Wealth Matters Newsletter - January 2023

The Search for Stability

Written by: Mark P. Bernier, CFA, Senior Vice President/Wealth Management Officer

 

Investors and the U.S. Federal Reserve are engaged in a tug of war.  While the Fed has reiterated its inflation-fighting policy position several times during the first three months of 2023, investors do not appear convinced that the Fed will be as resolute with current monetary policy considering the action in U.S Treasury yields and the Fed Funds futures market during the quarter.  Inflation readings continued to be mixed during the quarter, but failures of Silicon Valley Bank and Signature Bank and the takeover of Credit Suisse resulted in a flight to safety, pushing short-term U.S. Treasury yields down to levels last seen in the fall of 2022.  Will the necessity for stability in the banking sector outweigh the Fed’s mandate for price stability when considering future policy decisions? 

The Fed is truly in an unenviable position.  Until the woes in the banking sector materialized in March, it was clear that the Fed and investors were more aligned in their expectations of the direction of interest rates in the short term.  The chart below shows the historical short-term U.S. Treasury yields leading up to and following the bank failures mentioned earlier.

 

The flight to safety witnessed in the precipitous drop in U.S. Treasury yields was almost immediately at odds with the Fed’s stated position.  In fact, the Fed raised its benchmark Fed Funds rate by 0.25% just days after the failure of Silicon Valley Bank, Signature Bank, and UBS’ takeover of Credit Suisse.  It is our opinion that the Fed needed to raise the Fed Funds rate in order to provide a sense of calm to investors and that this was not a repeat of the 2008 financial crisis; to be clear, the events leading to these recent bank failures are not the same as those that toppled over 450 banks between 2008 and 2012.  One potential similarity between these two eras: reduced access to credit.  If financial institutions reign in lending in an effort to shore up liquidity in the aftermath of these recent events, the impact to the economy, and presumably inflation, may be similar to the Fed continuing to raise rates in the absence of these events: decreased access to credit will undoubtedly slow economic activity.  In addition to the reaction in the Treasury markets, Fed Funds futures markets are now predicting the potential for rate cuts this year.  According to the CME FedWatch Tool, the markets are currently reflecting over 90% probability that the Fed Funds rate is lower by November!  The Fed has acknowledged the need for aggressive tightening is likely behind us, but they have not indicated any intention or need to cut interest rates this year.

The Fed has been focused on two primary indicators of future policy action: falling inflation measures and easing employment figures.  The Fed’s preferred inflation measure is PCE, formerly known as the Personal Consumption Expenditures Price Index.  The most recent PCE report, from February data, indicated a 5% increase year-over-year headline figure and a 4.6% year-over-year increase in Core PCE, both of which were below January’s readings.  While both of these measures are still high relative to the Fed’s long-term target of 2%, the trend has been downward, with headline readings falling to their lowest level in more than 18 months.  On its own accord, this data would indicate that the Fed will continue to hike rates this year.

The employment picture remains strong, though perhaps beginning to show some signs of easing.  Large tech firms, such as Meta (formerly known as Facebook), Alphabet (formerly known as Google), Amazon, and Microsoft have all announced layoffs in the tens of thousands.  Additionally, layoffs have picked up in industries outside of technology; General Motors recently announced buyouts of 5,000 employees in an effort to reduce expenses.  For much of the last few years, the story in labor has been lack of supply, but there are signs this imbalance may be easing.  Job openings fell to 9.9 million – still quite high by historical standards, but the lowest in 21 months.  The employment report for March will be watched closely for any signal confirming easing in the jobs market.    

The shift in consumer demand towards services from goods is having a measurable effect on manufacturing.  U.S. manufacturing activity as measured by the Institute for Supply Management (ISM) – Manufacturing index showed a contraction in March and manufacturing activity has been slowing steadily since the end of 2021.  The service economy also witnessed a rapid slowdown in March; the ISM – Services index was reported at 51.2 (any reading above 50 indicates growth), but the high-water mark was set in 2022 at well over 65.  The slowing of activity illustrated by these two measures may be starting to reflect the Fed’s aggressive monetary policy actions from the summer of 2022.

As we enter corporate earnings season, investors will be keenly attentive to commentary from company management teams.  In particular, comments surrounding liquidity, unrealized losses in investment portfolios, and loan quality at banks of all sizes will be closely scrutinized.  According to the March 31, 2023 Earnings Insight report published by FactSet, analysts estimate earnings to drop by 6.6% year-over-year for S&P 500 companies.  We would expect some weakness in stocks, should these estimates come to fruition, especially following the S&P 500’s 7.5% return during the first quarter.

The Fed’s next meeting on monetary policy is not until May, but investors will have plenty to digest between corporate earnings and debt ceiling debates.  Our expectation for the appearance of a recession in 2023 remains unchanged, but the impact from decreased access to credit may expedite its arrival.

As always, we look forward to helping you meet your unique financial goals.