Economic Outlook

By: W. Kirk Taylor, CFP^®

In this week’s Commentary, we provide investors with some historical insights and perspective on how the economy performs, and how the stock market responds to presidential elections, as well as shifts in the balance of power in Congress.

What follows might surprise you and perhaps prevent letting a political headache turn into portfolio heartbreak.

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By: W. Kirk Taylor, CFP®

Executive Summary

Our outlook for 2024 is bullish for both stocks and bonds. While we expect modest equity returns in 2024 compared to last year, we see the S&P 500 rising 8%-12% this year, as falling inflation, modest economic growth, above-average profit growth, lower interest rates, and the now famous “Powell Pivot” breathe life into the prospects of a soft-landing.

We see the market making a new high early in the year but expect that the bulk of equity returns this year will be backloaded and occur post-election. Clients should be prepared for heightened volatility during the first part of the year as the soft-landing scenario will be swiftly questioned on any sign of economic weakness. This will be particularly true if the Federal Reserve hints at deferring rate cuts to mid-year or beyond. Heightened volatility is a nice way of saying that the market could see as much as a 10%-15% correction this year, given stocks appear to be priced for perfection presently. Nonetheless, corrections are healthy and common, even in a bull market.

Moreover, as we move into mid-year, investors will turn their attention to the Presidential Election in November, suggesting choppy or sideways trading action over the summer and into the fall. With the election outcome known, investors should anticipate the typical election year rally in the 4^th quarter.

As always, our advice is to view your investment portfolio through an economic lens and not a political lens and to look past the near-term noise and news headlines that are prominent during an election year. In the end, we expect the market to climb a Wall of Worry on its way to back-to-back gains in 2024. Please read on as we take a quick look back on last year and detail why we are optimistic on the year ahead.

2023: The Year That Wasn’t

2023 will go down as “The year that wasn’t”. By that, we mean that 2023 was anything but what was expected. There was no recession as predicted by 61% of economists in January 2023¹. There was no banking sector meltdown as feared early in the year as the Federal Reserve stepped into rescue Silicon Valley Bank. Goods inflation fell dramatically faster than expected, while service inflation surprisingly nudged lower, not higher. Unemployment didn’t climb to 4.8% as thought and instead held steady near an all-time low. Finally, the economy grew just over 3% for the year, nowhere near the anemic growth forecast. To boot, the S&P 500 gained 26%, far exceeding the consensus forecast of only 5%.

To be sure, broadly diversified investors with exposure to midcap, small-cap, international, and emerging markets were somewhat left behind as the Magnificent 7 (Amazon, Alphabet, Apple, Meta, Microsoft, NVIDIA & Tesla), surged 111% and accounted for the lion share of the gains, as the remaining 493 stocks in the S&P 500 gained only 12%².

At the Fed’s November 1^st press conference, Federal Reserve Chair Jerome Powell lit a fire under stock and bond markets when the heretofore “hawkish” Powell surprised investors by signaling that the Fed was likely done raising short-term rates. Moreover, they indicated that they were turning their attention to the possibility of three rate cuts in 2024.

This abrupt change in the Fed’s view is now famously known as the “Powell Pivot”. What followed was a multiweek win streak for stocks, the longest stretch in years, as the S&P 500 rallied nearly 13%. Effectively, 50% of the gain in the S&P 500 came in November and December alone. After peaking at nearly 5% in late October, the yield on the 10-year Treasury bond dropped from 4.88% on October 31^st to 3.86% by year-end, to end the year unchanged. Suffice it to say, that both stock and bond investors were taken for a wild ride last year.  

What’s in Store for 2024?

Below, we share our outlook on the themes influencing the economy and thus the financial markets in 2024:

