon’s surface, the astronaut noted that his horizontal speed was too great, indicating he would be more than four miles off course by the time he would touch down. The module was headed directly toward West Crater, full of impossibly steep terrain and huge boulders. As it passed over the relatively smooth and flat surface of their original target, Armstrong took manual control of the ship and made the game-day decision to overshoot West Crater to the east, risking low fuel in favor of a safer landing area. Avoiding certain death, he reached his new target with just 25 seconds of fuel remaining. The rest is history; one small step for man, one giant lesson for central bankers: sometimes you have to change course.
The economic resilience in the US extended into the first quarter of 2024, defying widespread predictions of a recession last year. While real GDP grew 2.5% overall in 2023, it increased by 4.9% in Q3 and 3.2% in Q4, accelerating in the second half of the year. Inflation, on the other hand, had declined sharply from its mid-2022 peak of 9.1% and by November 2023, at 3.1% it appeared to be safely heading toward the Fed’s 2% target. Along with leading economic indicators showing decelerating growth into 2024, by November the Fed felt comfortable guiding markets toward a soft landing and interest rate cuts by June of this year. Markets cheered the news and the rally continued through Q1. In fact, the market had begun anticipating even larger and earlier cuts than the Fed was signaling.
Following the Fed’s November guidance, however, inflation numbers began to surprise to the upside again, creeping back up to 3.5% by the end of the first quarter and indicating that the economy was still running too hot to pull off a soft landing in June as planned. In our last communication, we discussed the mixed signals under the surface of headline inflation numbers, especially in areas like wage-sensitive core services driven by a tight labor market. By March of 2024, the unemployment rate had remained below 4% for 26 consecutive months, something that hasn’t happened since Armstrong first walked on the moon. Ominously for central bankers, it was also economic terrain that presaged the wage-price spiral that fueled inflation in the 1970s. This labor market tightness, coupled with persistent inflation pressures, gave Fed Chair Powell serious pause; no way could interest rates start their descent as early as June without risking a hard crash later on as the Fed could be forced to play catch up with even higher rates.
By mid-April, Powell was forced to change course. At a conference with Canadian central bankers in Washington DC, Powell noted his concerns about labor market tightness and persistent inflation pressures, arguing he would need greater confidence that inflation was headed toward its 2% target before taking his foot off the brakes of interest rates. June was off the table and policy would need to remain flexible. Not only would the Fed not cut earlier than June, as markets had been hoping, it may not cut at all this year, depending on the trajectory of inflation and labor markets. This new higher-for-longer message set the stage for a turbulent period for risk assets going forward.