The Fed’s much awaited decision in mid-June to pause its rate hiking cycle along with a string of shrinking inflation readings had soft-landing proponents seemingly popping champagne. The growing wave of enthusiasm at the start of the third quarter spurred equity markets higher. However, as the period wore on, that optimism faded as investors were once again torn between hopes for a soft landing and fears of a recession. The prime cause of the fading optimism appeared to be rising bond yields both here and abroad.
This climb in yields coupled with a continued hawkish approach from the Federal Reserve drove the equity markets lower during the latter part of the quarter even as economic growth remained resilient. Indeed, nearly every major U.S. and global equity index ended the quarter in the red. Unfortunately, bond investors also saw negative returns as the impact of rising yields on bond prices outstripped the uptick in higher coupon income. And finally, broad commodity prices also pushed lower during the quarter, despite a rise in the price of crude oil. Simply put, investors aren’t likely to look back fondly at the third quarter.
While the move lower for asset prices seems at odds with a seemingly positive economic backdrop of receding inflation and resilient economic growth during the quarter, it’s important to remember that financial markets are forward looking. Consider that last year, during the height of inflationary fears, we forecasted that inflation was likely to move lower largely because it was tied to the diminishing economic oddities of COVID. We believed then this disinflationary backdrop would push financial markets higher. Indeed, by the end of July, the S&P 500 had rallied more than 28 percent from its Oct. 12, 2022, lows and was within 4 percent of its all-time high set on January 3, 2022.
Keep in mind that while a brief recession may hamper nearer-term equity market performance, the opposite side of a recession has historically been met with rising equity markets, especially in segments we currently believe are cheap and have already discounted some of sort of recession.
Over the past few months, we have shifted our outlook based on our belief that equity markets are due for a hard pause as investors reassess the impact of the Federal Reserve’s focus on snuffing out any lingering hotspots that could reignite inflation. Unfortunately, the current disinflationary trend is running into a period when the U.S. economy is showing signs of being in late stages of expansion. We note that every economic cycle since the wage–price inflationary spiral of 1966–82 has ended when the U.S. economy has run out of slack as reflected by low unemployment rates. The resulting labor tightness causes inflationary pressures to rise and in turn leads to the Federal Reserve aggressively raising rates to avoid a revisit of the 1966–1982 spiral.
With the U.S. labor market still tight, we believe the Fed will continue to exert downward pressure on the U.S. economy by leaving rates elevated. The higher-for-longer approach, we believe, will eventually result in a mild U.S. recession. Despite the rising yields of the past few months, we believe that bond prices represent real value and a hedge against any potential equity market downside caused by too little economic growth and declining inflation as we push through the fourth quarter and into 2024. Keep in mind that while a brief recession may hamper nearer-term equity market performance, the opposite side of a recession has historically been met with rising equity markets, especially in segments we currently believe are cheap and have already discounted some of sort of recession.
Wage growth remains the final inflation frontier
We’ve spent a lot of time covering inflation’s journey from liquidity pumped into the economy post-COVID that led to outsized goods spending just as supply chains were disrupted. Goods inflation soared and then quickly fell back as people shifted spending to services. Services inflation then soared but has now largely fallen back. Today inflation as measured by the Consumer Price Index (CPI) is basically back to historical norms if you remove shelter readings.
All-in CPI less shelter is running at a 1.9 percent pace year over year. Core CPI is running at a 2.2 percent year-over-year pace. We believe this highlights the significant impact lagging shelter prices have had on the inflationary backdrop during the past year. Given that year-over-year numbers can sometimes be distorted depending on the time period under consideration, we also watch additional inflation measures and note that the trimmed mean and median measure of CPI, which exclude categories with abnormally high or low readings, have returned to historic norms.