1. INFLATION: Inflation continues to approach, if not reach, the Fed’s 2% target. The direction of inflation is what matters, and it’s clear that the inputs (COVID related supply-chain challenges and massive fiscal and monetary stimulus) that led to a 40-year high in inflation are in our rearview mirror. The CPI peaked in June 2022, with a year-over-year (YOY) increase of 9.1%. The Bureau of Labor Statistics (BLS) reported recently that the December 2023 YOY increase in CPI had fallen to 3.4%; down substantially from 9.1%, just 18 months earlier. On Friday, the Commerce Department reported that the personal consumption expenditures (PCE) price index, the Fed’s preferred inflation gauge, increased 1.7% in Q4 of last year. This compares favorably to the 2.6% increase in core prices seen in the preceding quarter and is decidedly below the 5.4% YOY increase seen at the end of 2022. Equally important, the three six-month annualized rates of core inflation were 1.5% and 1.9% in December⁴.
2. INTEREST RATES: The Federal Reserve will indeed lower short-term interest rates this year (we forecast 3-4) but perhaps not as soon as, or as much as, investors might prefer. Given that inflation has peaked and is decidedly approaching the Fed’s target, it’s not surprising that investors reacted so positively when the Fed signaled it was eyeing rate cuts in 2024. Famed investor, Marty Zweig was best known for saying “Don’t Fight the Fed”. This axiom proved correct in 2022 as the Fed raised interest rates aggressively and the S&P 500 fell 18%. It proved correct again in 2023 when the Fed signaled rate cuts were coming, and the S&P 500 gained 13% in just two (2) months. Barring a hard landing for the economy, which is currently not a high-probability outcome, investors will be wise not to fight the Fed in 2024. Falling inflation begets falling interest rates, particularly mortgage rates, which is a key factor given the housing’s share of economic output. The average 30-year fixed rate mortgage recently fell to 6.6%, the lowest level since May of last year, and is down significantly from the 2023 peak of 7.79%⁵.
3. CORPORATE PROFITS & VALUATIONS: According to J.P. Morgan, consensus analyst expectations for corporate earnings in 2024, are for earnings to grow 12% and to reach $243⁶. Using the January 26^th closing price for the S&P 500 of 4,907 and $243 in earnings, the S&P 500 trades at a P/E ratio of 20x this year’s earnings, well above the 30-year median P/E of 16.6 and one (1) standard deviation above the median. Accordingly, stocks are somewhat overvalued at present, suggesting limited upside over the near term. In 2022, when earnings fell -1%, the P/E for the S&P 500 hit a low of 17x in October of that year, near the 30-year median. If the S&P 500 were to trade at 17 times 2024’s earnings estimate of $243, that would imply a price level of 4,131. This is coincidentally (or not) roughly 15% from the current level of 4,907 for the S&P 500.
4. CONSUMER SENTIMENT & CONSUMER SPENDING: Consumer sentiment surged 9.1% in January according to the University of Michigan survey, the biggest one-month advance since 2005 and the highest overall level since July 2021. Sentiment has risen 29% over the course of the last two months, the largest such increase since 1991. Meanwhile, year-ahead inflation expectations fell 2.9% on the heels of a dramatic decline in December and personal income was up 3.15% in December compared to a year ago, up significantly from the -1.28% annual rate registered in June of 2022⁷. Improving sentiment, rising personal incomes and consumer spending bode well for economic growth this year.
5. GROSS DOMESTIC PRODUCTION (GDP): According to the Bureau of Economic Analysis (BEA), the initial estimate for year-over-year (YOY) real GDP growth in Q4 of 2023 was 3.3%. This followed YOY growth of 4.9%in Q3. Across all four (4) quarters, real GDP grew 3.1%⁸. Our view for 2024 is that economic growth will land in the 2.0% – 2.5% range, as corporations and consumers continue to feel the lagging but temporary impact of high interest rates. For reference, 2% is effectively the long-run growth rate for the US economy. We are watching carefully several key economic inputs such as the Leading Economic Indicators (LEI), which has gradually fallen lower for the past twenty months. Another input is the yield curve, which remains inverted. An inverted yield curve occurs with short-term rates are higher the long-term rates and historically precedes a recession. Will this time be different?
6. SOFT LANDING: For much of 2023, the soft-landing thesis was challenged as the Fed steadfastly held to its commitment to put the inflation genie back in the bottle, keeping the threat of a recession front and center for investors, who on the heels of an 18% decline for the S&P 500 in 2022, were rightfully skittish. As has been the case for the past two (2) years, the market will continue to debate the hard landing versus the soft landing outcome. Given that the Fed has signaled its intention to lower rates this year and its propensity to cut rates when the economy softens, we’re firmly in the soft-landing camp. Having said that, investors should brace themselves for hard-landing rhetoric in the first part of the year as the economic data ebbs and flows and recession fears resurface.
7. THE PRESIDENTIAL ELECTION: The 2024 Election will provide plenty of theater for investors and every opportunity to fear the worst if your party and/or your candidate loses, regardless of your political affiliation. The outcome will not likely alter the fundamental course of the economy or the stock market in 2024 and perhaps not in 2025 but that bears watching. The simple truth is that the President is one person, and that person is subject to Congressional and Judicial checks and balances, against the backdrop of a slow-moving $26 trillion US economy. Sadly, the political landscape in our country is so divisive at present that Americans will continue to be (for better or worse) subjected to Congressional gridlock. This “balance of power” means the status quo will likely remain in place until it doesn’t. As we alluded to at the start of our Fearless Forecast, investors should not let a political headache turn into a portfolio heartbreak.

2024 Election Preview

We’ll have more to say about the Presidential Election on October 1st.

Mark the date on your calendar and stay tuned for more details regarding the time and location!

In closing, clients should expect 2024 to be a good year with stocks returning 8%-12% and bonds returning 5%-6% as inflation falls, and the Fed lowers interest rates. At the same time, clients should be equally prepared for a bumpy ride on the way to earning those returns. 2023 was a reminder that patience and discipline are the key to reaping long-term returns in the market. 

As always, do not hesitate to reach out with questions.

W. Kirk Taylor, CFP®

President and Chief Investment Officer

Commentary Disclosure

This commentary is a publication of Kirk Capital Advisors, LLC. The information contained herein does not constitute investment advice or a recommendation for you to purchase or sell any specific security. This information is intended to be educational in nature, and not as a recommendation or endorsement of any strategy, approach, product, concept, or asset class. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be suitable or profitable for your investment portfolio. All investment strategies have the potential for profit or loss. All expressions of opinion reflect the judgment of the authors as of the date of publication and are subject to change without notice to the reader and should not be regarded as a complete analysis of the subjects discussed. You are solely responsible for reviewing the content and for any actions, you take or choose not to take based on your review of such content. A professional advisor should be consulted before any investment decisions are made.

