Market Insights: Q&A with Towneley’s Investment Committee
Welcome to the Fall 2023 edition of the Towneley newsletter. In this edition, you will hear from our investment team in a frequently asked questions format.
We believe the saying that “too much of a good thing can be bad” applies to this market. The hangover from the combined $10 trillion fiscal and monetary policy during 2020-2021 will be with us for a while, mainly in higher inflation and interest rates. The policies added too much liquidity in too short of a period, and we’re now feeling the aftereffects.
The Consumer Price Index has decelerated to 3.7% year-over-year, far below its June 2022 high of 9.1%, while core CPI has slowed to 4.1%. Based on other measures, such as PCE and PPI, inflation has slowed even more. One area of improvement has come from shelter, which makes up 33% of CPI. Shelter costs have gradually eased and are expected to fall further. The economic shocks from the pandemic-related supply crunch are abating as supply and consumer demand normalize.
We believe that inflation has peaked but that Fed policy will remain restrictive until inflation reaches its 2% target. Given the strong labor market, wage pressures, and elevated service costs, achieving a 2% rate will likely take time. The outlook is especially challenging because we see a high likelihood of an economic slowdown/recession in 2024, and the Fed may be unable or unwilling to step in and spur economic activity given the inflationary headwinds. We’re in an environment we haven’t seen in over 40 years.
After one of the most rapid rate hike cycles in history, the Fed held rates steady on November 1st, citing softening inflation and the possibility of a recession. During the past 18 months, consumer lending rates surpassed 8%, presenting significant challenges for individuals and businesses seeking loans or mortgages. At the same time, shorter-term bond rates rose more than longer-term rates, as evidenced by the 6-month U.S. Treasury yield, which has hovered around 5.5% since July. Longer-term maturities have stayed below 4% for most of this year, while the 10-year U.S. Treasury yield reached its highest level since 2007, briefly surpassing 5%.
With economic indicators pointing towards a likely recession, reinvestment rate risk is rising, which favors longer-duration bonds. Historically, once a recession begins, the Fed quickly lowers rates. If a recession does materialize and inflation continues to slow, the Fed may have to reverse course, and we could see lower rates soon after that. Because of that view, we added duration to portfolios earlier this year, focusing on Agency Mortgage Back Securities (MBS). We saw an opportunity to add higher yielding bonds backed by high quality collateral which lowered credit risk. In July, we increased duration again and focused on expanding our Treasury exposure, which now makes up 46% of the fixed income allocation.
On the surface, the pullback of long bonds with yields near 5% appears compelling. Still, the massive levels of deficit spending and higher debt servicing costs are causing us to hang tight on adding any more interest rate risk. Historically, rates have declined in recessionary periods, but the question we keep asking is, can the bond market handle the number of new issues needed to sustain government spending? Unlike during the previous 13 years, the Fed is not supporting deficits by keeping rates low, which makes this a difficult question to answer.
After a strong start to the year, the market recently fell into correction territory, typically defined as a 10% decline from the previous peak, which is at odds with many recent measures of strength in the underlying economy. Since the end of July, the S&P 500 has pulled back 10.3% due to concerns about rising interest rates, Fed policy, slow growth in China, political uncertainty in Washington, and more. Even at its peak, the market had not fully recovered from last year’s decline, coming within 4.3% of its all-time high at the start of 2022. Year-to-date through October 31, the S&P 500 is up 10.7%, and the Nasdaq is up 23.6%.
The stock market tends to rise and fall in cycles (bull markets follow bear markets, which often follow bull markets). Stock valuations are currently elevated, corporate earnings are stagnating, and earnings and valuation forecasts for 2024 appear overly optimistic. While corporate profits were also sluggish at times between 2014 and 2017, the difference then was that the Federal Funds rate was 0%, investors were willing to pay more for stocks, and markets rallied. With the current Fed Funds rate above 5%, however, strong corporate earnings are needed to support a sustained market rally.
Our team took advantage of the rally in the first half of the year by rebalancing portfolios in July – this led to us scaling back exposure to Large Cap Growth stocks and adding to fixed income. The timing worked out well on this, as we’ve seen stocks pull back since that time. Given the rate rise, we may harvest tax losses in client portfolios before year-end to offset gains realized during the July rebalancing. We constantly focus on taxes and fees to benefit our clients with taxable accounts.
