Market Commentary

Markets are Primed for a Pullback

Evidence suggests that this year's risk asset rally is likely primed for a pullback.

So now, why now?

Why the glum news after the S&P 500 index posted one of its strongest year-to-date gains in a while?

Well, it's essential to remember that most market activity is underpinned by a narrative or a story that influences price swings either higher or lower.

And this year's rally isn't any different.

To be sure, the consensus view among many investors this year was that the Federal Reserve (the Fed) would finally beat inflation by aggressively raising interest rates.

And, while higher rates are typically a market headwind, investors bet that the Fed's aggressive moves would eventually tip the economy into a recession, prompting policymakers to reverse course sooner rather than later.

Now, the Fed tends to cut rates to get ahead of rising unemployment, which tends to happen during a recession, and so financial markets interpret falling interest rates as supportive of market prices.

And so, while headline inflation has fallen this year, the long forecasted recession has failed to materialize.

Now, in any other situation, this would be a win for households, businesses, and policymakers alike.

But the fact that the US economy continues to hum along even as it's now more expensive than ever to borrow money suggests that the fight against inflation isn't over yet, and the story many investors have been betting on this year likely won't happen as quickly as once hoped.

Adjusting Market Expectations

To be sure, according to implied Fed Funds futures coming into the start of this year, market participants expected the Fed to take higher throughout the year before eventually cutting Fed Funds to around 4.25% by December.

Now, as of the end of August, with the Fed funds rate sitting around 5.25%, that same futures data now suggests that policymakers will actually keep rates where they're at now and avoid cutting rates through well into the first half of 2024.

So then, what does this outlook do to the current market narrative?

Well, the truth is that the narrative that had driven asset prices to current levels is likely losing steam, even as higher interest rates have exposed fractures in the regional banking sector, as we discussed some months ago.

Now, what this means is that with interest rates staying higher for longer, there's more risk that something in the economy or financial system could come undone. But for now, economic and systemic concerns appear measured enough for policymakers to hold tight on current monetary policy.

Supply-side Inflation Normalizing

So then, with all that said, it's crucial to note that higher rates likely have influenced inflation's slowing, but the battle isn't over yet. Indeed, headline inflation, which includes food and energy prices, peaked at around 9 percent last June and has since slowed to 3.3 percent through July of this year.

At the same time, core PCE inflation, which is a better gauge of underlying inflationary pressures, peaked at 5.4 percent in February 2022 and declined to 4.3 percent in July.

So then, from this perspective, falling prices should be good for the economy and the markets, right?

Well, while slowing price growth is indeed a positive market development, the drivers of inflation are different now than they were three years ago. More specifically, it could be argued that the cause of today's inflation plight started with supply-side drivers and is now being carried along by demand-side momentum.

And what do we mean here?

Well, you likely experienced the full effects of supply-side inflation during the lockdowns when prices shot up at the supermarkets due to a shortage of goods. In fact, the cost of most goods and services started to increase as everything from toiletries to personal protective gear to cars, semiconductors, and appliances were in short supply, ultimately making most everything more expensive.

That's supply-side inflation, or when prices rise because there's not enough of something to go around.

You see, when inflation first started taking off in 2021, Fed policymakers and indeed central bankers globally turned a blind eye to the problem, assuming that these price moves would only be temporary or what they call transitory.

In other words, they assumed that once pandemic-era supply chain bottlenecks eased up or more goods were available to go around, prices would eventually return to normal or, at the very least, inflation would slow as more products hit store shelves.

Indeed, after hitting a post-Global Financial Crisis peak in 2021, international shipping costs, as measured by the Baltic Dry Index, are today trading around average levels. What's more, overland freight shipments tracked by the Cass Freight index show that activity has slowed over the past year, which likely suggests that store shelves are likely being stocked at normal levels again.

So then, if supply-side inflation appears to be normalizing, then what's the issue?

Changing Inflation Drivers

Well, the concern today isn't so much about supply-side inflation as it is about demand-side inflation.

