Stocks broke a three-week losing streak with a strong rebound last week and remain in a trading range established after the June low.
We remain neutral toward stocks given uncertainty around inflation, the Federal Reserve’s (Fed) pursuit of higher interest rates to curb inflation and slowing economic momentum. We have the following thoughts concerning all of this.
Inflation and Fed Rate Hikes
Short-term interest rates controlled by the Fed started the year below 0.25% and now stand between 2.25-2.50%. As of this writing, the market was assigning about a 90% probability that the Fed will raise rates by another 0.75% at its September 20-21 Fed policy meeting. This historically rapid rise in interest rates is in response to stubbornly high inflation, which was as low as 1.4% in December 2020 but rapidly spiked to a peak of 9.1% in June of this year (as measured by the Consumer Price Index). This peak inflation also coincided with the June stock market low.
A significant portion of this inflation is associated with the pandemic, including supply-chain problems and shifts in goods and services demand. This has been aggravated by the war in Ukraine and China’s ongoing shutdowns to deal with the pandemic. The good news is that many of these pandemic-related problems are fading. Supply-chain problems are being resolved while goods demand is reverting toward pre-pandemic trends. Importantly, inflation is off the June peak and leading indicators are suggesting further declines in the months ahead with the consensus calling for a rate of only 2.6% in December of 2023.
Stocks sold off this year in sympathy with stubbornly high inflation and higher interest rates. For a sustainable uptrend to resume for stocks, we believe the market needs to anticipate a sustainable downtrend in inflation and a shift away from aggressive rate hikes by the Fed.
Key to this is for the Fed to achieve a “soft landing.” This implies moving rates high enough to cool economic activity and reduce labor market overheating, but not so high to cause a recession. This is a narrow path that the Fed is attempting to navigate and the higher they must raise rates, the more likely a recession is.
Slower Economic Momentum
Many important indicators show a loss of economic momentum including business surveys and other leading indicators. However, most indicators are still consistent with further economic growth currently.
Weekly jobless claims are a timely and historically accurate indicator of economic health, and they remain consistent with further growth. Initial claims for unemployment insurance fell 6,000 last week to 222,000. This was the fourth consecutive decline, bringing the four-week average of claims down by 7,500 to 233,000 in the latest week. Although this is about 55,000 higher than the cycle low in March and slightly above the pre- pandemic level, it is still low by historical standards. It suggests labor demand remains robust, which is inconsistent with recession.
Consumer confidence, which shows a high correlation with gasoline prices, has not coincidentally improved recently and is consistent with further growth.
Important Supports for Economy
Outside of low-income earners that are hurt most by inflation, consumers are still relatively healthy with low debt levels and debt service costs and excess savings of about $2 trillion. There is also significant pent-up demand for housing, autos, and travel and leisure. Banks are very healthy and able to lend. The U.S. is now energy independent with many beneficiaries of high energy prices in the economy. All of this is in stark contrast to the conditions leading up to the 2008 financial crisis when consumers and banks were in very bad shape while we were importing significant energy.
All of this suggests healthy underpinnings for the economy and that a path still exists for a soft landing that would ultimately support a resumption of an uptrend for stocks. We are closely watching incoming economic and inflation indicators, Fed communications, and stocks themselves for potential changes to our stance.
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