August 8, 2023
Rockbridge Institutional – July 2023 Market Review
Inflation and a “Soft Landing”
Inflation expectations and the economic impact of the Fed’s ratcheting up its Target Interest Rate has been a major source of uncertainty. So far, the trajectory of inflation has been in the right direction and unemployment has remained low. The trailing 12-month change in the Consumer Price Index (CPI) has declined from its peak of 9% in March 2022 to less than 3% this month, while unemployment has remained in the historically low 3.6% range. Equity markets have responded positively. However, this good news notwithstanding, uncertainty seems to persist.
This uncertainty reflects the conventional wisdom that increasing interest rates to fight inflation means a recession. One indicator of an impending recession is a downward sloping Yield Curve (future interest rates expected to be lower). The argument here is that the Fed will have to reduce rates to pull the economy out of a recession. However, the shape could also mean lower future inflation. Interest rates typically include a risk-free rate plus a premium for expected inflation. With inflation coming down, a reduction in that premium could explain the expectation for lower interest rates implied by the downward sloping Yield Curve.
Further confounding the usual link between rising interest rates and a recession, is the extent to which inflation is embedded or transitory. The pandemic not only produced massive deficits to offset unemployment, but it also brought on supply chain disruptions. Additionally, the invasion of Ukraine drove grain prices up. While these factors seem temporary, with the recent 0.25% increase in its Target Federal Funds rate, the Fed seems committed to drive out any embedded inflationary expectations erring on the side of an economic slowdown.
What to do in the face of these uncertainties is always the same – avoid predictions, continue to rebalance to established strategic allocations, and enjoy the ups and endure the downs
Stocks up nicely this quarter with returns from 3% to over 6% for small cap value stocks. Diversification helped this quarter as markets other than the S&P 500 picked up the pace. Year-to-date, however, it’s that market (S&P 500), led by the usual Tech companies (Amazon, Apple, Facebook, Google, Microsoft and Nvidia), that turned in returns better than 20%. Nvidia, perhaps the most popular way to jump on the AI bandwagon, more than doubled since the beginning of the year. Other stock markets turned in returns nearing 10% over the year-to-date period.
Yields were up resulting in essentially flat bond returns (price reductions offsetting coupon payments) this month. This pickup in yields is consistent with the Fed’s 0.25% increase in its Target Interest Rate.
The Yield Curve (pattern of Treasury yields across several maturities) continues to slope downward, suggesting reduced yields ahead. The jury is still out as to whether this signals a future need for the Fed to reduce rates in response to a recession or reduced inflation expectations. The market’s expectation for inflation, as evidenced by the spread between 5-year nominal and inflation adjusted bond yields, remained at just above 2%. This number is consistent with the Fed’s target and a seemingly positive implication for inflation ahead.