LGOV - August 2023 Perspective
2023-08-02 05:35:00 ET
Summary
- As our conversation about the Federal Reserve (Fed) continues, officials have made it clear that they’re committed to lowering inflation.
- The Fed has three more scheduled meetings this calendar year, the next being in September.
- All three major indices, the S&P 500, the Nasdaq Composite, and the Dow, logged weekly gains in the last week of the month, with the S&P 500 and the Dow documenting their third consecutive positive week.
What’s New
As our conversation about the Federal Reserve (Fed) continues, officials have made it clear that they’re committed to lowering inflation. With the target rate at 2%, July reports of headline at 3%, and core inflation at 4.8%, there is still work to be done.
Following the brief pause in June, rates were raised by a quarter percentage point at the July Fed meeting, hitting a twenty-two-year-high. Chairman Powell stated that it is premature to tell whether we will see continued rate hikes throughout the year. How the economy fares in the months ahead will be the indicator on whether the Fed can achieve the soft landing that we have been hoping for.
What does the latest rate increase mean for investors? Continue to hang tight. The Fed has three more scheduled meetings this calendar year, the next being in September. If the rate hikes continue to be 25 basis points, investors should not feel too much pain. However, if there is another hike of 100 basis points, investors will feel an impact.
Rounding out July on a positive note, the Dow hit its greatest consecutive increase (13 days) since 1987. The previous record in 1987 occurred when the Fed was similarly fighting inflation with a former Chairman, Paul Volcker.
All three major indices, the S&P 500, the Nasdaq Composite, and the Dow, logged weekly gains in the last week of the month, with the S&P 500 and the Dow documenting their third consecutive positive week.
However, the incentive to continue to overweight portfolios with stocks over bonds is falling. Based on previous hiking cycles when rates plateau, the bond market tends to be bullish.
Looking at the economy, it is proving to be continuously resilient. Today’s ongoing inflation relationship debate revolves around the labor market. To what extent do job cuts need to rise and job openings slow to continue to relieve inflationary pressures?
If the Fed does not see a decrease in wages, prices, and weakening company profits, we are not likely to hit our inflation target rate.
Closing July, we saw these pressures mildly cooling, such as a slowdown in employer spending on compensation.
July Financial Market Performance:
- S&P 500: +3.11%
- Dow Jones: +3.35%
- NASDAQ: +3.81%
- 10-year US Treasury yield: +0.13%
Our Perspective
As we have been communicating, our outlook is a recession. With that in mind, we are placing an emphasis on risk management and therefore have adopted a defensive position strategy in our portfolios.
Our goal is to identify companies that we believe are economically resilient. These are companies that generate strong cash flows and hold competitive advantages in their industries. As active managers, we are building our portfolio to be able to weather nearing market volatility, while adding to our watchlist.
In terms of pro-cyclical sectors, we are continuing to shape our shopping lists and patiently watching for opportunities to increase our exposure in those areas of the market. With constant changes in the market, we are putting our time-tested portfolio creation process to work.
Rate Hikes: Are They Over?
After hiking rates since March 2022, we’ve seen progress made on inflation, but it’s still above the 2% target. Add in that we’re now seeing cracks are starting to form in the economy, this could suggest there may be greater reluctance from the Fed to keep hiking rates going forward.
While we do not expect the current tightening cycle to end until something in the economy breaks, what does the future of rate hikes look from here?
Read our views in What is the End Game for the Fed Rate Hike Cycle?
A Word from Our Investment Policy Group
- Economic Cycle
The economy is late cycle. The Fed has hiked aggressively and while the economy has remained resilient to date, the manufacturing industry is showing serious pain and we anticipate that the lagged effect of monetary policy will start to be felt in other parts of the economy in the coming quarters.
- Stock Market
The US stock market has rebounded strongly off its October 2022 lows. Sentiment now appears stretched and valuations are not compelling. To date, market returns have been driven by multiple expansion.
EBIT margins climbed to historical highs in the years following covid lockdowns; elevated input costs and weakening demand and pricing power are posing a risk to the ability of corporations to maintain earnings at their projected level. Returns will be harder to come by and stock selection will be increasingly important.
- Bond Market
Interest rates remain well off of their lows, as the economy has remained resilient and the market weighing the dynamics of still-elevated core inflation and the potential for interest rates to remain higher for longer. Corporate spreads remain well contained, particularly in light of the risks we see to the economy.
- Important Issues on the Radar
Inflation: Factors including a resilient demand environment and wage increases threaten to keep core inflation elevated. Should this be the case, the Fed may remain tighter for longer.
China’s Economy: China has pivoted on the two key economic issues that acted as severe headwinds to growth over the last two years; however, economic growth appears to be stagnating, and it will be critical to monitor the policy response in the coming months.
Source: Wall Street Journal, Bloomberg.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
For further details see:
August 2023 Perspective