US equity markets have enjoyed a solid streak of performance over the past eighteen months. The S&P 500 is over 10% positive year-to-date following an impressive +24% performance in 2023, largely buoyed by two tailwinds: hope that the Federal Reserve will decrease short-term lending rates in response to slowing inflation and the projected benefit of artificial intelligence. Financial markets and corporate earnings remain resilient, yet cracks appear to be emerging in the form of increasing unemployment, credit delinquencies, and contracting services Purchasing Manager’s Index
The Federal Reserve’s preferred inflation metric, the Personal Consumption Expenditures Price Index (PCE), most recent release on 5/31/24 was in line with expectations after two consecutive months of slightly higher than expected readings. Despite the Fed’s 18-month aggressive rate-hiking campaign, inflation lingers above the 2% target rate. Consumer demand remained strong, however, leading to record corporate profits through Q4 2023 and are only now showing signs of slowing. Most investors are not surprised; slowing the economy is precisely the objective of the quantitative tightening measures. Many economists called for a mild recession in 2023-the opposite occurred, and it is quite possible that recession prognostications were not incorrect, but rather premature. As history shows, recession predictions will eventually be correct, but a two-fold question remains: if we are not already in a recession, when will it happen and how severe will it be?
The answer? No one knows with any meaningful specificity, but we can look to history as a guide. No other period in modern economics is more like current conditions than the mid- to late-1970’s. While I do not believe similar mistakes will be made by the Federal Reserve (who whipsawed interest rate hikes and cuts resulting in the re-emergence of inflation) it would be foolish to ignore economic headwinds created by compounding growth in debt caused by record peacetime deficit spending and exacerbated by higher interest rates.
Other issues at play: current income tax rates will expire without legislative intervention and the Social Security trust fund will be exhausted at some point in the 2030s. Both point to higher income and/or payroll taxes in the future which historically results in lower economic growth. Finally, corporate capital structures suggest that a tidal-wave of low-interest rate debt will mature and be refinanced at higher rates, choking balance sheets and reducing profits. Storm clouds may be gathering on the horizon. You are wise to consider the appropriateness of your investment strategy while the sky is clear!
All is not lost. We’ve been here before. This too shall pass. It seems obvious present inflation is the direct result of $5 trillion injected into capital markets during the COVID era. Eventually the morphine high will wear off and return to average productivity, income, inflation, and growth rate will all occur. The silver lining is that for the first time in nearly two decades, investors are experiencing real (as opposed to nominal) bond interest yields as defined by the spread between the coupon rate and the inflation rate. Additionally, stocks have proven themselves viable hedges against inflation, particularly non-cyclical defensive and utility sector stocks. As always, we maintain that the best response to forecasted, perceived, or real market volatility is not a response at all; it is prior preparation through the financial planning process which enables an investor to maintain discipline and focus during volatile times.
We’ll repeat our mantra: The best line of defense is proper asset allocation, not attempting to time market movements or picking “winners and losers”. When coupled with clearly defined goals and disciplined behavior, proper allocation provides the objective basis for weathering market turbulence. The emotional response to the fear of loss is far more subjective. It is no coincidence that one of our fundamental value propositions is to help clients make long-term, goal-focused decisions in the face of frothy short-term markets. Whether you have yet to start planning or are simply ready for a fresh look at your existing plan, we stand ready to connect. In the meantime, keep your eye on the prize. Have a blessed week.
Disclaimer: All information is for informational purposes. No information detailed here constitutes an offer to sell or buy a security. This summary does not constitute advice. Investors should always seek investment advice specific to their unique financial situation and objectives.
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