Certain information contained herein was derived from third-party sources as indicated. While the information presented herein is believed to be reliable, no representation or warranty is made concerning the accuracy of any information presented. Where such sources include opinions and projections, such opinions and projections should be ascribed only to the applicable third-party source and not to KCA. We have not and will not independently verify third-party information. Historical performance results for investment indexes and/or categories, generally do not reflect the deduction of transaction and/or custodial charges or the deduction of an investment management fee, the incurrence of which would have the effect of decreasing historical performance results.

Kirk Capital Advisors, LLC offers investment advisory services and is registered with the U.S. Securities and Exchange Commission (“SEC”). SEC registration does not constitute an endorsement of the firm by the SEC, nor does it indicate that the firm has attained a particular level of skill or ability. You should carefully read and review all information provided by Kirk Capital Advisors, LLC including Form ADV Part 1A, Part 2A brochure, all supplements, and Form CRS. Kirk Capital Advisors, LLC only transacts business in states where it is properly registered or excluded or exempted from registration requirements. ©2024 Kirk Capital Advisors, LLC.

Commentary Footnotes

1 – https://www.wsj.com/finance/stocks/what-did-wall-street-get-right-about-markets-this-year-not-much-7d4368fe

2 – https://www.kiplinger.com/investing/stocks/what-are-the-magnificent-7-stocks

3 – https://www.bls.gov/news.release/pdf/cpi.pdf

4 – https://www.bea.gov/data/personal-consumption-expenditures-price-index

5 – https://www.cnn.com/2024/01/18/business/mortgage-rates-january-18/index.html

6 – https://www.bea.gov/news/2024/gross-domestic-product-fourth-quarter-and-year-2023-advance-estimate

7 – https://am.jpmorgan.com/us/en/asset-management/protected/adv/insights/market-insights/guide-to-the-markets

8 – http://www.sca.isr.umich.edu/

9 – https://www.bea.gov/news/2024/gross-domestic-product-fourth-quarter-and-year-2023-advance-estimate 

By: W. Kirk Taylor, CFP®; Chief Investment Officer

January, much to the chagrin of the consensus that was steadfastly calling for tough sledding in the first half of the year, has ushered in all sorts of technical “buy” signals and reviving the markets animal spirits in the process. At a minimum, these buy signals are suggesting more gains lie ahead for investors. They may be pointing to the start of the new bull market, but we are skeptical. We tend to agree with the bullish camp over the short-term but we do so with a few key caveats.

Prognosticators continue to hotly debate whether the Fed will become dovish i.e., they will pause, or they will halt altogether their aggressive rate hike campaign. Some even forecast that the Fed will lower interest rates in the latter part of the year; hardly something to be bullish about in our view as there is only one reason for the Fed to lower interest rates; to prop up a sagging economy. 

The bears on the other hand fear that the Fed will keep pumping the brakes of monetary policy far too long, unintentionally sending the economy head-on into the wall of a recession. This is not a risk to take lightly.

Both camps make compelling arguments for their view, but the former “doveish” camp is winning out for now. The market wants the Fed to pause. They believe the Fed can engineer a soft-landing. They may also believe in unicorns.

As Warren Buffet has famously said, “In the short run, the stock market is a voting machine. In the long run, it is a weighing machine.” In other words, sentiment and psychology can dictate the near-term direction of the market but eventually sentiment and psychology will give way to the cold reality of the underlying fundamentals, whether good or bad.

The Technical Take

2023 is off to a good start after a challenging 2022. Stocks are rising broadly with small, mid and large cap companies performing well. Interestingly, growth-oriented stocks are up but value-oriented stocks are up more. Non-US equities are up on the heels of a weakening dollar and bond prices are rising as interest rates fall. Everywhere you look, there’s nothing but “green on the screen” of Bloomberg terminals and in client portfolios. What a relief!

We observe that “breadth” is strong, moving averages are giving “golden cross” buy signals and “sentiment” is improving among individual investors as they believe the worst is behind us. Investors seem to be saying “Keep Calm and Carry On”.

We believe this bout of optimism may prove to be different than the optimism that drove multiple failed rallies in 2022. According to some analysts, we may see double-digit gains for the S&P 500 during the first part of the year given the strength of the technical indicator.

We caution investors however to “not drink the Kool-Aid”.

For investors who lowered their equity allocation in 2022 in a prudent defensive posture, we see a brief window of opportunity to broadly increase their exposure to stocks and bonds on pullbacks. For the time being, it’s safe to “buy the dip”. Just recognize, as we lay out below, that more challenging times likely await investors in the second half of the year.

Don’t Fight the Fed

In 1970, famed investor Marty Zweig coined the phrase “Don’t Fight the Fed.” He observed that both stock and bond market returns are highly correlated with the direction of short-term interest rates i.e., the Federal Funds Rate (FFR) established by the Federal Open Market Committee (FOMC). The FFR serves as a “guide” for overnight lending rates among U.S. banks, which in turn impacts the interest for all borrowers. Notably, for consumers it means less disposable income to spend on non-discretionary and big-ticket items.

 In short, when the Fed is raising rates, thereby contracting the supply of money, investors should be cautious given the damaging effects of higher interest rates on all borrowers – corporations, consumers, and the US government.

The opposite is true when the Fed is lowering interest rates and expanding the supply of money, as lower interest rates translate into lower borrowing costs for all borrowers. This in turn translates in to increased discretionary spending by consumers. Given that consumer spending accounts for two-thirds of Gross Domestic Product, this spending naturally leads to an expanding economy, higher corporate profits and of course higher stock prices. As always, stock prices head higher well in advance of the actual rebound.

