Looking back, 2022 was a difficult year for investors with both equity and fixed income markets suffering substantial declines in value. In contrast, as we move into August of 2023, this year has been kind to investors thus far. As of the end of July, equity markets are up by more than 20 percent (as measured by the S&P 500 index) and bond markets are up by more than 2 percent (as measured by the Bloomberg US Aggregate Bond index). Despite this solid year-to-date performance of US markets, looking forward, there is still an abundance of concern about markets and the economy overall. Perhaps the biggest open question is whether the Federal Reserve can make the necessary interest rate adjustments to return the level of inflation to its target of two percent without simultaneously triggering a sharp decline in economic activity. An outcome where the level of inflation is lowered without inducing an economic slowdown is what economists term a “soft landing.” Historically, soft landings have been infrequent.
Economists have been pessimistic about the future path of the economy this year. Many have argued that a soft-landing outcome is unlikely. However, with strong economic growth year to date and despite the Federal Reserve increasing its target federal funds rate over the past one and one-half years by 5.25 percent, forecast revisions have been numerous and a shift away from the forecast of a recession has become common. This shift has been accompanied by a more positive view of the policy of the Federal Reserve.
While the economic outlook early this year was not strong, it is the case that currently the environment is reasonably positive. Real GDP increased at an inflation adjusted annual rate of 2.2 percent for the first half of 2023. The labor market remains strong with significant job creation and a low rate of unemployment. In June, total nonfarm payroll employment increased by 209,000 and the unemployment rate was low at 3.6 percent. The monthly increase in total nonfarm payroll has exceeded 200,000 every month since December 2020.
What about inflation? Inflation has declined dramatically over the past year. As of the end of June, looking back one year, the rate of inflation as measured by the Consumer Price Index is 3.0 percent. Despite the fact that the two percent target of the Federal Reserve has not yet been reached on an annualized basis, this CPI reading reflects significant progress. One year ago, as of June 2022, the reading was 9.1 percent. While this reduction is good news, it may be premature to conclude that inflation is under control. Signs of inflation are ever-present. One example is the recent increase in many commodity prices including oil. Using West Texas Intermediate (WTI) crude oil to measure the price, since early May, the price of oil has increased by 15 percent. We have seen the impact of that increase recently in the price of gas. Oddly enough, the previously mentioned strong employment market is itself a potential driver of higher inflation due to the impact of wage increases. A fair characterization of inflation is to declare it under control but not necessarily gone.
What are the implications of the current economic environment for valuations in financial markets? As these implications are market dependent, we will consider the fixed income market and the equity market separately.
When considering the fixed income market, interest rates are key. The Federal Reserve signaled at its last meeting that more rate increases may not be needed. In discussing future rate increases, Fed Chairman Powell stated that the Fed “can afford to be a little patient,” implying further rate increases may not be needed. However, the Federal Reserve emphasizes that its actions are data dependent so increases are always possible based on new data arriving. The most likely cause of a rate increase would be signs of higher inflation. But this feedback from the Fed does create an expectation of a stable interest rate environment. In such an environment fixed income values should experience a positive return and a low level of volatility.
For the equity market, earnings drive valuations. The value of equities can be thought of as today’s value of future expected earnings. For the second half of 2023, earnings are expected to grow relative to 2022. In the third quarter, growth is expected to be low at 0.4 percent. In the fourth quarter, growth is expected to be robust at 7.5 percent. (These estimates are based on data from The Conference Board.) A positive view of the equity market results from combining these earnings growth forecasts with current valuations. However, given there are differences in current valuations across sectors, it is prudent to maintain a diversified allocation. (For example, by most metrics, the technology sector looks more highly valued than other sectors.) At PMA, on an ongoing basis as part of our risk control process, we monitor the equity allocation to verify that it is well diversified.
Can the Federal Reserve engineer a soft landing? The current outlook suggests it is possible – even likely. The Fed has been able to get inflation under control without seriously slowing economic activity. However, given the unpredictability of markets, investment portfolios must be carefully monitored to control risk.