Despite the positive current inflation backdrop, we believe that wage growth remains the final frontier in the Fed’s fight against inflation. Quite simply, the labor market appears too tight. When labor demand exceeds labor supply, wages rise as employees have more bargaining power. This is where we believe we are today. High-profile labor market strikes during the quarter, such as the United Autor Workers standoff with the big three automakers, highlight this dynamic. The strikes are reflective of the broader conditions that are occurring in both union and non-union segments of the U.S. economy as a tighter labor market has given workers more leverage in wage negotiations.
While it’s possible wage pressures could ease if more Americans re-enter the labor market, the reality is the easy lifting has likely been done.
At his press conference following the Federal Reserve’s July board meeting, Fed Chairman Jerome Powell was asked about wage growth and its impact on inflation. He responded that current wages were not consistent with 2 percent inflation. No one asked the obvious follow-up question of what level the Fed views as conducive to its target inflation rate. However, a few weeks later New York Fed CEO and Vice Chair of the Federal Open Market Committee John Williams offered his take that he believed annual wage growth of 3.25 to 3.5 percent in the longer term was consistent with 2 percent inflation. While he expressed optimism given the recent downward trend in wages from 7 percent year-over-year gains in March 2022 to September’s 4.3 percent level (for non-supervisory and production workers), we believe that the Fed will continue to err on the side of caution when it comes to the potential for rising wages to reverse the current disinflationary trend.
Indeed, each economic cycle since 1982 has ended with the Fed raising rates, which has capped wage growth in the low 4 percent range. While it’s possible wage pressures could ease if more Americans re-enter the labor market, the reality is the easy lifting has likely been done. Consider that the labor force participation rate among workers of prime age (25- to 54-year-olds) ended the quarter at 83.5 percent, the highest level since mid-2002. Another path forward could be a surge in worker productivity from increased use of artificial intelligence; however, we don’t believe those gains are likely to lead to a significant spike in output in the near term. While each of these could occur, we believe that with inflation above the Fed’s target, it will continue to focus on defeating price pressures now rather than waiting to see if wage pressures subside on their own. Powell drove this point home during his post-September meeting press conference.
The ghosts of 1966–82 still weigh heavily on the Fed’s thinking. Indeed, at his recent press conference, Powell responded to a question about balancing the trade-offs between elevated inflation and the risk of rising unemployment and a recession by saying, “The worst thing we can do is to fail to restore price stability, because the record is clear on that: If you don’t restore price stability, inflation comes back, and you can have a long period where the economy’s just very uncertain, and it will affect growth; it will affect all kinds of things. It can be a miserable period to have inflation constantly coming back and the Fed coming in and having to tighten again and again. So, the best thing we can do for everyone, we believe, is to restore price stability.”
While Chairman Powell finished his answer with comments on how the Fed would be careful in its actions going forward, we believe the exchange frames committee members’ broader thinking. The bottom line, in our view, is that the Fed isn’t going to ease policy until it is convinced that the final embers of inflation are fully extinguished. Wage growth is still too high, and we don’t think wage pressures will move sustainably lower until the labor market weakens, which we believe, unfortunately, will ultimately cause a recession.
The full impact of rate hikes has not yet been realized
Against this backdrop, the U.S. economy has continued to grind higher despite the Fed’s 19-month rate hike cycle that has brought interest rates to 5.5 percent. This has led many to conclude that because we have not yet had a recession, the economy is in the clear. To bolster this argument, many add that they believe the lag between changes in monetary policy and impacts on the economy are shorter and more predictable than they have been in the past. The argument goes that this is particularly true thanks to the Fed’s forward guidance on rates through its so-called “dot plot,” which shows the mean estimate of where the Fed believes the funds rate will be over the course of the next three years. The thinking goes that this forewarning allows the economy to adjust sooner thanks to more clearly defined rate expectations going forward.
