Written by Steve Andrews
Market Overview
The stock market rally that began just after Halloween continued right up to New Year’s Eve. The S&P 500 climbed nine consecutive weeks and investors felt immense relief when the Fed began to signal that it was all but through raising short term rates. If anything they might begin cutting the Federal Funds rate in the New Year.
Market Sentiment Shifts
However, stock market rallies (and corrections) don’t last forever as investors appeared to have taken the time over the holidays to ponder whether they might have gotten ahead of themselves. The minutes of the December FOMC meeting showed Fed members felt that “a lower target range for the federal funds rate would be appropriate by the end of 2024,” FOMC participants also noted that their outlooks were associated with an unusually elevated degree of uncertainty and that it was possible that the economy could evolve in a manner that would make further increases in the target range appropriate. While both sets of comments may appear to be at odds with each other, the sentiment reads very much like the “data dependent” approach to monetary policy that they have long followed. Still, investors took the words literally and reconsidered their expectations for six quarter-point (0.25%) rate cuts this year, instead of the three hinted at by the Fed, dampening prices for both stocks and bonds and pushing interest rates higher.
Inflation Metrics
The inflation data from December could seem to be conflicting, as consumer prices (CPI) rose 3.4% from a year ago (a 3-month high), compared with the 3.1% rise in November, led by shelter (up 0.5%) and energy costs (up 0.4%). Meanwhile, Producer Prices (PPI) for goods and services used in the production process, fell 0.1% last month and were up 1.0% from the year before. “Core” PPI (i.e., excluding food and energy) was up 1.8% year-over-year - the lowest annual inflation rate since December 2020 – and the downward trend PPI should continue as prices in the pipeline continue to moderate with prices for intermediate-processed goods.
As we’ve discussed here before, old habits are hard to break and investors are having a tough time letting go of their fear of the Fed. Disinflation has come a long way, with annual CPI falling from 6.5% in December 2022 to 3.4% last month but progress from 3.4% CPI down to the Fed's target of 2.0% might not be as smooth. So, when there's a detour in the road (like December’s 0.3% monthly increase) investors begin to worry that the Fed rate cuts may be delayed. However, once you look past the headline data, the meat of the report (housing, core CPI, etc.) shows that disinflation continues, and the PPI data, which eventually feeds into the CPI index, backs that up.
Futures Market Predictions
Despite the seemingly conflicting signals from the twin inflation readings, the futures market still sees a 75% chance of a March rate cut, with two additional rate cuts by the end of June. While that is certainly possible since the Fed will have several more inflation (and employment) reports to digest before the March FOMC meeting, this “when, and how much?” discussion will remain a source of volatility for the markets in the short term.
Taking a step back, we still believe that no matter the timing, the next FOMC move will be to lower the Fed Funds rate. The expectation of a more friendly Fed is what has lifted the markets since late October and should serve as a backstop to support the market through the inevitable dips in the months ahead. There will be hiccups and travails in the disinflationary path, like the attacks on cargo ships in the Red Sea which have caused shipping costs there to double in recent weeks, but global markets are still preparing for 2024 to be the year of global central bank rate cuts, led by the US.
Economic fundamentals remain healthy even as the pace of growth is expected to slow through the first half of the new year. The US added 216,000 non-farm payroll jobs In December and has now added jobs for 36 months straight, but the rate of gains has slowed. Non-farm payrolls grew by 2.7 million (about 225,000 per month) last year – down from 4.8 million in 2022. Job openings have also trended down, from close to 10 million for the better part of 2023, to 8.8 million, and the number of “quits” (3.5 million) is edging down as well. The December unemployment rate remained at 3.7%, while the broader U-6 unemployment rate, which includes those working part-time for economic reasons, edged up to 7.1% from 7.0% (it was 7.0% before the pandemic hit). The labor force participation rate eased to 62.5% in December from 62.8% the month before.
Labor Market & Sector Updates
While activity in the US services sector has surged, the US manufacturing sector has sagged for well over a year, but manufacturing has been clawing its way back toward growth mode since Fall. US housing remains hamstrung by affordability issues (high prices and mortgage rates) and supply constraints, yet US builders continue to work through record amounts of units under construction as demand remains steady as household formations continue to grow.
More importantly, liquidity remains abundant in the financial system, which is a strong defense against a recession since most recessions are triggered by a credit crunch. According to the Fed, excess US banking reserves at the Fed currently sit near $3.3 trillion. While bank C&I loans fell 1.1% last year, overall bank credit, which includes loans and leases, grew 2.5%. Corporate bond spreads (the rates they pay above Treasury rates) and swap spreads remain at low levels, showing no signs of systemic risk to the US financial system.
Consumer Behavior and Trends
The consumer has done the lion’s share of keeping the economy afloat and, even as the “COVID cash” has been all but depleted, they continue to get support from near-record household net worth, relatively low debt loads, and wage growth (at 4.1% in December) that has moved ahead of the rate of inflation. Overall, we are still paying higher prices than we did a year ago but many goods prices (eggs, gasoline, coffee, milk, butter, TVs, airfares, furniture, clothing, etc.) are lower than a year ago, according to the Bureau of Labor Statistics, and the rise in other goods and services (like rents) continues to moderate. With every monthly inflation report, the media harps on the fact that we are not yet at the Fed’s 2.0% broad target for inflation, but Fed Chair Jerome Powell has stated several times that they are willing to tolerate above target (2% to 3%) inflation for a while since we spent the better part of the years between 2008 - 2018 with inflation running below their 2.0% target.
In Conclusion
We are waiting for the GDP data for Q4 2023 to arrive, but it looks like the economy grew around 2.5% last year – quite a difference from the recession that was all but assured as the year began. We may not be as fortunate this year as growth moderates somewhat, but we should be able to keep the prospects of a recession at arm’s length as long as the consumer does not turn turtle and stop spending, and the disinflationary trend remains in place. We think that the markets will make it through that last mile to the Fed’s inflation target despite some angst along the way.