Indeed, the pandemic not only exposed the shortage of goods in the economy, it also highlighted the shortage of workers for essential jobs. That's why, after years of resistance, many firms decided to raise prices to pass along various costs, including the higher wages needed to draw in more workers.

And when you have hundreds of thousands of individuals making 20% more than they were before the pandemic, then you have a recipe for demand-side inflation.

And what is demand-side inflation?

Well, you'll likely recall that with supply-side inflation, prices rise because there is an equal amount of money chasing fewer available goods.

So then, with demand-side inflation, you have prices taking off because individuals have more money to spend, which means more money chasing after an equal amount of goods and services.

Now, earlier this year, the Fed assumed that it would be able to put a lid on this demand-side inflation by tipping the US economy into a recession through its aggressive monetary policy.

That's because history has shown that demand-side inflation tends to follow suit when the economy slows as businesses lay off workers and households think twice about spending money.

Hence, wage growth and spending both slow.

And so, coming into the start of this year, market watchers and economists alike were betting on the narrative that slowing growth and the potential for a recession could pull the legs out from under the economy and hence allow the demand side of inflation to finally cool off.

But that doesn't seem to be the case today.

How come?

Well, that's because labor market and household spending data, while having softened in recent months, continues to show that the US economy is much more resilient than most had anticipated, prompting many economists to revise higher their year-end US GDP forecasts.

To be sure, this view was solidified by the fact that the Fed's economists had, for all intents and purposes, stopped projecting a US economic recession.

And even at last week's Jackson Hole presser, Fed Chair Jay Powell indicated that economic growth has been stronger than expected and, so much so that now there are concerns among policymakers that if this growth trend sticks around, it could put further upward pressure on inflation, which would require more rate hikes heading into 2024, instead of the rate cuts that markets had expected.

Primed for a Pullback

So then, what should we make of this year's rally?

Should we throw in the towel and move to the sidelines since the narrative seems to be changing?

Well, not so fast.

You see, market narratives evolve and change all the time. They turn on a dime, as they say.

Indeed, that's where we get the old adage, "buy the rumor, sell the news…"

With that said, adapting to changing plot lines is a way of life for most savvy investors.

And the truth is that we've been here before.

In fact, it was precisely this time a year ago that the markets were obsessed with a Fed pivot and were sorely disappointed with Jay Powell's comments about bringing pain to the economy at last year's Jackson Hole Symposium.

You'll also recall that the late summer selloff set the stage for a bull market rally that took hold this year.

Now, make no mistake, we're not calling for an all-clear or a repeat of last year's events.

To be sure, persistent demand-side inflationary momentum and shifting market narratives suggest that markets are likely primed for a pullback in the weeks ahead.

Indeed, with the economy still primed to produce higher prices, the prospects of a year-end rate cut have all but faded away, and now, investors are trying to figure out a new story, or a new narrative, to carry the market momentum forward.

And so, history has shown that market volatility tends to pick up when investors are trying to piece together an investment thesis or story they can sell to themselves, to their investment committees, and to their clients.

Indeed, until markets can get a consensus view on a new market narrative, expect more significant day-to-day and week-to-week price swings.

Either way, staying agile, well-informed, and ready to pivot based on evolving circumstances in this market will be essential to taking one step closer to becoming the master of your own financial independence journey.

by Peter Donisanu

Bull Markets, Shifting Catalysts and Evolving Narratives

Stocks in the US are back in bull market territory this month but don't tell that to the market bears.

That's because it seems like just around every corner, there seems to be a risk that could take the steam out of the current rally and send risk assets into a sharp drawdown only matched by those related to recent economic, political, or security dysfunction.

Make no mistake, this year's risk asset rally is likely to be one of the most hated bull markets in history. That's because some major indices continue to charge higher even as various indicators point to hazards ahead for the US and global economy and hence, corporate earnings that underpin corporate asset valuations.

And you see, this is a particular problem for some investors because the thinking goes that it's foolhardy to be fully invested at a time of rising interest rates, slowing economic activity, and looming geopolitical risks because these events have the potential to topple risk asset prices that already appear to be overvalued compared to many historical measures.

