We continue living in an inflationary environment, brought on by easy monetary policies amidst the Covid crisis. The Federal Reserve is now determined to bring inflation back to its pre-pandemic level. The question remains: will the Fed succeed or are we permanently stuck with higher inflation for the foreseeable future? Either outcome has its own set of economic, social and capital market challenges that could reverberate for years.
On the one hand, lowering inflation to the Fed’s goal of 2 percent annually could mean higher unemployment and a slowing economy. On the other hand, accepting a higher inflation rate could put long-term financial pressure on consumers, impact corporate profits and lead to further ballooning federal deficits. While neither path is without sacrifices, history has proven that our capitalistic system is resilient and can overcome these types of challenges. For now, the domestic economy remains on a modest growth path with decelerating inflation, a robust jobs market and modest consumer spending.
Signs of softening in the economy
While resilient, there are signs of softening in several sectors of the economy, as persistent inflation has taken its toll on consumers and businesses. For starters, manufacturing activity has contracted for 10 straight months but appears to be stabilizing recently. Consumers have pulled back spending on high-ticket items, forcing factories to slow production and manage down their inventory. However, the larger services sector of the economy remains in expansion mode. The latest reading came in above estimates, with 13 of 18 sectors reporting growth and an improvement in new orders, employment, and overall business activity.
The housing sector is another part of the economy struggling to deal with higher interest rates and uncertain demand. The sales of previously owned homes declined in August to a seven-month low. Borrowing costs are now hovering around the highest level in decades, discouraging existing homeowners, many of whom previously locked in lower mortgage rates, from moving. The combination of high financing costs, diminished inventory and elevated home prices has created one of the least affordable housing markets on record.
Finally, the Leading Economic Index fell 0.4 percent in August and has now fallen for nearly a year and a half. The index provides an early indication of significant turning points in the business cycle and where the economy is heading in the near term. The index continues to be negatively impacted by weak new orders, deteriorating consumer expectations of business conditions, high interest rates and tight credit conditions. All these factors suggest that forward economic activity will likely decelerate and could experience a mild contraction.
Employment remains strong
With certain areas of the economy struggling, one of the most important segments remains strong: employment. The latest data shows an unemployment rate hovering near a historic low of 3.8 percent, as over two million jobs were created this year. Although the pace of employment has cooled from its torrid pace of the prior year, wage growth remains strong at about 4.3 percent annually and labor participation has edged up as more people come back into the workforce. Furthermore, with a relatively tight labor market, workers are beginning to demand higher pay and benefits. A firm labor market should support consumer spending and keep economic growth positive.
Investors concerned about higher rates
Overall, this generally positive economic environment with elevated inflation has led the Federal Reserve to reiterate its commitment to keep interest rates high enough to cool inflation over time. Already, the Fed has raised short-term interest rates from 0.25 percent in early 2022 to 5.5 percent today, a historically fast pace. Further, they detailed their commitment to assess and monitor inflation’s impact on labor markets, credit conditions and growth.
Attempting to reduce inflation without putting the economy and capital markets into a tailspin is a balancing act with little room for error. For the quarter, the continued uncertainty and concerns about higher interest rates led to modest declines in most sectors of the capital markets. The S&P 500 Index produced a -3.27 percent return while the Aggregate Bond Index declined -3.23 percent and international markets fell modestly.
Looking ahead, inflation remains the linchpin to whether the economy and capital markets will trend higher or lower. While inflation has receded, it remains higher than the Federal Reserve’s target range, and it has put pressure on credit conditions, the housing market and consumer spending. For now, the economy has been resilient, with modest growth and low unemployment. Yet, several sectors, including manufacturing, housing, and leading indicators, reflect the strain inflation has on parts of the economy.
We expect further volatility in growth and returns in the capital markets until investors get a clearer picture of the direction of inflation. Domestic stock returns should see modest returns through the end of the year, while aggregate bonds are likely to struggle should interest rates migrate higher. Long term, the economic foundation of low unemployment and solid consumer spending should provide stable growth and modest returns for both stocks and bonds.
We thank you for your continued support of our firm, our investment process, and the trust you have given us to manage your assets. We will continue to work hard on your behalf to deliver solid risk-adjusted returns. Should you have any questions, please do not hesitate to reach out to your financial adviser.
Chris is the President and Chief Investment Officer (CIO) of Advance Capital Management. As CIO, he directs the strategy and structure of the discretionary model portfolios and leads the investment committee.