The economy will continue to slow

The U.S. economy’s resiliency is showing some cracks, and we expect these weak spots will become more apparent in the months and quarters ahead. The much-lauded strength of the consumer continues to ebb, particularly in lower-income segments where loan delinquencies are rising and short-term pay-day loans have risen 35% in the past year, according to data from LexisNexis. More broadly, total credit card debt has surged to above a record $1 trillion, according to the Fed, and the latest Fed study of household finances indicates that most U.S. households have depleted their excess savings (built up in part by pandemic stimulus payments) to the point where they now have less than they did before COVID. Adding to the headwinds, federal student loan repayments start again in mid-October, redirecting previously disposable income to debt payment.  

The impact of tighter financial conditions, thanks to the Fed’s rate hiking measures, are also becoming more apparent. Real rates—the interest rate paid above the current inflation rate—have spiked as Treasury yields surged while inflation expectations remained relatively stable. This puts stress on rate-sensitive industries, such as banking and commercial real estate, as well as the consumer. A recent Atlanta Fed survey reported that 60% of households find it more difficult to get credit than a year ago, while mortgage costs have surged. As of July, 44% of the median household’s income must be spent on mortgage payments for the median-priced house, the highest percentage since 2006. The problem has surely only gotten worse in recent months.

Bottom line: The stress of higher interest rates is beginning to take its toll on the economy. 

Inflation and the Fed remain the key

Inflation remains high. While it has drifted lower recently, the 3.3% year-on-year rise in the July Core Personal Consumption Index (PCE) measure, a common gauge of inflation, is still well above the Fed’s target rate of a 2% long-term average. And we believe the last percent or so will be the hardest to wring out.

Indeed, this is why we think—at this late stage of the game—the Fed is being particularly clear about its higher-for-longer message. The most recent projections from the Fed’s September meeting revealed a target policy rate of 5.0% at the end of 2024 and 3.9% two years out. This is a significant rise from the Fed’s expectations just six months ago that the same rates would end 2024 at 4.3% and 2025 at 3.1%. The Fed wants to convince the market that inflation must continue to fall, even if the cost is a weaker economy, because the damage of persistently high inflation and high inflation expectations is worse in the long run. The recent rise in Treasury yields and weakness in equity markets suggest that the message is getting through. Rates aren’t likely to fall significantly anytime soon.   

But, in terms of restricting monetary conditions, the Fed has done its job. With 10-year Treasury rates and 10-year real rates back to levels not seen since before the Global Financial Crisis, it is hard to imagine the Fed has much more to do than wait and monitor the lagging effects of higher rates. Yes, the Fed has indicated that it could raise rates another 25 bps before the end of the year, but this would be more like icing on the cake than a step towards another level of tighter monetary conditions. In our view, there just isn’t a lot of room for the Fed to hike rates without a significant impact on both investor sentiment and the real economy.

Meanwhile, the market has come closer to our view expressed last quarter that the Fed will keep rates higher for longer. But the market is still pricing in three 25-bps cuts for 2024, and this seems too aggressive to us. Inflation, particularly the Fed’s preferred Core PCE measure, is simply too high, and the Fed wants it lower. Should inflation fall more rapidly than we expect, the Fed could start cutting rates later in 2024 even if economic growth remains strong. But, in our view, it is more likely that inflation only drifts lower as higher-rates-for-longer have their intended effect. In this scenario, rate cuts come only once the Fed sees the right balance of acceptable inflation and the need to restimulate economic growth.

Bottom line: The Fed is (mostly) done but won’t cut rates as fast as the market thinks.

Growing headwinds on equities

Some investors might have been surprised by how well the U.S. stock market performed in the first half of 2023, a period when the Fed was actively raising interest rates. But the economy was outperforming expectations, in part because earnings expectations had fallen so low. It takes time—a year or more—before the full impact of higher rates starts filtering through the economy via higher borrowing costs for mortgages, credit cards and loans to corporations. It is often easier to shrug off the impact of tighter future monetary conditions when weekly economic headlines say everything is coming up roses.