Even so, some market bulls are taking even greater risks as they look past events that are likely already priced into the market and shift their focus to up-and-coming developments that could supercharge economic growth over the next decade.

So, who's got it right?

Is the current rally nothing more than a bull trap, that could lead to a renewed bear market and set the stage for one of the sharpest downturns in quite some time, as rising interest rates trigger the next bank panic and economic recession?

Or does this bull market have legs, and will it continue to charge higher into the second half of the year?

Now, while it's still unclear whether bulls or bears are making the right call, which way the market goes in the months and year ahead will likely depend on the dominant market narratives currently underpinning investor sentiment.

How Narratives Influence Market Behavior

And, so what do we mean when we talk about market narratives?

Well, a market narrative is a story that market participants tell themselves to rationalize a near-term or long-term investment decision. To be sure, all you need to do is turn on financial news channels or scroll through social media to get a sense of the story that some market participants are telling themselves and others as they defend their investment views.

And while these views can range from a call on a particular stock, sector, or asset class within the markets, what often drives the broader direction, and hence general investor sentiment, is the macroeconomic narrative.

And what do we mean here?

Well, let's use a hypothetical example to illustrate this point. Imagine we're back in a period of prolonged economic stability, like between 2014-2019. During this time, GDP had been rising steadily, unemployment was at historic lows, and inflation was largely under control.

Generally speaking, in a stable period like this, it created a prevailing narrative of continual, albeit moderate, growth in US corporate earnings.

As a result, risk assets went on a bullish run, with many indices hitting all-time highs. In fact, from the start of 2014 to the end of 2019, the S&P 500 index nearly doubled in value. That's because investors got used to this steady-state, predictable, low-volatility market environment and just kept buying, driving prices ever higher.

Now, you'll likely recall that the narrative at the time was that while the Fed would have to raise interest rates to curb potential economic and market asset bubbles, but it was constrained by the economy's addiction to near-zero interest rates and stubbornly lower inflation that wouldn't move no matter what policymakers threw at it. Therefore, low-interest rates and easy money policies would allow stocks to rise for an extended period of time.

So then, when we think of market narratives from this perspective, it's this sort of thinking that shapes investor behavior, making them more risk-tolerant as they come to expect that the good times will continue. This outlook led to increased investments in equity markets, higher asset prices, and arguably the formation of asset bubbles.

At the same time, economic participants, namely households and businesses, had also become influenced by the narrative as well. Given positive investor sentiment, firms had been more willing to issue new stock or debt offerings, and many investors readily stepped in to buy them up.

What's more, financial institutions continued to openly lend at low-interest rates, fueling economic activity even more, and households gladly opened their wallets to spend.

Now, let's say new information emerges that challenges this narrative. And what could this be?

Well, this catalyst, or new information, could come from reports of potentially disruptive geopolitical tensions, or signs of an economic slowdown in the US or some major economy abroad. And why are such developments relevant when everything else seems to be going ok? 

Well, this new narrative of impending uncertainty has the potential to shift investor sentiment quickly. And when an unfavorable catalyst crops up, the risk-averse investors might start pulling out their investments, leading to a selloff in the markets, increased volatility, lower asset prices, and a decline in economic activity.

At the same time, this narrative shift could affect corporate and financial institution behavior as well. That's because firms might hold off on issuing new securities given the uncertain environment, and banks might tighten their lending standards.

How New Catalysts Lead to Narrative Shifts

Alright, now it's critical to note that these narratives don't operate in isolation. That's because they're constantly interacting with catalysts like changing economic data, government policies, and geopolitical tensions that can influence investor psychology. To be sure, when new catalysts present themselves that challenge the current market narrative, it can become a self-fulfilling prophecy, where the belief in a narrative can cause actions that make the narrative come true.

For example, if investors believe there will be a market downturn, their selling activity can actually cause the downturn. Indeed, if we extend our earlier narrative example beyond the end of 2019, you'll likely recall that an unexpected catalyst in March 2020 led to a dramatic shift in the market narrative.

