Market Commentary - October 2023

“Screeching, squealing, grinding, rubbing.”

—A WCF Creation Inspired by The New York Times game, Connections

In the example below, the player is provided with sixteen words that somehow fit nicely into four categories.  We promise—it’s harder than it looks. 

Screeching, squealing, grinding, and rubbing belong together because, according to no less of an authority than Google, each are common signs of failing brakes.  You might have also heard those sounds coming out of the Federal Reserve Board last week as they weigh the effectiveness of their efforts to slow inflation without choking the economy.

The Problem

Inflation, as measured by The Consumer Price Index (CPI), stayed subdued in the U.S. for 30 years until COVID-19 infected the world.  In January of 2021, nearly one year after the pandemic was declared, consumer prices began a rapid ascent.  The Fed long proclaimed the price pressures as “temporary,” until the data overwhelmed the narrative.  Inflation peaked in June of 2022 at 9.1%. ⁽¹⁾ 

The Remedy 

Monetary policy remains somewhat primitive in a world that includes artificial intelligence, self-driving taxis, and robots that vacuum floors and mow lawns.  One is stuck with the image of The Flintstones slowing their automobile by dropping their bare feet to the road.  The Fed has but a single crude tool—interest rates.  The Federal Funds Rate has increased from zero in January of 2022 (one year after prices escalated) to 5.33% by September of 2023. ⁽²⁾  That climb has been the steepest since 1980 and absolute rates are at the highest level since 2000. 

The Results

Mixed.  The latest read on inflation of 3.7% represents considerable progress. ⁽³⁾  However, considering the Feds’ stated target of 2.0%, it’s still shy of “mission accomplished.”  With rates up aggressively, what seems to be the obstacle?

The Culprit

Energy prices had been cooperating in 2023 until July, when Saudi Arabia, the world’s second largest oil producer, cut production by 1 million barrels per day. ⁽⁴⁾  Oil prices have jumped 28% since summer, but energy only constitutes 7.5% of the inflation calculation.  Shelter, by contrast, accounts for a whopping 42% of the core CPI. ⁽⁵⁾  Housing prices should wilt under the pressure of mortgage rates that have doubled in the past two years, reaching the current 7.3%, right? ⁽⁶⁾ 

This is where things get complicated.  Pricing reflects the intersection of supply and demand:

• The current supply of housing is 7.8 months of demand today compared to 10.1 months last fall. ⁽⁷⁾
• Existing homeowners are reluctant to sell after locking in sub 4% mortgage rates, reducing supply.
• Median home prices are up 44% between 2020 and 2023 and mortgage rates are twice as high as they were in January of 2022. ^{(8, 9)}
• Builders are cautious about aggressive building after getting punished in 2008 with excess inventory and home affordability at the lowest rate since 1986. ⁽¹⁰⁾
  
  
  
• Yet, millennials now outnumber boomers, and newly formed families need a place to live.  With existing homeowner’s holding, buyers are turning to the new house market, elevating prices.

Thus, new home prices have defied logic and continue to rise despite both higher sticker prices and higher mortgage rates as seen in the chart to the right. ⁽¹¹⁾

Rerouting

It matters little that the most stubborn aspects of inflation are structural in nature and warrant surgical solutions.  The Fed has only a hammer, so it will just hammer harder.  When Fed Chair Jerome Powell spoke on Wednesday, September 20, he remained resolute, at least in words.  Interest rates will have to stay higher, for longer. 

Implications

The 10-Year Treasury yield, which eased to 3.80% last quarter, has rebounded to 4.59%.  Mathematically, higher interest rates make existing bonds worth less, as reflected in the Aggregate Bond Index that is down approximately 4% for the quarter. ⁽¹²⁾  Fortunately, this is good news for bond buyers.  The “real” rate of return (the stated yield minus the rate of inflation) is near its highest level in the past 10 years.  Investors (ignoring income taxes) can stay ahead of inflation without having to assume risk. 

Stocks are more complicated.  The forecast for earnings on the S&P 500 remain unchanged at $220. ⁽¹³⁾  At 18 times earnings, valuation is elevated by historical standards.  The AI surge that pushed up seven stocks last quarter is noticeably absent and interest rates are higher.  Not an ideal backdrop and it manifested in the weak performance of stocks during the quarter.  Of course, these data points do not take into consideration the threat of a government shutdown, an escalation of the conflict in Ukraine, the autoworkers strike, the election cycle, or any of the unknown, unknowns.  [Note that the government shutdown was narrowly averted the evening of September 30].

Despite these headwinds, equity losses for the quarter were modest.  Earnings for 2024 are forecast to grow 12% to $245.  In addition to the specter of improved fundamentals, and despite the Fed rhetoric, the financial markets continue to believe that interest rates will begin to ease next year. 

Strategy 

The financial landscape has not changed significantly over the past quarter.  It would be a stretch to interpret the “higher, longer” mantra positively, but markets continue to look beyond the immediate.  Josh Wardle, the creator of Wordle, responded to inquiries about his next project by saying, “I’m just gonna bugger around and see.” ⁽¹⁴⁾  That’s one tactic.  

We prefer to take a more disciplined approach.  Higher interest rates pressure bond prices so we have kept maturities short to minimize the sensitivity to changing rates.  Because of aggressive Fed actions, short-term bonds currently provide a higher yield than longer-dated bonds.  We lean into quality.  For bonds, that means staying away from the higher yielding junk bonds, because they move in tandem with stocks and offer less diversification benefits.  We recently sold a few of the more volatile stocks and replaced them with companies that demonstrate more consistent sales and earnings.  We will balance stocks, bonds, and cash, and the equity exposure will be diversified by size, industry, and geography.

Connections is ultimately about the identification of common threads.  We strive to align our interests with yours and to manage your investments in a manner that enhances the probability of achieving your goals and objectives. 

1. “Peak Inflation Has Come and Gone.” Forbes; March 15, 2023.
2. Effective Federal Funds Rate; Federal Reserve Bank of New York. September 26, 2023. 
3. “Consumer Price Index Summary.” U.S. Bureau of Labor Statistics; September 13, 2023.
4. “Oil prices have risen. That’s making gas more expensive for US drivers and helping Russia’s war.” AP News; September 24, 2023.
5. “Forecasting CPI Shelter under Falling Market-Rent Growth.” Federal Reserve Bank of Boston. 
6. Freddiemac.com.
7. FRED; Federal Reserve Bank of St. Louis. Monthly Supply of New Houses in the United States.
8. FRED; Federal Reserve Bank of St. Louis. Median Sales Price of Houses Sold for the United States
9. Freddiemac.com.
10. “U.S. Economic Indicators, Housing Affordability Index.” Yardeni.com; September 8, 2023. 
11. YCharts.com.
12. YCharts.com.
13. Yardeni Research; September 29, 2023.
14. “Wordle creator describes game’s rise, says NYT sale was a way to walk away.” ARSTechnica; March 25, 2022.