December Investment Comments

The stock market continues to be driven on a daily basis by the outlook for interest rates. Data suggesting inflation is easing or the economy is slowing is favorably received by stock investors who are looking for, or more precisely hoping for, signs the Federal Reserve is ending its aggressive rate hikes. Every speech from Fed Governors is scrutinized for these signs.

We saw a similar pattern during the summer, but it didn’t last. Some investors didn’t believe the Fed would continue raising rates by three-quarters of a percent each month past the first couple of months. Traditional rate hikes are typically one-quarter or one-half percentage point per month, but this time the Fed started very late and attempted to make up for lost time. Summer optimism is easier to perpetuate because the Fed doesn’t meet in August, allowing investor sentiment to go off on a tangent without a reality check. But Fed Governors saw this market optimism and in mid-August doused it with a bucket of ice water, sending stocks down to new lows by the middle of October.

During the summer bounce, we felt the Fed would be letting investors off too lightly by easing up on the brakes so soon. The punishment typically goes on much longer. In fact, our worry was that they might indeed slow down too soon before the job of squelching inflation was done. Unlike last year when the Fed missed clear signs of persistent inflation and maintained a stance of ultra-easy monetary policy, this time there was no hesitation to stay on task.

But investors have been forced to suffer longer; so is now the time when we get to have fun again?  We wish we could say with any confidence that the recent rebound will turn out to be more durable than the summer head fake, but it is encouraging that this market resembles the contour of a normal bear market. A typical bear market lasts about a year with a median decline of 24%. This bear market is over ten months old and had fallen 28% at its recent bottom in mid-October.

There are signs that higher interest rates are starting to have an impact on the economy. New home sales are down about 18% over the past year although prices remain surprisingly firm, up 14%. Perhaps a better indicator of trouble in the housing sector is that home mortgage applications are down 42% over the past 12 months. The housing sector has heard the Fed’s message loud and clear.

Third quarter Gross Domestic Product appeared to represent a significant improvement over the past two quarters when GDP fell. However, the devil is always in the details and in economics there is no end of details and contradicting information to sort out. The first two quarters were negatively affected by foreign trade and inventory adjustments. A measurement called Real Final Sales to Private Domestic Purchasers excludes trade, inventory, and government purchases. By this measure, the economy slowed to miniscule 0.1% annualized growth in the third quarter, down from 0.5% in Q2 and 2.1% in Q1.

Economies in Europe and China are also slowing, and Japan’s has turned negative once again. A deep recession in Europe appears inevitable. Inflation has already reached double-digits there as Europe is highly dependent on imported energy, and Russia has largely turned off the spigot in retaliation for Europe’s support of Ukraine. China’s economy remains sluggish because of sinking exports, a severe real estate slump, and rolling lockdowns in an attempt to eradicate Covid.

There are signs the U.S. may have already reached peak inflation for this economic cycle. The Consumer Price Index has edged down in recent months as energy price inflation has receded somewhat. Food prices continue to surge, however. The year-over-year change in inflation was 7.7% in October. The “core CPI” excludes changes in food and energy and was up 6.3% in October from a year earlier. This is a few tenths of a percent below its peak reached over the summer. The Producer Price Index measures business prices and also appears to be on a slight downward trajectory.

We continue to see signs of economic slowing, but much of it is anecdotal and isn’t apparent from government statistics. Reports of layoffs appear to be rising, but overall measures of layoffs are up only modestly. In reviewing third quarter corporate earnings, more companies appeared to indicate that they are preparing costs cuts in the event business slows from their expectations. “Cost cutting” is frequently a euphemism for “layoffs” as companies don’t want to alarm their workforce by prematurely uttering the word “layoff.”

Official retail sales surged in October, but the results appear to be mixed. Some relief from computer chip shortages has allowed car makers to increase deliveries to customers. Walmart outperformed expectations while Target has indicated fourth-quarter sales are likely to decline. While seemingly contradictory, this data suggests that pinched consumers are prioritizing necessities over discretionary purchases. This would advantage Walmart over Target. Both companies, and many others, are struggling with high inventories. They ordered merchandise early to avoid supply chain problems but ended up taking delivery just as consumer demand turned lower. Reports suggest some companies are cancelling orders or asking suppliers for discounts.

Treasury interest rates have fallen in recent weeks as they did over the summer. As was the case with the summer rally in stock prices, lower Treasury yields this summer appeared to us to be simply too optimistic too soon. Will this time be any different?  It is hard to tell, but eventually investors will have been punished enough and markets will recover.

The Treasury yield curve remains “inverted,” with short-term Treasury yields of 4.4%-4.7% exceeding long-term yields of 3.7%-3.9%. The implication here is that Fed rate hikes will induce a recession, which the Fed will ultimately address by reducing interest rates in the future. Some investors are willing to buy long-term Treasuries in order to book a capital gain if the Fed is eventually forced to cut rates. This is what the tea leaves tell us.

Short-term interest rates will eventually come down, but not yet. It will take a few more months of better inflation readings before the Fed is willing to significantly curtail rate hikes. Fed Vice Chair Lael Brainard recently noted, “It probably will be appropriate soon to move to a slower pace of increases.”  That is exactly what markets wanted to hear.

The recent election appears to have resulted in divided government. Democrats retain the White House and the Senate while Republicans won the House. Markets tend to do better because divided government forces stability and compromise and takes off the table any abrupt legislation.

Every bear market and recession come to an end, leading to recovery and a new bull market. Having endured a tough year, we must maintain our resolve to wait out this market. But that doesn’t mean sitting still. Investors can prepare themselves for a more productive future by taking tax losses and repositioning into better companies. As J.P. Morgan said, “In a bear market, stocks return to their rightful owners.

Scott D. Horsburgh, CFA