April 21, 2023
Economic cracks emerged during the first quarter of this year, as rising interest rates, tighter lending conditions, and shrinking liquidity weighed on economic growth. The banking system turmoil that followed compounded investor concerns. On March 22, the Federal Reserve raised the federal funds rate by 25 basis points, trying to balance the threats associated with the banking crisis and the need to combat still-high inflation. Despite this challenging backdrop, markets showed impressive resilience and closed out the quarter with solid gains.
Recent economic data has yet to provide much clarity for the immediate path ahead. The March U.S. employment report showed strong payroll gains, but it also revealed a softening labor market due to slower average hourly earnings growth. The latest consumer price index (CPI) data was mixed, with "core" inflation remaining above the Fed's comfort zone. Weaker retail sales and lower-than-expected producer price index data could support a pause in the rate-hike cycle that began in 2022. The issues in the banking system will likely continue to be important factors in the Fed's decision-making process.
The banking sector turmoil shifted the landscape dramatically for fixed income markets at the end of Q1, resulting in a drop in yields across the curve. Powell initially suggested raising short-term interest rates higher than previously expected to fight inflation. However, within days, wobbles in the banking sector led to speculation that the Fed might pause or slow its rate hikes to ensure financial stability. Markets now expect cuts to the federal funds rate in the second half of the year, but Chairman Powell reiterated that cutting rates in 2023 wasn't the Fed's baseline expectation. This difference between market expectations and the Fed's statements could be a source of volatility going forward.
The Fed's dual mandate is to keep inflation in check and promote full employment, with an unwritten third mandate to maintain financial stability. In times of stress, financial stability concerns often take precedence over the other two mandates. The Fed believes the issues in the banking sector are not widespread, but until the outlook is clear, it could prefer a wait and see approach before resuming its rate hiking cycle.
A key issue in the coming months is the extent to which recent events cause banks to reduce lending, which could weigh on consumer demand, business investment, and accelerate the slowdown in the global economy. The current economic slowdown has a rolling aspect to it, with negative GDP quarters among the G7 economies not being consecutive or synchronized. This unusual rolling characteristic could persist and lead to further market volatility.
The US consumer is beginning to show signs of strain from higher inflation and the lagged effects of less fiscal stimulus. So far this year, the personal savings rate has only averaged 4.7%, well below its long run average and a sign that consumers have been running up their credit card balances. However, a continued tight labor market and solid wage gains amidst a backdrop of cooling inflation may help to keep consumer spending stable.
While inflation appears to be on the decline, it is not likely to recede in a linear fashion. Like subsequent waves of COVID, waves of inflation could be milder in their impact on the economy and markets, yet still cause investor nervousness. The current economic slowdown and potential recession should continue to have an overall downward effect on prices, but the question remains whether we’ll see the Fed’s 2% target during this cycle.
The outlook for corporate earnings is cloudy as companies grapple with higher costs while anticipating weakening demand. The current consensus expectations for double digit earnings growth in 2023 appear too optimistic. However, certain sectors with high margins such as energy should continue to benefit along with businesses that provide essential goods and services. This is an environment where active management is increasingly important in identifying companies that exhibit higher quality factors such as stable earnings, consistent cash flow, and reasonable valuations.
While there are risks on the horizon, opportunities remain in the aftermath of last year’s market corrections. Asset classes across the board are cheaper today compared to the end of 2021, but by varying degrees. Fixed income looks attractive as U.S. Treasuries, core bonds and municipal bonds remain below their average valuation levels. Growth concerns and potential rate cuts mean that bonds offer not just income, but capital appreciation and diversification benefits. International equities appear poised to continue their recent run given deeply discounted valuations compared to the US and weakness in the US dollar. Income producing alternatives such as private real estate and private credit offer non-correlated returns and a potential inflation hedge.
We expect more clarity surrounding the economy’s path and the Fed’s approach to fighting inflation in the months ahead as the impact of higher interest rates and tightening credit conditions continues to play out. In the meantime, should you have questions or concerns, please let us know.