And do you recall what that catalyst was?

That's right, it was the US government announcing a national emergency in response to the COVID outbreak, which paved the way to an unprecedented economic shutdown and trillions of dollars of stimulus to support the economy and markets. Initially, the national emergency announcements led to a sharp market selloff due to the negative catalyst that was the pandemic, but later supported by a positive catalyst that included supportive actions by policymakers that paved the way for an extended market rally only weeks later.

This process underscores the importance of monitoring and understanding the prevailing market narrative and potential catalysts, as they can greatly influence investor behavior, market activity, and, ultimately the economy at large.

Narratives and Catalysts in the Current Environment

Now, considering where we are today, it would seem that there is still some uncertainty about the dominant market narrative. To be sure, the debate between bulls and bears is what leads to price discovery and makes for a more-or-less healthy functioning market. And more often than not, those debates and how they play out in the market through price action are not just about the dominant narrative but also about how various catalysts could potentially influence the direction of the prevailing market story.

So, what are the catalysts that are currently under consideration by market participants?

Well, the dominant catalysts likely up for debate affecting the broader narrative center on 1) inflation, 2) central bank policy, 3) financial instability, and 4) the potential for an economic downturn.

Inflation and Interest Rates Normalizing

Now, as it relates to the first two points on inflation and central bank policy, you'll likely recall that uncertainty surrounding where inflation was headed coupled with the fact that policymakers seemed asleep at the wheel, were the catalysts that led to last year's bear market selloff.

Indeed, inflation that was supposedly transitory due to supply chain constraints transformed into stickier, widespread price hikes from across most economic sectors, leading to declining purchasing power and dented household wallets and confidence.

Now, it's essential to note that central bank policymakers usually aim for a low and steady inflation rate as their target because price stability allows for better financial planning and fosters overall economic well-being among households. That's because when prices are stable, households can more accurately predict their expenses, which makes it easier to budget and plan for the future.

And, so, without price stability, it's difficult to know how much money you'll need to spend on essential goods and services. And when this happens, it can lead to uncertainty and possibly financial hardship. And it was this catalyst that many market watchers had been calling out for quite some time. And, when Fed policymakers finally reversed their stance on “transitory” inflation and began rapidly raising interest rates 18 months ago, the dominant market narrative shifted.

But now, with headline inflation having fallen to just over 4% in May for its lowest reading since April 2021, and producer price inflation falling for 11-straight months, it appears that the two catalysts that had threatened economic stability, that is, high inflation and high-interest rates are likely to come back to normal soon.

And for many of the bulls out there, it's arguably this outlook that has renewed investor demand for risk assets, and underpinned the current market rally as many market participants are looking past the risk of high inflation, and now pricing in central bank rate cuts by the start of next year as price stability returns to the US economy.

Financial Instability and Economic Recession

And so, if inflation seems to be stabilizing and bringing policymakers to the point of normalizing interest rates, you might be asking yourself, "Well, what about the lingering financial instability issues and the looming economic recession on the horizon? Don't these catalysts have the potential to derail the current bull market rally?"

Well, the short answer is: it depends. On the one hand, a spreading bank contagion could bring into question the health of the US and global financial system and spark a greater crisis of confidence in US and global financial markets. To be sure, this risk, while less noticeable than it was a few months ago, remains a salient threat. That's because, even as headlines surrounding the failures of small regional US banks have eased, data according to the Federal Reserve show that banks are three times more reliant now on emergency borrowing from the central bank than during the height of the pandemic.

What's more, the latest Senior Loan Officer Survey shows that both large and small US banks are tightening lending standards and reducing overall lending to businesses and households. Indeed, in recent months, many financial institutions have announced planned exits from various auto lending and mortgage markets. And with central bank policy rates poised to rise to their highest levels in two decades, market bears could argue that it's all but certain that an economic downturn is just around the corner.