Looking back over the past two plus decades, there are three shining examples of the powerful impact that lower interest rates can have on the economy: the 2001 recession, the Great Recession and the COVID recession. In each case, the stock market ultimately skyrocketed in anticipation of an economic recovery when the Fed flooded with the economy with cheap money.

In each instance, once the Fed opened the monetary spigot and figuratively dropped money from a helicopter, the mantra of “Don’t Fight the Fed.” was plastered over every news outlet and media publication in the land as justification for spurring an economic recovery and importantly, a rebound in stock prices.

During a 60 Minutes interview with Scott Pelley in 2009, then Fed Chairman Ben Bernanke, tacitly admitted that by dropping the FFR to nearly zero, the FOMC was hoping to prop up the economy, and thus the stock market, via the ”wealth effect”; a theory in which consumers increase their spending more than they might otherwise have because their stock portfolio and home values are appreciating. They “feel” wealthier than before, thus they spend more. How simple is that?!?!.

During the COVID crisis, the Fed once again lowered the FFR to near zero. This policy soon became known as ZIRP – Zero Interest Rate Policy. ZIRP was followed by TINA – There is No Alternative to stocks and finally FOMO – Fear of Missing Out. Low and behold it worked. From mid-March 2009, (the depths of The Great Recession) when the S&P 500 closed at 666, through December 2021, the S&P 500 gained 4,100 points or a whopping 615% in less than 12 years.

To put the magnitude of this stunning gain into context, at the end of 2021, the 3-year, 5-year and 10-year average annualized return for the S&P 500 was plus 15%. For perspective, the average annualized return for the S&P 500 since 1926 is approximately 10%. In other words, and rather remarkably, the S&P 500 gained FIFTY PERCENT MORE than the nearly 100-year average over the preceding 3, 5, and 10-year periods. That’s a rare occurrence.

It’s easy to see how impactful lower interest rates can be on spurring an economic recovery and boosting stock prices. I guess you could say that Marty Zweig was spot on when he said, “Don’t Fight the Fed.”

The Slope of Hope

Not to be cynical, but one has to wonder if lowering interest rates to zero and keeping them at zero for a prolonged period of time can have such a profound impact on the economy and stock prices, shouldn’t the opposite be true?

In other words, can a prolonged period of high interest rates also be the catalyst for the next bull market? We think not, and we think investors may be sorely underestimating the impact of higher interest rates on the overall health of the economy and equity valuations.

Therein lies the great conundrum for investors in 2023. As we pointed out in our Feb 2022 commentary, “The Winds of Change?” in 2021, investors looked past a bevy of risk factors, including the prospects for higher interest rates, as the S&P 500 rose nearly 26%, driven by ZIRP.

In 2022 that changed. Investors could no longer look the other way as the Fed was removing the proverbial punch bowl from the party in the form of five rate hikes that totaled 350 basis points in one year. This was simply a steady campaign of interest rate hikes, designed to combat a 40-year high in inflation. The result, much as we suggested one year ago in our “Are You Prepared for the Great Rotation”, commentary, was that growth stocks were pummeled (the NASDAQ fell over 30%) while the S&P 500 narrowly avoided a formal bear market, defined as a 20% loss, by declining 18%. Yet again, “Don’t Fight the Fed” proved to be more than just cute saying.

At the start of 2023, investors are back at it once again. They’ve hung their hats on the fact that inflation, at least as measured by goods inflation seems to have peaked, leading the Fed to soon pause its aggressive rate hike campaign. As mentioned previously, some even expect the Fed to lower the FFR later in the year, as economy meanders toward a recession in 2023. Again, there is only one reason for the Fed to lower interest rates, and that is because the economy is in trouble.

As my colleague, Dr. Mark D. Troutman, CFP®, detailed in our recent accompanying Economic Commentary titled “Inflation: Maybe Not Dead Yet”, the other side of the inflation coin, which is comprised largely of labor and services inflation, shows little sign of abating anytime soon. Unlike goods inflation, wage inflation is quite “sticky”, especially with unemployment at an all-time low of ~3.5%.

There are simply too few workers (at the moment) to meet demand despite puny layoffs from Big Tech giants like Meta and Alphabet. At the same time and given the supply and demand imbalances in the labor market, employees are emboldened to not only ask for pay increases but without reservation they are demanding other benefits and perks e.g., working remotely full-time.

As we ponder what is ahead for investors in the form of risks and opportunities, our primary concern is that the Fed is likely to disappoint investors regarding the highly anticipated pause in rate hikes. The Fed may indeed pause after the March rate hike but unless wage inflation falls, which it is currently not doing, the Fed may once again be forced to increase the FFR, not lower the FFR later in the year as the unicorn believers are hoping for.

While Mark describes in detail why “sticky” inflation has a long way to go before approaching the Fed’s 2% target, he also details the destructive nature of higher interest rates on corporate profits and discretionary income for individuals. Remember, “Don’t Fight the Fed.” was coined at a time when inflation was front-of-mind for investors and decimating their standard of living.

Our fundamental outlook on inflation, interest rates and thus the economy, leads us to a somewhat sanguine view for the market for the latter part of 2023. Moreover, when it comes to engineering the soft-landing that so many investors are expecting, there is scant evidence of the Fed’s ability to do so.

