Over the river and through the Fed
If anything taught me directions growing up, it was the countless trips to visit family around the holidays. It was probably too much to ask for turn-by-turn navigation or the estimated time of arrival but, with one exception, I tended to have a good sense of where we were going and how to get there.
As we survey the economic landscape entering another holiday season, there’s an interesting parallel between my formative years and the current environment. Many of those trips were fraught with bad weather, the occasional bump in the road and even the rare mechanical problem. And, just as with those winter holiday travels, there are plenty of challenges to the current economy.
One threat this year has been the persistence of inflation. Year-over-year measures of consumer price inflation peaked near 9% in June and are likely to remain elevated for a while longer. But despite the inflationary storm, which appeared at times to reach “named” storm status, there are signs we’re heading in the right direction.
Lost amid the high inflation numbers has been the general direction. According to Capital Economics, disinflation – or a decrease in the rate of inflation – appears to finally be taking hold. Prices are unlikely to fall, and the rate of inflation remains above the Federal Reserve’s target, but direction matters.
Direction matters because investors have spent all year watching the Fed. A slowing rate of inflation is an important signal that the causes of earlier inflation may finally be abating. As inflation continues to moderate and the Fed adjusts to the changing data, investors can finally stop holding their breath over how far the Fed will need to go and for how long. It’s probably too much to ask when we’ll get there or what specific roads we’ll take, but so far investors have applauded the change in direction.
Of course, a common concern in inflationary cycles is that the Fed will overtighten, leading to economic contraction. It can be a problem of market mechanics, exacerbated by corporate America’s concerns about recession. The prospects of slowing growth, caused by higher borrowing costs, can lead to less corporate spending, becoming the self-fulfilling prophesy of recession.
Further, recessionary fears can trigger contractions in the labor market. But this time around, employment concerns seem greatly reduced. Despite more than 6 million unemployed individuals, there are more than 10.5 million job openings. The unemployment rate sits at 3.7% as of the end of October. More stories of layoffs are appearing, but the labor market does not appear to be signaling a problem anytime soon.
The remaining question is what all this means for stocks and bonds.
The easier answer is bonds. Because nearly all bonds eventually mature at some predetermined value and pay interest along the way, bonds are a fairly straightforward exercise in arithmetic. With interest rates higher now than five or 10 years ago, the next five to 10 look far more compelling. As 2022 proved, it won’t be a straight line, but bonds appear poised to stabilize along with inflation and provide strong income for the years ahead.
Unfortunately for stocks, the math is never quite as easy. That said, the two foundational inputs to determine the worth of stocks are earnings and interest rates. If interest rates are finally showing signs of stabilizing as inflation moderates, investors can get back to trying to value stocks based on expectations for earnings growth. That’s a far more attractive proposition given the period of weakness we’ve already come through for so many businesses.
Certain routes we travel quite regularly, yet we still can make mistakes. Traveling home to Kenosha from Madison one Christmas Eve with my sister and brother-in-law, I advised taking the Chicago exit too early, leading us south down I-90 rather than east on 94 toward Milwaukee. While it didn’t add a lot of time to the route, the signs for Janesville confused me more than I was willing to admit, and the whole detour put more of a rush on our preparation for Christmas Eve services.
Just as with investing, the key is to leave plenty of cushion for delays and make sure you’re pointed in the right direction. For investors, that cushion is our balanced approach, recognizing we won’t always get it exactly right. Add in some cautious optimism that at least we’re pointed in the right direction, and I’m starting to feel a bit more encouraged about where we’re headed.
2022 Investment Outlook Seminar, a Money Talk Video with Bob Landaas and Kyle Tetting
Revisit balance: Gain from Powell’s “pain”, By Kyle Tetting
The Fed: What investors should know, a Money Talk Video with Dave Sandstrom
Recessions: Uncertainty suggests balance, a Money Talk Video with Kyle Tetting
(initially posted Nov. 23, 2022)