After two painful years of historically high inflation, which wreaked havoc on the economy, consumers, businesses and the capital markets, it appears inflation may be headed back to a more normal range. While the damage it has inflicted on the economy is obvious and the process to bring it down further will take time, it’s encouraging to see the yearly Consumer Price Index (CPI) fall by half in 2023 and by more than two-thirds from its high in June 2022.
Getting inflation under control has been the mission of the Federal Reserve over the past few years. During that period, they aggressively raised short-term interest rates on 10 occasions, from a low of 0.25 percent to 5.25 percent today. In their most recent statement on interest rate policy, they suggested that rates are now high enough to modestly slow economic activity, restrict credit, slow job gains and, ultimately, further ease long-term inflation. They also indicated lower interest rates are probable next year if favorable inflationary trends continue.
Today, economic growth is mildly positive, the unemployment rate has increased but remains relatively low and consumer spending is holding up well. These are positive developments for both the economy and capital markets going forward.
Production shrinks while services expand
While the decline in the rate of inflation is a relief for many sectors of the economy, its impact has been profound and could last for years. For instance, the measure of factory activity shrank for the 13th straight month in November, as elevated interest rates and weak demand hampered production. New orders have contracted for 15 months, the longest streak since 1981-1982. Companies have right-sized inventory and slowed capital improvements to accommodate weaker consumer demand. However, the larger services sector expanded at a faster pace in the recent month as business activity and employment picked up.
Consumers keep spending
While consumer spending, the backbone of the US economy, has continuously surprised in large part due to incessant demand for various personal services, many forecasters don’t expect that level of strength to last much longer as employers scale back hiring, and wage gains recede.
Still, the latest read on retail sales defied expectations and posted a modest increase. Eight of 13 categories posted increases, led by restaurants as well as sporting goods and online retailers. The drop in gas prices and modest wage gains continue to help consumers maintain their spending habits.
Housing still has a long way to go
Another sector significantly impacted by elevated interest rates is the housing sector. The 30-year mortgage interest rate is over 6 percent today, compared to around 3 percent a few years ago. Existing homeowners are reluctant to sell, which limits inventory and keeps home prices elevated.
Many prospective buyers have pursued new construction. While volatile, new housing starts jumped 14.8 percent in November to a six-month high with single-family home construction up 18 percent, the highest since April 2022. All regions reported growth, with the southern regions leading the way. Still, home affordability, which measures home prices, incomes and mortgage rates, is hovering near its historic low. This indicates the housing sector has a long way to go to get back to normal.
Healthy employment picture
Although many areas of the economy have felt the effects of inflation and economic uncertainty, it’s encouraging to see employment hold up relatively well. For example, the economy has produced about 2.5 million jobs so far this year. Annual wages have increased about 4 percent, higher than the long-term average.
While the nation’s unemployment rate has increased slightly from 3.4 percent in January to 3.7 percent today, it remains historically low, and the labor participation rate continues to increase, indicating workers' willingness to get back to work. A healthy employment picture along with rising wages should continue to keep consumers spending and the economy on a modest growth path.
Declining rates boost capital markets
These somewhat uncertain economic trends coupled with the Federal Reserve’s aggressive interest rate policy led to subdued returns and heightened volatility for both stocks and bonds throughout most of the year. In early November, investment sentiment began to change. Interest rates started to fall from their recent peak in anticipation that the Fed was done raising interest rates and perhaps would start dropping rates in 2024, which they confirmed at their meeting in December. This led to a significant bounce-back for most sectors of the stock and bond markets during the last few months of the year.
The S&P 500 index returned 11.7 percent during the quarter, while small- and mid-cap stocks returned 15.1 percent and 11.7 percent, respectively. Interest rates fell during the quarter, leading to solid gains for bonds. The Barclays Aggregate Bond Index returned 6.8 percent, while the Barclays Corporate Index returned 8.5 percent.
Our 2024 market outlook
Looking ahead, the combination of lower expected inflation and the Federal Reserve’s shifting interest rate policy should bode well for economic growth, employment and returns in the capital markets. Although valuations are a bit elevated for certain large-cap stock sectors, mid-cap and small-cap sectors appear cheaper and more leveraged in terms of economic growth and inflation. Therefore, we expect healthy returns in both domestic and international stocks in the year ahead.
Further, if inflation continues to moderate and the Fed reduces interest rates as expected, bond returns should rebound close to their historical averages and produce much better returns than compared to the last few years. From an economic perspective, data trends suggest the economy will benefit from lower inflation with modest growth and a continued healthy job market.
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.