Q3 Commentary: Inflation, Consumer Spending, and Soft-Landings
The Federal Reserve has increased its overnight target rate 5.25% since March 2022. Rate increases this fast and large would, by most thinking, quickly slow the economy. On the contrary, consumers and businesses have continued to spend and invest, the housing market has not fallen off a cliff, labor markets have remained strong, and the banking sector has not imploded following several regional bank failures. The performance of the economy has many previously pessimistic economists now predicting the Fed will be able to engineer a soft-landing. However, since stock and bond markets are forward-looking, the performance of both markets suggests the economic outlook may require cautious optimism.
The Economy
Current estimates for third quarter GDP growth are looking for 3.5% or higher, which, if true, would be a significant acceleration from the 2.1% growth rate in the second quarter. In normal environments, the economic data coming out would be reasons to cheer. However, with inflation still above the Fed’s comfort level, the strong labor market reports in the third quarter rang alarm bells. These reports suggested that inflation may begin rising again, due in part to the September job gains jump to 336,000 which was well above expectations. According to the chart below, job growth has come down, but it is still higher than expected.
The strong job growth gives consumers the confidence to spend, and spend they have. The spending has been concentrated on trips to restaurants, vacations, and other services to the tune of 8.7% above the 2022 third quarter level. Businesses have shown confidence in spending money as well, with a proxy for business spending rising 2.1% over the past year. Business spending has seen solid growth in equipment, research and development, and factories. The jobs market and consumer and business spending are generating an optimistic outlook for economic growth in the third quarter and an outlook for a soft landing.
Capital Markets
Equity and bond markets did not follow the economy in the third quarter as U.S. stocks declined 3.27% and the aggregate bond index dropped 3.43%. The Fed is reluctant to surprise the markets and for months gave the bad news that rates would be higher for longer. Investors, however, did not buy in to the higher for longer argument. Both bond and stock investors believed the Fed would cut rates late in 2023, but this outlook changed during the Fed’s press conference in July, and interest rates increased throughout the third quarter.
For example, the yield on the 10-year Treasury started the quarter at about 3.8% and ended just below 4.8%. The Fed’s July meeting was the catalyst for the spike in rates and resulted in a negative return on bonds. Rising interest rates decrease the value of future earnings so equities become more expensive at a constant level of earnings, but unfortunately, in the second quarter earnings declined 4.1%, making stocks even more expensive. The higher yields and drop in earnings resulted in the fall in equity prices in the third quarter.
The Allen Trust Company clients fared better than the indexes in the third quarter, as our equity holdings were down 2.55% and our bond holdings declined approximately 1.41%. On average, our client portfolios declined 1.9%, net of fees, in the quarter compared to a blended benchmark return of approximately -3.0%.
Outlook
We believe the growing labor markets and subsequent strength in consumer spending could produce the soft-landing the Fed is targeting, but we recognize this is not written in stone. The 13.7% year-to-date return in stocks is concentrated, with a few companies such as Nvidia, Alphabet, and Amazon driving the performance. This does not give us confidence that the strong performance will persist. Consumer spending faces headwinds as the pandemic stimulus is now fully spent, wage growth is returning to pre-pandemic levels, student loan payments are restarting, and all-time highs on credit cards.
On the other hand, we believe businesses are unlikely to decrease headcount in the face of tight labor markets, helping the consumer. Accounting for these items, plus others, we believe the economy will slow below the 2.1% level of the second quarter. If we do fall into a recession, we believe it will be shallow with relatively low unemployment. The result of these factors will be lower interest rates and inflation, and equity markets will find it difficult to rise, but we expect bond markets will be positive. Optimistically, equities will then undergo a solid recovery as buying opportunities are created through an improved economic and earnings outlook.
Our team is here to help. Please reach out with questions that may arise throughout the fourth quarter; call our office at 503-292-1041. You may also find current and past “Focused Investing: Economy and Markets Update” on our website at www.allentrust.com.