Remember, this is the same Fed that kept interest rates far too low, for far too long. Their rather poor forecasting skills played a definitive role in creating a 40-year high in inflation; inflation they are now steadfastly committed to returning to their longstanding target of 2%. 

Although the reasonably strong start to the year likely has more upside before rolling over, the advance in stock prices feels more like the “The Slope of Hope” than it does the start of a new bull market.

Having said that, and unlike the conventional wisdom coming into the beginning of the year, we suspect the first portion of the year may surprise investors in terms of its upside. It is the back portion of the year that worries us. Investors may unknowingly be standing on a trap door as the expectations of a soft-landing fade.

Valuations Matter

The forecast for corporate earnings for the full year of 2023 for the S&P 500 is currently in a range of $195 to $225. The S&P 500 closed at ~ 4,195 on February 2^nd, the peak so far for the year.

Earnings forecasts are backloaded as analysts are looking for a moderate decline in the economy and earnings in the first half of 2023, and then a notable increase in both indicators in the second half. The softness in the first half is the “soft landing” that virtually everyone is expecting. We have come to learn over the years that it’s often wise to be skeptical of the consensus. And we are.

For context, and per J.P. Morgan, the long-run median forward P/E multiple is 16.5. At 4,195 the S&P 500 is trading relatively close to the peak P/E multiple of 21 in 2021. It’s hard to imagine that there’s a tremendous amount of sustainable upside in the market at current levels.

If anything, and even though the S&P 500 was down nearly 20% in 2022, one could argue that the S&P 500 seems priced for perfection. Previous bear market lows have occurred when the S&P 500 traded in the 12-14 P/E range, not in the 18-20 P/E range. Consequently, we think there are tremendous risks in market in the back half of the year.

Outlier Risks

Not to complicate an already complicated and complex set of forces impacting the outlook for the economy and the market, investors should pay close attention to a few outliers that may create more uncertainty in the coming months.

Notably, China, in a stark turnaround driven by social unrest, has moved away from its strict “Zero COVID” policy. While deaths have and will continue to rise, perhaps the bigger risk is that pent up demand in China may spur already high inflationary pressures as their economy reopens. Should this prove to be the case, the Fed’s job will only get harder and more complicated.

Outside of China, geopolitical risks loom large given the ongoing Russian invasion of Ukraine, and the potential for a Chinese invasion of Tiawan. A further risk surrounds the unfolding struggle over raising the debt ceiling. Many will remember the summer of 2011, when the last incident of debt ceiling brinkmanship eroded consumer confidence and sparked a 17% decline in the S&P 500.

Play The Long Game

We certainly have concerns about the myriad of risk factors facing investors later in the year, and as a consequence, we see limited upside for equity investors beyond the first half of the year.

Having said that, we strongly suspect that a great buying opportunity lies ahead for patient investors who created some dry powder in 2022. We would like to see a soft landing for the economy as much as anyone else, but our decades of experience tell us that the Fed is unlikely to pull that rabbit out of its hat. As always be patient and stay disciplined while looking for opportunities in the second half of the year. They’ll be here before you know it.

Inflation: Maybe Not Dead Yet

By: Mark D. Troutman PhD, CFP

In the 1974 cult classic, Monty Python and the Holy Grail, viewers are invited to engage in a bit of black humor as the film traces the characters through the plague-ridden Middle Ages. As one of the characters proclaims “…I’m not dead yet!…” one of the village residents “helpfully” strikes the unfortunate character to “help him on his way” and get village life back to normal. In some ways, the macabre incident could describe the attitude toward inflation with the victims being workers and investors.

Perhaps the most anticipated question of 2023 is “…will there be a recession?” The answer: in all likelihood, yes. In order to restore price stability and its credibility, the Federal Reserve may have to accept higher unemployment and lower output for a time in order to restore price stability, defined as 2% inflation on a sustained basis.

We will outline the investment implications of this environment in our upcoming Market Commentary titled “Don’t Fight the Fed.” The basic problem for investors stems from the fact that Fed policy and economic fundamentals are pointing toward a recession while market optimism may allow for further expansion. If the Fed restores price stability, defined by a return to CPI inflation at 2.0 on a sustained basis, it will set the conditions for an expansion and resurgence in equity prices. However, this could take longer than investors expect, and optimism could quickly fade. Consequently, investors should remain defensive, hold cash, and prepare to take opportunities that will develop in 2023 and beyond.

Too Low For Too Long

First, some historical perspective. The Federal Reserve, in a desire to favor employment growth and recovery from the COVID-induced recession, held interest rates too low and expanded its balance sheet for too long. The Fed thought that inflation would be temporary as the recovering global economy resolved supply disruptions and labor returned to work.

The view of temporary inflation has proved half right. Goods prices have peaked and are falling, though the process has taken longer than Fed leaders anticipated. In its December (latest) inflation report, the Department of Labor reported that the core Consumer Price Index had fallen to 5.7% and was clearly on a downward path. Absent any further disruptions, we expect this path to continue, and the goods prices will continue to fall. We outlined these factors in earlier commentaries, and our analysis has proved largely accurate.

But – goods prices are not the whole of inflation. They represent 43% of the Consumer Price Index (CPI). Most of the CPI (57%) consists of services such as transportation, dining, medical, and travel. Services are labor intensive and comprise 4/5 of US jobs, so wages heavily impact this category. Service prices are still headed upwards at a 6% annual rate. In short, the path to price stability requires a cooling in wage and ultimately service inflation, and the case for this cooling is not yet convincing.