We believe this view is flawed and offer the following counterargument. The much-heralded
Excess savings accumulated by consumers during COVID.
resiliency of the consumer is likely the result of an estimated $2.1 trillion dollars in excess savings accumulated during COVID that are now likely running out. Indeed, the San Francisco Federal Reserve bank published a paper noting that the third quarter likely marked the end of these savings. Additionally, a different Fed study noted that the bottom 80 percent of consumers now have less cash on hand than before the pandemic. Throw in the resumption of student loan debt payments and it is reasonable to believe consumers will continue to tighten their financial belts. The Fed’s August Beige Book, which provides real-time anecdotal assessments of business conditions across the country, supports this view. It noted that tourism spending was stronger than expected during the most recent period; however, most respondents believed that the uptick represented the final surge of pent-up travel demand stemming from COVID. This came while noting that other retail spending continued to slow, especially on what were deemed non-essential items.
We are also skeptical of the claim that the lags in the impact of monetary policy have evaporated. Many consumers likely have not yet felt the impact of rising rates because most consumer debt is in the form of fixed-rate mortgages, which have not repriced due to homeowners staying in residences bought when rates were considerably lower. The Federal Reserve calculates a debt service ratio, which is a calculation of total required household debt payments (consumer debt and mortgage payments) to total disposable income. The recent rise in rates has pushed this ratio up from 8.3 percent in March 2021 to today’s level of 9.83 percent; however, the ratio is still near 43-year lows because of low fixed-rate mortgages.
Should rates remain elevated, this will eventually change. Credit card debt now carries a 21 percent interest rate, which is the highest level recorded in data going back to 1972, and will continue to be a drain on consumers’ income. Additionally, housing debt costs will rise as new homeowners enter the market and take on higher-rate mortgages. Corporations will also experience rising interest costs, which will drain money that may otherwise be used to fund more growth. While many businesses locked in favorable rates through long-term debt during the recent low interest rate environment, new debt is going to carry significantly higher rates. The same holds true for new commercial mortgages as existing loans come due.
We’d be remiss to ignore that the U.S. government will be subject to the same challenges in the debt markets going forward. As Treasurys have matured and the government has issued new ones over the past year, interest costs have risen. Consider that interest costs for servicing the federal debt have now pushed toward $1 trillion during the past year, from the $400 billion to $500 billion range during much of the past 10 years.
The bottom line is that we believe the impact of higher rates is going to exert downward pressure on the domestic economy in the coming months. The reality is that bank lending standards are tight, the money supply is decreasing, and corporations are likely to see margins and revenues squeezed as consumers pull back. While the Fed will be positioned to act on this opposite end, we believe it will take its time in doing so to ensure that inflation is fully behind us, which we believe won’t occur until we see job losses.
About that strong labor market
While the labor market stayed strong during the third quarter, leading indicators of the employment picture appear to be flashing yellow. The Conference Board’s Employment Trend Index—an index that aggregates eight leading indicators of employment—inched higher during the quarter but remains in a downtrend since March 2022. On a year-over-year basis, it is negative. We note that in data going back to the early 1970s, each time the index has been negative on a year-over-year basis, a recession has ensued. Certainly, this COVID-impacted economic cycle has been unusual, but we believe enough indicators are flashing caution that we will eventually see job losses and a recession.
Impacts to the financial markets
Near the end of the quarter, bond yields rose dramatically as reflected by the Bloomberg US aggregate bond index, which is an index of U.S. investment-grade debt, hitting a yield of 5.39 percent, up from the prior quarter’s 4.81 percent and 1.75 percent at the beginning of 2022. This marks the highest yield level since late 2008. For further context, prior to June 2008, the last time yields were at this level was 2002.
