January, 2024
Robert Currie, CFA
A smooth landing of the economy, is it possible? Portfolio manager Robert Currie shares his perspectives on the various factors at play and their potential impact on financial markets.
Nearing the end of 2022, pundits and professional investors would have put a very low probability on the Federal Reserve achieving what they were calling a soft landing. However, the market seems to have changed its tune after the latest round of economic data, allowing the Fed to soften its messaging.
It’s always difficult to write generalized commentary about the Market, as if it were one thing. But what I want to explain today is how the fall in the stock market throughout most of 2022 and the subsequent recovery we’ve had since has been driven by a material shift in narrative about interest rates and inflation. There are other pieces at play as well – the AI investment boom, strong consumer spending, infrastructure bills around the globe – but regardless of industry, general optimism about asset prices has returned to financial markets.
Let’s rewind a bit. When inflation around the world started its upward trend, there was a goods problem. The COVID-19 related shutdowns and higher commodity prices made input costs for physical items much higher. This is what the central banks were reacting to first. This rise in inflation forced central banks to increase their policy interest rates and shrink their balance sheets to cool their respective economies while supply chains caught up.
Pundits and professional investors, even the Federal Reserve themselves for that matter, were convinced that inflation was transitory. While short-term interest rates rose from 0% to above 5% on the back of rate hikes, longer-term interest rates went from around 1.5% to over 4%, only a 2-3% increase in comparison, implying short-term rates will only stay this high for a short period.
The Federal Reserve Chairman, Jerome Powell, acknowledged the risk of a recession as the FOMC raised rates, but saw multiple paths to a soft landing where higher interest rates would lead to softer demand, not a recession. This would create some slack in the labour market and ease inflation. Then, the Federal Reserve would decrease interest rates, bringing the economy back to steady growth and steady prices. However, very few thought this was truly achievable.
The soft landing messaging has been consistent from the beginning. However, the specifics of how they planned to achieve it have remained very open. After such a large increase in prices for goods, workers demanded more income to absorb the higher cost of living. Because there were so many job openings and not enough people to fill them, businesses acquiesced. Businesses demanded higher prices to absorb their higher cost structure and given the strength in consumer spending, consumers also acquiesced. Thus began a cycle of more entrenched (i.e., not transitory) inflation coming from services and labour rather than goods.
This narrative shift from transitory to entrenched inflation created another spike in longer-term interest rates and a lot of volatility in the stock market. The US 10-year treasury yield floated above 5% in late-October of this year, in conjunction with the Fed’s comments about possibly increasing short-term rates further.
In the chart below, you can see both inflation expectations and real yields (return earned after inflation). Inflation expectations have been much less volatile than real yields, which fell at the beginning of the pandemic and then spiked up rapidly, followed by a second wave in the second half of this year as the entrenched narrative took hold.
However, rates have fallen substantially since then. Real yields fell almost a full percent. With this reprieve in interest rates, we’re already seeing stronger housing data in the US, lumber prices are starting to rise again, and confidence is returning to financial markets. This all points to inflation staying elevated and interest rates with them.
The market is now expecting six rate cuts next year starting in March, implying around 1.5% lower short-term interest rates by the end of the year in both Canada and the US. This will only happen if inflation remains under control. If we don’t get those rate cuts, both stocks and long-duration assets will almost certainly fall in price.
There are a number of things still pushing inflation higher, like onshoring supply chains, new union contracts, job openings remaining above the number of people looking for work, clean energy transition, new infrastructure building around the globe, large government deficits, the list goes on.
What’s the conclusion? It is not the time to chase returns, investors should be taking a cautious stance on both risk and long-duration assets. It’s always possible the market is right and this recent fall in rates will not restart inflation, but the risk seems skewed to the downside.
Author:
Robert Currie, CFA is a Portfolio Manager with Louisbourg Investments. Comments or questions may be submitted to Robert at robert.currie@louisbourg.net.
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This writing is for general information purposes only and is not intended to provide legal, accounting, tax or personalized financial advice. If you are not sure how to proceed with a request for further information, seek help from a professional. Any opinions expressed are my own and may not necessarily reflect those of Louisbourg Investments.