Today, increasing evidence of future weakness in economic growth makes us more cautious heading into 2024. Equities could rebound somewhat in the near term on the back of solid earnings but, longer-term, higher interest rates are a growing headwind. This is particularly true for growth stocks, which are more sensitive to the impact of higher rates on the value of future earnings (so-called long-duration stocks). As higher real rates work their way through the economy, the proverbial glass may seem more like it’s half empty than half full.

While recent earnings have been encouraging, we continue to believe U.S. corporate profit margins have probably peaked. Higher inflation helped companies raise real prices over the past year, but that opportunity is closing as inflation has fallen and should continue to grind lower. Add a slowing economy on top of a loss in pricing power and we think it will be difficult for profits to continue to beat expectations into next year.

Nevertheless, we continue to think investors should keep their eye on small cap stocks. As we wrote last quarter, history suggests that the time to increase exposure to this portion of the stock market is when the economy is in a recession, with a window to a recovery. While we are not there yet, valuations are attractive, and we are looking for opportunities to become more bullish. Furthermore, small and mid-cap stocks can be advantageous in environments like today because they naturally lend themselves to security selection, a strength of active managers who tend to focus on individual companies’ long-term outlook relative to the overall market.

Bottom line: Stay neutral on US stocks broadly, favoring the small and mid-cap sectors.

And we are still positive on bonds

Short-term securities issued by either the U.S. Treasury or high-quality companies offer attractive yields given our expectation that the Fed is likely to keep short-term interest rates high into next year. The issue, however, is their reinvestment risk because these securities mature within year or a bit more. Given our expectation that interest rates are near their peaks and likely to fall as the economy slows and the Fed cuts rates, investors would then be forced to reinvest at lower rates.

Buying longer-maturity bonds, however, offers the opportunity to lock in today’s higher yields. If we are right that Treasury rates have likely peaked, then the total return realized in longer-dated bonds could be impressive as the capital appreciation gained from any decline in rates is added to the already-attractive yield earned just by holding them. And, if we are wrong, and rates continue to drift higher in the coming year, long-dated Treasuries’ relatively high yield provides both attractive income and some mitigation against those rising rates.

High-quality corporate bonds also offer attractive yields, in our view, insofar as both the underlying Treasury yield and the spread offered over that yield have risen from their 2022 lows. While this is most apparent in the high-yield (below investment grade) market, we are not convinced their current yields adequately compensate for the risks that are likely to emerge from a slowing economy. Investment-grade corporate bonds, however, are more likely to weather any economic storms.

Bottom line: Short- and long-dated Treasuries are increasingly attractive, as are high-quality corporate bonds.

Braking into the turn

As we look ahead to the end of 2023, we are reminded that when driving on a winding road, you want to brake a bit as you enter a turn, then accelerate after you’ve moved past its apex. There probably isn’t something dangerous around the bend, but you never know, so you brake. And you don’t want to spend the whole drive being overly cautious, so when the coast is clear, you accelerate again.

The U.S. economy could pick up, alarming the Fed and prompting them to be even more hawkish. Or inflation could mature from sticky to downright stubborn, prompting more rate hikes. Either scenario could lead to significantly higher rates and a hard landing. While neither scenario is likely, neither is it likely that an out-of-control semi-truck is just around the bend. But we proceed more cautiously anyway.

We expect the economy will slow in the coming quarters, causing the Fed to pause any further action. Then, we predict that, slowly but surely, inflation will decline enough towards the Fed’s target to prompt rate cuts. But there are always blind spots in turns. In financial markets, these blind spots can cause severe market moves—or relatively harmless increases in short-term volatility. In either case, these periods can provide opportunities for investors who have maintained a balanced portfolio, tapped the brakes, and are ready to accelerate.

Bottom line: Growing caution on equities into 2024 is merited, and we continue to like higher-quality bonds.