Wages are still increasing, and labor markets are still tight. The latest unemployment report (December 2022) was a “goldilocks” report in the estimation of one labor economist. Unemployment stood at 3.5% and job growth notched 223K against a consensus forecast of 202K. Payroll growth, which averaged a gain of 375K jobs per month through 2022, has markedly slowed. Wages grew at 4.1 % (annual), down from nearly 6% annual growth in previous months. We must ask whether this perfect scenario will continue in future reports.

Labor remains scarce and there still exist 1.7 job openings for every available worker. Labor force participation remains lower than pre-COVID levels, and 2.1 million workers have not returned to the workforce. It seems that the path to cooling wages must come by moderating the demand for labor. This is the view that the Federal Reserve has adopted and that Fed Chair Powell articulated in his speech at the Brookings Institution on 30 November 2022. Other Fed governors have acknowledged the signs of moderating inflation while at the same time stressing the need for labor demand to cool.

Hope Springs Eternal

Market participants, as they have done for the last few months, reacted with optimism to the favorable inflation reports. They sparked a mini-rally on hopes that favorable inflation reports and mentions of a pause to evaluate the effects of rate rises would be followed by a fall in interest rates. The S&P 500, which closed 2022 and traded the first week of 2023 with a 5.3% decline, recovered nearly all its losses by January 23^rd and has continued to rise. While the rebound in stock prices is good news in the short term, it complicates the Fed’s aim by loosening financial conditions when the goal, in actuality, is to tighten them. This “push-pull” illustrates the delicate nature of engineering a soft landing… something the Fed has a scant history of achieving.

The Fed leadership responded to these conditions with admonitions that the central bank remains focused on price stability and that as a consequence, interest rates would have to remain elevated for some time until there was solid evidence of a return to 2% inflation.

It should not be lost on investors that most of the senior leadership of the Fed came of age during the Volcker years, so we can expect them to avoid at all costs the error of giving up the fight prematurely.

In the backdrop of these developments, the Federal Reserve continues to quietly reduce the size of its balance sheet at a rate of $95B per month. Some studies estimate that this translates to an additional 50 – 100 basis points of upward pressure on interest rates. Should the Fed continue this policy through 2023, this will remove more than $1.1B of demand for treasuries from bond markets. This will create additional tightening and upward pressure on interest rates. In sum, monetary policy is sharply contractionary, and while yields have fallen over the past several months, upward pressure on interest rates remains.

Fiscal policy, by contrast, remains expansionary even as the massive COVID stimulus packages wind down. The Fiscal 2023 omnibus budget package increased discretionary spending by 9%. The flagship Social Security program includes an 8.7% increase in benefits payments to offset inflation.

By: W. Kirk Taylor, CFP®

Executive Summary:

As we enter the second half of 2022, investors will continue to face a myriad of economic cross- currents. These include persistently high inflation, the prospect of rising interest rates, economic contraction and falling corporate profits. While it’s too soon to say with confidence… these are the hallmarks of stagflation; an economic scenario that investors have not seen since the 70s.

Clearly, the Fed has its hands full as it attempts to engineer a soft landing. Investors have doubts about the Fed’s ability to do so, as evidenced by growing forecasts for a recession in late 2022 or early 2023. The Fed has backed itself into a corner and their track record for engineering a soft landing is dubious at best.

As we entered 2021, the S&P 500 was trading at 22 times forward earnings, well above the 50-year average of 16.5 times earnings but below the all-time high P/E ratios seen just prior to The Great Crash in 1929 and the Tech Bubble of the late 90’s. Stock valuations are more compelling today at roughly 16-17 times earnings, but the outlook for corporate earnings is quite uncertain at present. If corporate earnings disappoint in the coming quarters as some expect, investors should be prepared for the prospect that stock prices will overshoot to the downside.

According to Stock Trader’s Almanac mid-term election years are characterized by above average volatility, particularly during the summer months. The silver lining is that mid-term corrections generally end by late summer or early fall, ahead of the November election. This period generally marks the start of an extended rebound in stock prices.

In short, investors should brace for more volatility and uncertainty over the next several months, while being prepared to take advantage of the next great buying opportunity that lies ahead!

Roller Coaster Ride

The first half of 2022 was bumpy to say the least, with the tech laden NASDAQ falling 30.3% through June 30th (it’s worst quarter first half since 2008), and the S&P 500 flirting with bear market territory as denoted by a 20% or more, peak-to-trough decline. It was the worst six month start for the stock market in decades. [1]

In what can only be described as classic bear-market action, the broader market year-to-date, has experienced multiple rallies of 8%-10% before giving way to even lower prices. This kind of action is often referred to as the “slope of hope”.

The cause? Persistent inflationary pressures, brought on by a “one-two punch” of the Fed’s excessively easy monetary policy and massive COVID-induced government spending in the trillions combined with supply shortages brought on by pandemic shutdowns and Russia’s invasion of Ukraine. Collectively, these forces, along with the prospects of much higher interest rates and a have investors on edge. 

The Inflation Genie

Clearly, the “inflation genie” is out of the bottle, and the Fed has it’s back against the wall. Putting a genie back in the bottle is no easy feat… which you know, if you ever watched the sixties sitcom I Dream of Jeannie.