So, with all that said, it's possible that these two catalysts may have less bite than their bark. Make no mistake, many financial institutions are facing significant risks. Yet, it could be argued that the current plight of banks adjusting to higher interest rates likely has more to do with balance sheet management practices, than general systemic concerns related to the quality of assets held by these banks.

Indeed, this is a topic we wrote about several weeks ago and pointed out this distinction. Even so, the banks' precarious position is likely to make them less willing to lend, especially at a time when collateral backing many of the loans, like real estate and autos, are falling in value along with the decline in overall inflation.

And what about this recession that we've been waiting for the past year? Well, it's true that higher interest rates have historically led to lower hiring activity and so the potential for layoffs, and subsequent weaker household spending remains an elevated risk.

Even so, this labor market has been one of the most stubbornly strong markets we've seen in decades. To be sure, compared to historical recessionary periods, labor market data this time around has been more resilient, suggesting that, while economic growth likely will slow into the end of the year as many economists predict, a rise in unemployment likely could be less severe than we've seen in cycles past.

Bull Markets, Evolving Narratives and Shifting Catalysts

So then, assuming that inflation and interest rates come down to more normal levels, regional banks find their footing, and the economy experiences a soft landing in the second half of the year, then, there is a case to be made that this bull market has legs.

Again, you might ask yourself, "But aren't valuations already stretched?" and "Isn't the current risk asset rally being led higher by a handful of the largest companies?"

Certainly, from this perspective, some assets appear overpriced. These assets are largely tech related that have rallied in line with expectations that artificial intelligence will lead to future economic efficiencies. With that said, however, many assets remain attractively valued given the market selloff we’ve seen over the past twelve months.

Now, add to this the fact that there is a historic $1.3 trillion parked in retail money market mutual funds and a case could be made that we might see a reallocation in the bull market currently supported by a handful of expensive names to one supported by a broader base of cheaper or fairly valued names as cash moves back into the markets once retail investors are convinced that negative market catalysts are likely to have less of an impact on the overall market narrative.

So then, from this perspective, is now the time to dive into risk assets? Well, if you've been trying to time your way into the markets this year, then you likely missed out on a number of opportunities. Indeed, if you've been following along with us this year, we've made a strong case for remaining fully invested in the markets despite perceived headwinds.

So, who's got it right?

Is the current rally nothing more than a bull trap, that could lead to a renewed bear market and set the stage for one of the sharpest downturns in quite some time, as rising interest rates trigger the next bank panic and economic recession?

Or does this bull market have legs, and will it continue to charge higher into the second half of the year?

While the sustainability of the current bull market rally is questionable, we remain cautiously optimistic on the outlook for the US economy and financial markets alike. Here again, we believe that investors should remain fully invested in the markets and not try to time their way in and out in anticipation of changing market narratives. Rather, you're likely best served by remaining committed to your disciplined long-term investment strategy.

by Peter Donisanu

Inflation, Banking Crises and Recession: Position Your Money for Success

If you had to guess how financial markets performed in the first quarter based solely on news headlines, what would you find?

Performance was likely quite poor, right?

Well, the truth is that markets held up quite well in the first quarter, but I wouldn't blame you if you guessed that it was just another disappointing repeat of what we saw last year.

To be sure, after news of markets swooning back and forth on optimism and pessimism on central bank policy, stubbornly high inflation, the prospects of another banking crisis, and the ongoing talks about a recession, there certainly is a lot for the markets to be worries about these days.

Even so, market sentiment has remained buoyant even as a host of worries continue to capture news headlines.

So, given how resilient markets have been in the first quarter, the big question now is, "where do we go from here?" Indeed, could the positive start to the year be a sign of a sustained risk asset rally through the end of 2023?

Well, the short answer is, maybe.

You see, while markets have taken many of this year's bad events in stride, history tells us that we're likely not out of the woods yet as far as how outstanding negative events could dent market sentiment. Even so, it's possible that investors could look past historic precedent on their way to a renewed rally after last year's bear market sell off.

