Stocks sold off in August as still robust growth, sticky inflation, and higher bond yields gave investors pause. The S&P 500 Index fell 1.77% during the month, with 10 of its 11 sectors generating a negative return.
A greater than expected 187,000 new jobs were added in August while retail sales rose 0.7%—nearly double consensus expectations—and corporate profits rose 4.5% in the second quarter, according to the Bureau of Economic Analysis’ August 30 report. As such, it was not surprising to see some second-guessing of the more bearish scenarios, with firms like Goldman Sachs cutting its odds of the U.S. economy entering a recession to just 15%.
Unfortunately, inflation increased slightly, with the headline Consumer Price Index (CPI) rising 3.2% in July. While the rise was largely driven by housing costs—shelter inflation contributed 90% of the index’s rise in July—it didn’t help that oil prices rose after Saudi Arabia and Russia extended their voluntary production cuts. Core CPI (which doesn’t include the more volatile food and energy sectors) fell 0.1% in July, to 4.7% year-on-year. Also, the Federal Reserve’s (Fed) favored inflation measure, the core Personal Consumption Expenditures Price Index, ticked up to 4.2% year over year, which is well above the Fed’s target rate.
Fed Chairman Jerome Powell was clear in his remarks at the annual Jackson Hole symposium when he said, “Two percent is and will remain our inflation target.” While most investors feel the Fed’s policy rates are near their cyclical peak, Powell added that they “intend to hold policy at a restrictive level until we are confident that inflation is moving sustainably down toward our objective.” For investors hoping for a swift decline in interest rates to boost economic growth and corporate profits, this was probable cause for some profit-taking, or a lightening of investment risk.
Outlook: The U.S. economy has remained resilient, fueled by strength in the labor market and solid consumer spending. This has provided support to the equity markets, though the S&P 500 index’s performance has been dominated by select names within Information Technology and related sectors.
As such, investors are increasingly expecting that a U.S. recession is more likely to happen next year than in the second half of this year. While debate continues on the likelihood and severity of a recession, we believe we are beginning to see the signs of a slowdown. Employment data has weakened, with payrolls slowing, and the consumer is starting to show some signs of stress, with credit card delinquencies rising significantly.
In our view, the impact of the Fed’s swift interest rate rises is starting to show. We expect it will eventually lead to a noticeable slowdown in the economy, but whether it meets the definition of a technical recession (two consecutive quarters of contraction) is unclear, and the latest economic data suggests it may be slightly less likely.
However, the markets are expecting four cuts of 0.25% to the Fed’s policy rate next year as of this article’s publication, which we think is aggressive. We take Chairman Powell at his word that “two percent is and will remain” their inflation target and believe that will take time. Core inflation is simply too high to expect confirmation that it is moving “sustainably down toward” their objective anytime soon.
Nevertheless, we do believe we are at or near the peak in longer-term interest rates, and as short-term rates fall next year, we expect the U.S. Treasury curve will steepen. As such, both short and intermediate government bonds, with current yields near 5%-5.5%, continue to look compelling. Longer-dated U.S. Treasury bonds also deserve a closer look as they historically perform well as the economy slows significantly or turns into a recession.
But turning points in the U.S. economy are notoriously difficult to time. And today’s more globalized economy adds additional complications as geopolitical wild cards abound. Might we see a post-Putin Russia in the second half of 2023? How, and when, will the tensions between China and Taiwan be resolved? How convoluted and disruptive might the 2024 U.S. Presidential election become in the coming quarters? In this uncertain environment, we encourage equity investors to stay focused on the longer-term trends and—absent clarity—wait patiently for clearer signs of the economy’s direction.