October 16, 2023

The U.S. economy has withstood the effects of higher interest rates better than expected, as what feels like the most anticipated recession of all time has not yet materialized. Leading economic indicators, which predict a change in the business cycle, have been flashing red for nearly a year and a half. These include an inverted yield curve (higher short-term interest rates than long-term rates), declining consumer confidence, and slowing bank credit. Yet, unemployment remains around historic lows even as the Federal Reserve has raised its benchmark short-term rate by a cumulative 5.25% over the last 18 months to combat rising consumer prices – actions which in theory should dampen consumer and business spending. Economists are finding different sides of the same coin for almost every variable at play, as traditional economic theory cannot neatly explain the economy’s resilience.

We can find comfort in an improving inflation picture. One popular measure, headline CPI, has fallen from a high of 9.1% last June compared to the previous year to 3.7% year-over-year in August, helped by declining energy, vehicle, and shelter costs. Even so, it may not feel that way to consumers facing high grocery bills and gas prices in California hovering around $6 a gallon.    

It’s worth noting that economic data is often aggregated and doesn’t always tell the full story, thus making it difficult to interpret the current landscape. For example, consumer spending has shown impressive resilience, but delinquencies on consumer loans have started to rise. These conflicting data points may reflect the competing effects of high prices and what continues to be a high level of household savings, even if savings have been in decline. It’s also useful to segment consumers into the high end – where there are still ample funds available for big-ticket experiences like concerts – and the low-income consumer where savings are fast depleting, forcing them to take on more debt to maintain current spending levels. To complicate matters, we expect the resumption of student loan payments to impact consumer spending to some degree.

On the labor side, the unemployment rate is near 50-year lows despite decreasing consumer demand. The story again appears mixed, perhaps as the lingering effects of the pandemic weigh on businesses. An example of this is that layoffs over the past year have been of professional workers rather than frontline, skilled trade, manufacturing, or construction workers. Management teams seem reluctant to lay off workers after experiencing so much difficulty hiring coming out of the pandemic. While they are reluctant to let go of workers, the pace of job gains has been declining since last year. The strength of the labor market may be starting to ease. Even if this is the case, the unemployment rate still faces downward pressure as U.S. businesses face structurally lower labor force growth as baby boomers retire.

Strong economic growth and a tight labor market leave the Federal Reserve a small needle to thread as they balance the risks of over versus under-tightening. The Fed kept rates steady at 5.25% to 5.5% at its September meeting, while its forward guidance allowed for the possibility of another rate hike. Whether or not rates rise again, the Fed appears near the end of its tightening cycle. Expect the discourse to reverse from the possibility of rate hikes to rate cuts. The strength of the U.S. economy will largely determine the pace of rate cuts.

Even considering the mixed economic signals of this past year, many sectors of financial markets have posted year-to-date gains and volatility (ranges in prices) has been relatively low. While the S&P 500’s largest “Magnificent Seven” technology stocks led the rally starting in October 2022, market returns have not been evenly distributed. For instance, over 70% of S&P 500 stocks underperformed the overall Index through the end of September. The resulting wide dispersion in stock valuations is offering compelling opportunities for active managers like Clifford Swan to buy high-quality businesses at good prices. Additionally, bonds are once again attractive sources of income. This is a welcome relief after ten years of near-zero yields on U.S. Treasuries. Now is a good time for looking at asset allocation if a portfolio leans heavily towards stocks, especially for nontaxable retirement, foundation, or charitable accounts. The era of TINA (there is no alternative [to stocks]) is over. Within fixed income allocations, we continue to focus on quality and liquidity. As the Fed appears to be nearing the end of its tightening cycle, we are also looking for opportunities to extend maturities to lock in higher yields.

The above information is for educational purposes and should not be considered a recommendation or investment advice. Investing in securities can result in loss of capital. Past performance is no guarantee of future performance.

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