Recent Consumer Price Data (CPI) and Producer Price Data (PPI) indicate that inflation is running at levels not seen in over four decades. The Fed has stated its commitment to bringing inflation down from 8%, and closer to its 2% target, but its own admission monetary policy is a blunt tool.

Monetary policy can’t fix supply chain problems and it can’t cool off one area of the economy where inflation is extra hot without cooling off areas where inflation is less intense. I guess you can call this the “law of unintended consequences.” We can hope for a soft landing, but history tells us that such an outcome is very hard to achieve.

While “goods” inflation and commodity prices might be on the verge of peaking as COVID-driven supply chain issues appear to be subsiding, wage inflation is still very prevalent in corporate America, especially with unemployment at historically low levels. The JOLTS survey tells us that employers still can’t find enough workers to meet demand, so one must assume that wages won’t slow until the economy has cooled dramatically.

It’s hard to imagine that the same Fed that kept interest rates too low, for too long, has the ability to rein in inflation without causing a recession.

The Interest Rate Outlook

With higher inflation comes higher interest rates. The two are undeniably linked. Simply put, higher interest rates translate into higher borrowing costs for both corporations and consumers. In turn, higher interest rates translate into lower corporate profits for companies and less disposable income for consumers. For example, in just six months, Home Depot’s cost to borrow funds over a year period soared from 1.875% to 3.25%. Wildly unpredictable inflationary pressures on corporations clearly explains downbeat corporate earnings, as well as the recent uptick in credit delinquencies for consumers.

Higher interest rates are having a significant impact on the residential housing market as the double-whammy of soaring housing prices and interest rates, have led to a plummeting in the housing affordability index, i.e., housing is the least affordable it has been in decades. Over the past 18-24 months, the 30-year mortgage rate has surged from roughly 2.75% to over 5%.

Consumer spending, of which housing is a significant portion, can only slow given these forces. Hence, consumer spending rose at its slowest pace in 2022, as consumers struggled to manage the higher food, housing, transportation and energy prices.

Rising Treasury yields, in turn, are cascading throughout the economy in the form of higher borrowing costs, squeezing households and businesses alike. Car loans, credit cards and corporate debt all stand to get more expensive as rates rise. [2]

The Earnings Wildcard

According to FactSet, “on a year-over-year basis, the S&P 500 is reporting its lowest earnings growth since Q4 2020. During the upcoming week 175 S&P 500 companies are scheduled to report. In aggregate, both revenues and earnings are set to come in well below the long-term averages. As noted earlier, P/E ratios have contracted to levels that are more realistic given the significantly. At the end of day though, market prices will directly reflect the direction of earnings. If earnings fall, so will broad market averages. Fortunately, the reverse is also true. [3]

It\’s the Economy Stupid

About 90% of investors expect the U.S. to enter a recession before the end of 2023, and 72% of investors surveyed said they expect the S&P 500 to fall further before it stages a sustained recovery. according to a survey published Thursday by Deutsche Bank.

At the beginning of 2022, the average interest rate on a 30-year mortgage hovered above 3%. Today it stands at 4.72%, according to Freddie Mac.

Higher rates will make monthly mortgage payments—already at the least affordable level since November 2008—even less so. A median American household needed 34.2% of its gross income to cover mortgage payments on a median-priced home in January, according to the Federal Reserve Bank of Atlanta. That is up from 29% a year earlier. [4]

The Good News!

While an economic slowdown likely awaits investors, the good news is that consumer balance sheets are relatively strong, the banking system is on solid ground and any contraction in the economy is likely to be limited. The broader market may move lower over the coming months, but we are not likely headed for another 1999 bubble bursting or for a Great Recession seen in ’08-’09.

The best advice for investors at present, is to be defensive but on the lookout for a great buying opportunity. We are watching every day for evidence of a turn!

Footnotes:

[1] S&P 500 Posts Worst First Half of Year Since 1970, The Wall Street Journal June 30, 2022, https://www.wsj.com/articles/global-stocks-markets-dow-update-06-30-2022-11656487667-11656574533?mod=hp_lead_pos1&mod=hp_lead_pos5 

[2] Cooling Consumer Spending Points to Further Economic Slowdown, The Wall Street Journal June 30, https://www.wsj.com/articles/inflation-consumer-spending-personal-income-may-2022-11656531317?mod=article_inline 

[3] S&P 500 Earnings Season Update, Factset July 22, 2022, https://insight.factset.com/sp-500-earnings-season-update-july-22-2022

[4] Interest-Rate Surge Ripples Through Economy, From Homes to Car Loans, The Wall Street Journal April 8, 2022, https://www.wsj.com/articles/interest-rate-surge-ripples-through-economy-from-homes-to-car-loans-11649426081?mod=series_stockmarket

Mark D. Troutman, PhD, CFP®, Director of Financial Planning

The famous baseball coach Yogi Berra once famously observed that “…It\’s tough to make predictions, especially about the future.” Yet, sound investing requires combining a fact-based view of the future with reasonable assumptions about essential information that is needed to make fully formed decisions.

Furthermore, sound investing requires the humility to question widely accepted assumptions and identify unknown but necessary facts. As former Secretary of Defense Don Rumsfeld once said, “you don’t know, what you don’t know”. Finally, and perhaps above all, when new information appears and it’s clear that the facts have changed, it’s critical that you change your view and pivot accordingly.

