Highlights:
· The elusive soft landing remains in firm sight with strong economic data continuing to pour in.
· March’s stellar labor market should allow the Fed time to wait for inflation to come down the “last mile” before starting to cut rates. The European Central Bank and Bank of England seem unlikely to begin cutting rates until the Fed starts easing, Japan finally exited its negative interest rate policy, and there are signs that China’s economy might be starting to stabilize.
· Even in light of favorable economic conditions, one must not forget unexpected market declines are the price long-term investors must pay to realize return premiums relative to safer cash and fixed income investments.
Commentary:
“The economy actually isn’t becoming tighter, which it ordinarily would. It’s actually becoming a little looser, and you’re seeing inflation come down – very unusual situation.”
-Jerome Powell, Chair of the Federal Reserve
Evidence continued to mount during the first quarter of the year that the economy might be able to achieve the elusive soft landing in the face of elevated interest rates. Nearly all first quarter indicators told the same story – slowing inflation, solid economic growth, and a robust job market. Strong economic data is no longer spooking financial markets and policymakers believe, for the moment anyway, that inflation can be beaten without a painful downturn. Lael Brainard, the top White House economic advisor, said during the quarter about 2023 that “We looked historically: We’ve never had a year where inflation has declined this fast while the economy has grown above trend, and unemployment has remained stable at a low rate.” Jared Bernstein, chair of President Biden’s Council of Economic Advisors, added, “We’re always happy to see a very strong job market and we’re particularly happy to see wages outpacing prices. The best indicator of inflation is inflation.”
The labor market’s strength in particular is allowing the Federal Reserve (Fed) to hold off reducing interest rates in order to allow time for inflation to get back down to its 2% target rate. The Fed has been able to hold rates steady for eight straight months, in large part because unemployment continues to stay close to record lows. Whereas for most of 2022 and 2023 the Fed saw strong economic activity and hiring as a headwind to bringing down inflation, Fed Chair Jerome Powell has signaled recently that he no longer sees strong hiring as something to fear.
Unstoppable might be a better word to describe the current labor market. Most investors deemed the March jobs report as good as it gets. The job market has now grown for thirty nine straight months, employers added more jobs in March alone than in the previous ten months, and the unemployment rate dipped to 3.8% which has now remained below 4% for twenty six straight months, for the first time since the 1960s. The labor market seems to be getting stronger, but in ways that do not seem likely to raise alarm bells for the Fed. Strong job creation in March coincided with an expanding labor force and moderate wage growth – a seemingly ideal situation for both workers and inflation-wary central bankers and investors.
Fed officials will likely focus less on hiring and more on inflation data in the coming months to determine when they can begin cutting rates. This “last mile” in the Fed’s fight against inflation is proving tough because inflation has not come down as fast as they would like to see in the face of strong economic data. March’s inflation data showed that the current pace would entrench inflation at over 4%, which is double the Fed’s 2% target. The Fed’s dilemma continues to be that cutting interest rates too soon could cause inflation to stay high or even re-accelerate as it did during the second wave that characterized the high inflation of the 1970s. Recent rising commodity prices have renewed such inflation fears. On the other hand, if the Fed waits too long to reduce rates, current high borrowing costs for business loans, mortgages and car loans could weaken the economy and even tip it into a recession.
The prospect of Fed rate cuts is at odds with stocks at all-time highs at the end of the quarter. Investors seemed to take solace during the quarter that the Fed appears to be done hiking rates, even though economic growth and corporate earnings remain strong. Usually, the Fed only cuts rates when the stock market is going down or the economy is in recession. The Fed’s challenge will be to cut rates to a level that allows the economy to keep expanding and the labor market to remain strong. At the start of the year, the market was expecting six rate cuts, beginning in March. Now, some investors think the central bank might not cut rates at all. Markets have retrenched accordingly as of the writing of this commentary.
