Are We There Yet?
Road trips seem to be a common staple of American families during the summertime. Despite higher gas prices, this summer seems to be no different. I remember taking many road trips as a child. We did not have DVD players nor most of the electronic gadgets available today to help occupy our time, plus most speed limits were only 55 miles per hour so the trips took longer. Like most rather impatient children enduring a long ride in the car, my siblings and I would annoy our parents with the question of “Are We There Yet?” The same question could be asked of the economy and markets today, especially as it relates to a recession.
The answer may not be so simple and our thought is that we are not yet there. With two consecutive quarters of negative economic growth being reported, an argument is being made that it meets the classical definition of a recession. Besides negative GDP growth, a recession also generally entails a time when trade and industrial activity are reduced so it is difficult to justify we are in the midst of a recession with the labor market remaining strong, unemployment near historically low levels, and fairly resilient consumer spending. As a matter of fact, some of the most watched economic releases regarding activity in the industrial sector, such as Capacity Utilization and Industrial Production, came in better than expectations last week and indicate there is not a slowdown. Monthly retail sales also showed continued growth, although consumer spending is shifting from discretionary items to essential items such as food and clothing due to higher prices and monthly household budgets not going as far as they used to.
Recessions are a natural part of the economic cycle and sooner or later we will experience one. If we are not there yet, when should we expect to see one and what will be the cause? Our estimates are that we won’t see a real recession until at least the latter half of next year or sometime in 2024. With inflation remaining elevated above historical averages and the Federal Reserve’s comfort zone, it is expected the Fed will have to continue to raise interest rates. Furthermore, they have not yet begun reducing their balance sheet by selling bonds, known as quantitative tightening (or simply “QT”), in earnest. Coupled with raising interest rates, QT will lead to a lower supply of money and eventually should help lower inflation. But it is very likely the Fed will push us into recession in doing so. The spread, or difference in yields, between 2-year and 10-year U.S. Treasury notes remains negative, or inverted, which in the past has been a strong predictor of future recessions since it indicates anticipated weakness in future economic growth. What may be an even more ominous sign of a future slowdown is the difference in yields between 3-month T-bills and 10-year Treasuries, which at one point did invert a few weeks ago. Shorter term bonds are much more susceptible to interest rate hikes by the Fed so when they raise rates next month, as widely anticipated, T-bill yields should be quick to follow and there will again be a negative spread between 3-month T-bills and 10-year bonds. This time the inversion is likely to last much longer.
When Can We Stop?
Besides wanting nothing more than to arrive at your destination, perhaps the second most asked question is “When are we going to stop?” Whether it is to go to the bathroom or get something to eat, everyone seems happy to get out of the car for a few minutes. In the same vein, investors may want to know when market volatility will end. It seems everyone is happy when the markets are moving in a positive direction and they are making money but when the market drops they may want to stop and take a break and may even ask themselves why they are invested in the market. There are two answers – 1) because at some point they expect the market to again perform well, which historically it has done or 2) maybe they should not be invested in the stock market. Over long periods of time the stock market has performed very well and provided the best means to beat inflation but over shorter time periods it can be more challenging. You should not invest money you cannot afford to lose, or that by losing your lifestyle would be negatively impacted. As a very general rule of thumb, any money you plan on spending in the next five years should not be invested in the stock market. Also, any money invested in the stock market should only be done once your monthly income needs are taken care of over the aforementioned time period.
What should you do with money you need to spend in the next few years to keep it safe? The 40 year bull run in bonds seems to be over and with rising interest rates bonds are no longer the safe haven they once were. Do not let the recent rally in longer-term bonds fool you, it is doubtful bond yields will drop significantly from here in the near term. This means bond prices are unlikely to move higher anytime soon and any income earned will not overcome what could be lost with falling bond prices. It is different for shorter-term bonds, where we now do see yields that are enough to beat price decreases since their duration, a measure of price sensitivity to changes in interest rates, is lower. However, shorter-term bonds are not keeping up with inflation and you are slowly losing purchasing power. It might be time to consider other alternatives that keep your money safe yet might provide for better returns to keep pace with rising prices. This trip has already gotten long, so we will save those ideas for another time.
Last week was the first negative week for the stock market in four weeks so it would seem the recent stock market rally is cooling off. We are at a crossroads; will momentum remain positive and we see further gains or with the recent run-up will the market take a break and level off? The worst-case scenario is this was a bear market rally and we will again see the market drop to the lows experienced in June. This coming week will bring some interesting economic releases, including Personal Consumption Expenditures (PCE) and an update to second quarter GDP. We do not expect a significant change to the previously reported GDP number but given the recession arguments it will no doubt we debated. PCE tends to be the Fed’s preferred measure of inflation and the year-over-year change is expected to drop slightly from last month but at over 6% remains well above the Fed’s comfort level of 2-3%. Barring any major surprise this will most likely continue to add fuel to expectations of the Fed continuing to raise rates at their next meeting in September. We may hear some clues about this later in the week from members of the Federal Reserve during their annual symposium in Jackson, Wyoming.
Remember, getting to retirement is a destination but living in retirement is a journey. Invest accordingly and make sure you are comfortable. You will have to contend with challenges such as inflation, recessions, and market downturns throughout your journey. Hopefully it is a long enjoyable trip, and you won’t have to stop and ask if you have arrived. Please let us know if you would like our help in this important journey.
Have a wonderful week!
Nathan Zeller, CFA, CFP®
Chief Investment Strategist
Please contact us if you would like to review your individual financial plan or learn how the TaxSmart™ Retirement Program can help you.
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