by Kenneth J. Entenmann, CFA
One of the oldest Wall Street adages is “Don’t Fight the Fed.”
In general, it means when the Fed is raising interest rates, accept that they are and adjust accordingly. The most of the first half of 2023, the markets have not followed that guidance, constantly rejecting the Fed’s every move. The market convinced itself that the Fed’s rate hikes would cause a recession, unemployment would spike, and inflation would come crashing down. The Fed would have to capitulate on its tightening policy activity.
Money flowed into money market and fixed income funds. Money market funds with 5 percent annual yields were attractive and bonds were back. Everyone loved bonds. Yet, year-to-date, the aggregate bond index is up only 2.46 percent. That would be considered good if a recession did in fact occur, but it did not, at least not yet. Equities are supposed to be toxic heading into a recession and most of Wall Street entered 2023 significantly underweight. Six months into the year, the S&P 500 index was up 9.65 percent and the NASDAQ was up over 30 percent. So much for the hated asset class.
The economy continues to lumber on. No recession, but languishing growth. Manufacturing is clearly in recession. Housing is coming to life; the housing shortage is overwhelming higher mortgage rates; the consumer sector remains on fire. A mixed bag, but not a recession.
The employment market continues to be dysfunctional. In June, the unemployment rate was 3.6 percent. The non-farm payrolls were 209,000, less than the 240,000. Importantly, the average hourly earnings were 0.4 percent, higher than expected. It is good news that the payroll numbers have returned to a more sustainable level around 200,000.
However, the Fed has been focused on wages and a higher-than-expected earnings numbers today are unlikely to sway the Fed. Compounding the wage concerns, several large union negotiations are heading for a strike. This hardly suggest any weakness in the labor markets. Another rate hike of .25 percent is highly likely.
Inflation continues to trend lower, but the core index remains stubborn. In our last blog, we discussed the statistical basis for a lower CPI number on Tuesday. Yet, as those high numbers roll-off, the inflations comparisons will become more stable and will settle in around 5 percent. The move from 5 percent to the Fed’s target of 2 percent will be much more difficult than the trip from 9 percent to 5 percent.
This overview suggests the second half of 2023 will be challenging. The fixed income markets are unlikely to make any strong moves with the high probability of additional rate hikes and the consensus that rates will remain “higher for longer.” While the equity markets have surprised on the upside in the first half, most of that positive return was driven by an AI tech rally that resulted in a higher Price/Earnings ratios for the overall market and some very lofty P/Es in tech. Can the tech rally, driven by prospect of robust earnings way out in the future driven by AI, be sustained if interest rates continue to increase or remain high? The basic math of a dividend discount suggests long-duration assets (AI Tech) suggest higher rates should hurt the most in this sector. In short, a major upside move in the major equity indexes will be difficult unless earnings start to materially improve, something that will be an uphill battle in a slow growth or receding economy.
This blog has long emphasized the need for investors to take a long-term view of the markets. Many of the experts have missed a surprisingly good move in the equity markets while they were waiting for Godot to arrive.
Like the play, the recession has not arrived. Plowing money into bonds for “safety” in front of the imminent recession also has not worked to well. There is a reason we balance the asset allocation of our portfolios. It balances the long-term return and risk for our clients. Once again, the first half of 2023 demonstrates just how difficult it is to fight the Fed…and time the markets.