European and U.K. policymakers face a more challenging task than the Fed. Unlike in the U.S., these central banks still fear a recession, with gross domestic product (GDP) flat to slightly negative over the last several quarters. At the same time, inflation has remained above targets. The European Central Bank (ECB) and Bank of England (BoE) have a single mandate to maintain stable prices. This differs from the Fed’s dual mandate of maintaining price stability and full employment. This is part of the reason that, to this point, the ECB and BoE have focused their efforts on too high inflation rather than too low growth.
Historically, the actions of the ECB and BoE have lagged those of the Fed. In this vein, the consensus seems to be that it is unlikely that either central bank will begin cutting rates until the Fed starts easing, although continued slow growth could change these forecasts. In this regard, the U.K. economy did enter a technical recession with its economy shrinking for the second consecutive quarter in the fourth quarter of 2023. However, early estimates for the first quarter of 2024 are that the U.K. economy grew for the first time since last summer. U.K. consumer spending, the main driver of the U.K. economy just like in the U.S., fell over the second half of 2023 even as purchasing power was boosted by wage growth outpacing inflation for the first time in two years. While economic output might have declined, job markets in both the U.K. and Europe remain tight. On the surface, this makes it less likely that these economies will fall into full-blown recessions.
Japanese consumers, who are still seeing prices rise faster than wages, also cut their spending in the final quarter of 2023. Japan unexpectedly slipped into a recession at the end of last year, which initially raised doubts about when the Bank of Japan would begin to exit its decade-long ultra-loose monetary policy. Nevertheless, Japan’s stock market finally hit the high-water mark set before its asset bubble burst over three decades ago. The AI boom and worsening relations between China and the west has been a near term boon for many major Japanese corporations. This was enough for the Bank of Japan to move its key policy rate back to zero, becoming the last major central bank to exit a negative interest policy that began worldwide a few years after the 2007-2008 financial crisis.
A string of recent monetary stimulus measures and plan to boost growth by pouring money into factories is showing signs of starting to stabilize China’s faltering economy. China’s credit markets noticeably improved during the quarter and its extensive manufacturing sector returned to expansion in March, following months of contraction, which helped exports top expectations and industrial profits return to growth.
China likely still has a bumpy road ahead though, as the job market and consumption still look weak, a drawn-out property slump has yet to show signs of bottoming out, and deflationary pressures still exist. Further complicating matters is that China is concerned about letting the yuan fall too far, a fear that has been exasperated with rebounding U.S. rates. If the Fed delays rate cuts, it could make further significant monetary stimulus from The People’s Bank of China much trickier. On the other side of the coin, western governments and some big emerging economies are complaining that a growing wave of cheap Chinese exports threaten domestic jobs and industries.
If you find the endless reporting of economic indicators to be conflicting, join the club. Some numbers point in one direction, while others point in the opposite. Add an election year to the mix where partisans from both political parties have an interest in promoting one type of economic news and downplaying the other, and it is outright confusing. If you are thinking about trying to time interest rates, you might want to think again. Wall Street has been caught offside in both directions on the path of interest rates over the past few years. Almost no one thought the Fed would raise rates as high as 5% and as fast in the first place, and while the consensus was that a bevy of rate cuts beginning in early 2024 would be inevitable, this has proven less obvious with each batch of strong economic data.
Only time will tell if the goldilocks narrative of strong economic growth, strong corporate earnings, and immaculate disinflation will continue to drive equity markets to even higher levels, or if investors take a step back to allow fundamentals to catch up with current valuations. That being said, it would be hard to complain too much if the worst thing that happens this year is that central bankers do not cut interest rates because the economy is too strong.
At some point though, whether it is this year or a future year, the current economic expansion will end. The economy will slow. We will have a recession. When that happens, equity markets will likely decline. Unless you believe you can consistently predict the future and time markets, living through declining equity markets is the price that must be paid in order to realize long-term return premiums vis-à-vis safer cash and fixed income investments. We continue to emphasize that your investment policy should be based on time in the market and not attempting to time the market.
Urban Financial Advisory Corporation – April 2024
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