The crisis in Europe is truly different and navigating it requires all of the facets of sound investing cited above. Russia’s invasion of Ukraine has thrown financial markets into disarray, and by all measures, the outcome is highly uncertain.

In situations like this, i.e., when uncertainty is high and predicting what happens next is challenging, it is helpful to consider a range of possible outcomes and to assign probabilities to those outcomes. This exercise helps us identify what is known and unknown, and it helps us pivot in the right direction with confidence, once we are able to clarify and combine unknown information with known information.

What appears below are a range of scenarios and outcomes. Some are very dangerous but unlikely and some are less dangerous and more likely, and are importantly based on the facts presently at hand.

These scenarios come to us from national security professionals with whom I have worked with in the past, and from whom seem to have made the right calls early on. I’ve interpreted these scenarios with my fellow colleagues in the field of economics to assess the macroeconomic landscape both in the immediate term, and over the long run.

First, Ukrainian forces might be able to extend their early successes and reach a standstill, potentially leading to a Russian withdrawal. This outcome, however, seems very unlikely given the depth and breadth of Russia’s military forces in comparison to Ukrainian forces. History tells us that such an outcome is possible but only with outside support, which the US and Europe are providing to Ukraine, albeit in a very risk averse manner i.e., support thus far, has come in the form of economic sanctions, not troops on the ground or the enforcement of a no-fly zone. Even if this ideal scenario comes true, i.e., Ukrainian forces win the war, both Europe and the larger world would be less secure. Such an uncertainty might lead investors to adopt a more conservative investment posture.

A second and more likely outcome is a grinding campaign by Russian forces that results in a replacement of the Ukrainian government by a pro-Russia puppet regime. Another possibility involves a negotiated settlement whereby Ukraine continues as a state, in part or whole, with a form of Finland-like neutrality. In any case, we can expect continued Ukrainian resistance coupled extreme brutality brought upon them as Russian forces seek to consolidate their current gains. This crisis seems destined to drag on for longer than any of us would like, likely continuing the volatility of late, while bringing about the risk of lower asset prices until the crisis has concluded.

If Ukraine successfully fights back, such setbacks would likely lead to political unrest in Russia and greater uncertainty for the markets in general. Ukraine and Russia account for about thirty percent of world wheat output. The Economist points out that Russia is the source of ten percent of the world’s oil, 24% of world natural gas, and is a major supplier of basic industrial materials such as nickel and more advanced materials critical to high technology manufacturing.

The world can replace these basic commodities, but the adjustments will be costly and painful, and they will not be replaced in the short run. In short, even the best of outcomes, will not come with a cost and negative implications for the economy.

A third and immensely more dangerous set of outcomes, involves direct clashes between NATO forces and Russian forces. While western governments are seeking to avoid such an outcome, Russia’s provocative behavior raises the risks of accidental contact, or worse, direct military contact that leads to escalation. In fact, just this past weekend, Russia bombed a Ukrainian military base that just 15 miles from the Poland border, killing 35 people and injuring as many as 100 more. This is undoubtedly too close for comfort.

Moreover, Russia’s reckless behavior around Ukrainian nuclear power facilities risks radiation discharges and introduces multiple hazards to greater Europe. A radiation discharge could warrant the presence of US and European response teams to assist in clean up, thereby increasing the risk of direct clashes between Russian and NATO forces on Ukrainian soil.

A few conclusions clearly flow from the facts at hand:

One, the Russian invasion of Ukraine, may only seek to further ignite inflation that sits at a 40 year high, pushing out even further the timeframe in which inflation will subside. By all measures, it is likely that high inflation will persist at least through 2022 before it cools. Moreover, there is the real possibility that inflation might be permanently higher, even after this military crisis subsides.

Two, business conditions have entered a new period of uncertainty, and this is particularly evident given supply chain disruptions and the need for physical security of supply chains. Companies will respond by seeking more secure and reliable sources for materials, intermediate inputs, and final production. This is positive development in the long run but hereto, it does not come without costs in the short run. These costs manifest themselves in the form lower corporate profits, while the uncertainty around future profits implies lower price-to-earnings multiples. In aggregate, lower asset prices may be the end result.

Third, expect western governments to invest more in defense security. I attended a recent defense sector conference at which the Department of Defense Chief Financial Officer stated that the pending defense budget bill on its way to the President for signature, contains a 5.7% increase in the DoD’s topline. Germany, long seeking to minimize defense spending, announced a greater than $100B investment in its defense. Companies that have provided standout capability to the present crisis such as Lockheed, and Raytheon (Stinger and Javelin missiles), and European manufacturers SAAB (Sweden), Thales (France), MBDA (Multinational Europe) and Bakar (Turkey) will likely be looked to for innovation in the days that follow.

I opened with humor and seek to close what might be a dark commentary with wisdom. The saying “…keep calm and carry on…” which was common in the UK during the dark days of the World War II, seems to be a good mindset given the set of circumstances in front of us.

Kirk and I are calm. We have mapped out a range of scenarios and outcomes as discussed above. We are vigilantly monitoring short-term developments and we are prepared to adopt a more defensive investment posture, if warranted.

At the same time, we are opportunistically focused on uncovering rewarding investment opportunities for long-term investors. While there is undoubtedly more volatility to come in the near term, in the years ahead we will look back on this time as an opportunity to buy quality assets at depressed prices.

We pray for peace and count it a privilege that you allow us to partner with you during these uncertain times. ■