A myriad of factors likely contributed to the rise in yields, and this is not solely a U.S. phenomenon; German government bond yields hit highs not seen since 2011, while their Japanese counterparts rose to levels last reached in 2013. We also note that while elected officials averted a shutdown earlier this fall, they’ve yet to reach a long-term agreement on the budget, and the threat of an eventual shutdown remains. Highlighting the rancor in the nation's capital was the ouster of Kevin McCarthy from his position of Speaker of the House. The acrimony in Washington could cause an additional challenge for the economy. Consider that in early August, Fitch Ratings downgraded the credit rating of the U.S. to AA+ from AAA. The agency joined S&P Global, which downgraded the federal credit rating to AA+ in 2011. As a result, Moody’s is the sole agency of the three major ratings organizations to still have an Aaa rating on U.S. debt. However, Moody’s has noted that a shutdown would be viewed as a negative for government-issued debt and said such an outcome would underscore the weakness of U.S. institutional and governance strength relative to other Aaa-rated sovereigns. Furthermore, they noted that in the wake of the federal debt ceiling brinkmanship earlier this year, “a government shutdown would demonstrate the significant constraints that intensifying political polarization continue to put on U.S. fiscal policymaking during a period of declining fiscal strength, driven by persistent fiscal deficits and deteriorating debt affordability.”
Impact on expectations
Despite the above-mentioned challenges, inflation remained relatively stable, while investors anticipated the Fed would hold interest rates steady. However, we note that the market has reduced its expectations for rate cuts in 2024 by 50 basis points and by 75 basis points for 2025. Certainly, the Fed’s higher-for longer language coupled with a still resilient economy has led to the revised rate forecasts; but as always, we note forecasts can and do change, and we expect that any recession would be the catalyst for the Fed to cut rates, as an economic recession would likely snuff out any remaining inflationary pressures in the U.S. This is not to say that we expect rates to return to the abnormally low levels that prevailed from 2014–20, but we do believe that rates will ease in the future and will result in lower yields and higher bond prices.
While we believe that nearer-term returns are likely to be challenged, intermediate- to long-term prospects remain solid, particularly in areas that we believe have discounted some potential for an economic slowdown.
What has changed, though, is that investors are demanding extra real compensation for the risks that currently exist. The real yield on Treasury Inflation-Protected Securities (TIPS) has moved higher across the duration spectrum. The five-year TIPS real yield ended the quarter at 2.4 percent, up from 1.99 percent at the beginning of the period, while yields on the 10-year increased to 2.23 percent from 1.62 percent, and the 30-year yield rose from 1.63 percent to 2.31 percent. While we acknowledge that risks have increased, we feel comfortable that the current level of real interest rates provides adequate compensation against these risks.
Not all is dire on the equity front either. While we believe that nearer-term returns are likely to be challenged, intermediate- to long-term prospects remain solid, particularly in areas that we believe have discounted some potential for an economic slowdown. U.S. Small Cap stocks ended the quarter trading at a historically low 12.5 times forward 12-month earnings expectations, which have already been reduced by 13 percent from their previous highs. While an economic slowdown could further dampen earnings for small companies, we believe there is a valuation cushion already in place to absorb further earnings reductions. Once again, we remind investors that during five of the past 11 recessions, stocks were positive. Once a recession is announced, it’s possible that the worst may be over for the markets. More importantly, in 10 of the last 11 recessions the market has been higher by an average of nearly 20 percent one year later.
The way we suggest dealing with uncertainty is 1) develop a financial plan, and 2) always adhere to diversification. Work with your advisor to develop a financial plan that you follow through both good times and bad. Embedded within that plan is the reality that life and markets are uncertain. Any resulting asset allocation acknowledges that potential volatility. We believe the best manner to deal with that volatility is through diversification, which acknowledges that no one knows for certain what will happen. At Northwestern Mutual our advisors have tools to help prepare for all of life’s challenging events and uncertainties.
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As the chief investment officer at Northwestern Mutual Wealth Management Company, I guide the investment philosophy for individual retail investors. In my more than 25 years of investment experience, I have navigated investors through booms and busts, from the tech bubble of the late 1990s to the financial crisis of 2008-2009. An innate sense of investigative curiosity coupled with a healthy dose of natural skepticism help guide my ability to maintain a steady hand in the short term while also preserving a focus on long-term investment plans and financial goals.
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