Inflation is What it's All About

Now, truth be told, where the markets land by the end of the year is anyone's guess. If I had a crystal ball and could tell you where the markets are headed with certainty, I'd likely be the richest man in the world. Even so, one factor likely to drive market direction either higher or lower this year is inflation.

And why's that?

Well, that's because inflation is affecting all of our lives in material ways. Certainly, weeks ago, we saw headlines about how basic staples like a dozen eggs and snack foods like a 7.5-ounce bag of your run-of-the-mill potato chips fetched as much as $7.00 each. And these anecdotes only point to the broader problem of housing affordability, the price of new and used cars, and how expensive many of the goods and services we depend upon have become over the past few years.

At this point, the key issue for the markets is that if policymakers demonstrate that they can't get inflation under control, then we'll likely have a new set of challenges to deal with.

Now, the truth is that inflation is a phenomenon that we've dealt with for time in memoriam. However, the reason that inflation is a concern right now is because when consumer expectations of inflation remain elevated, or what policymakers call "unanchored," it has a lot of unintended economic and social consequences.

And while inflation has been slowing in recent months, according to the University of Michigan's latest survey of households, individual expectations of inflation remains elevated. Indeed, in its February survey, data showed that consumers expect inflation to end around 4% in about a year from today. And while this expectation is an improvement from the near 5.5% level we saw last year, it remains well above the 2.5% figure we saw in the months just before the pandemic started.

At the same time, the Richmond Fed's quarterly survey of CFOs shows that business leaders expect inflation to remain around 5% over the coming year. What this means is that the household and business expectation surveys are still way above the Fed's 2% inflation target.

The point here is that the data show that the air has yet to entirely come out of the inflation bubble, especially when it comes to what people expect about inflation. And as we pointed out in previous reports, inflation tends to become a self-fulfilling prophecy, which is why officials are so keen to put it to bed.

What this means is that as long as the data show that inflation is still running hot, and workers and business owners alike are feeling it, then policy rates likely will need to remain higher for some time so that the US economy will eventually slow to the point where prices are less of a concern, and staying solvent is.

Boring Bonds Bring Down Banks

Now, the thing about the Fed pushing rates higher is that it has had knock-on effects across all aspects of the financial system, especially in the bond market. You see, in this sleepy corner of the market, when interest rates go up, the price of a bond goes down. And under normal circumstances, these price swings are par for the course when it comes to investing.

But, what's different this time is that US banks hold a lot of Treasurys, or US government bonds, as assets on their balance sheets. Now, banks hold these assets for various reasons, but one of them is to ensure that they can absorb losses in the event of an economic downturn.

Typically, when the Federal Reserve tightens its policies, banks and other financial institutions are able to look past the falling value of their bond portfolios as interest rates move higher in a steady fashion. 

Now, that's not what happened over the past year as officials raised rates aggressively, catching some banks flat-footed. Indeed, we learned in March that many US banks had become overly complacent with how they manage their otherwise boring bonds, contributing to the failure of several highly visible banks and sparking widespread worry that a financial crash was on the horizon.

And while policymakers were able to quickly avert a widespread crisis following the collapse of Silicon Valley Bank, the event itself has sparked greater caution across the broader banking system. 

For example, financial institutions, on the whole, are now tightening lending standards and granting fewer loans. What's more, many of these organizations have announced layoffs across various lending groups, including mortgage and auto lending, and are increasing their loan loss reserves in anticipation of borrowers simply giving up on their expensive loan payments. 

Now, on the surface, a decline in lending activity is generally bad for the economy. That's because when it's more challenging for a business to obtain financing to keep its operations going, managers tend to lay off employees to free up working cash flows. And when households are facing potential job losses and the prospects of lower available credit lines when banks tighten lending standards, consumer spending tends to slow.

The silver lining is that falling bank lending, slower business and consumer spending, and slowing economic activity, in general, can have a more significant effect on curbing inflation than a central bank solely pulling the lever on higher interest rates. 

What this means is that if banks aren't lending as freely as they were because they're now worried about a recession, then businesses and consumers alike are likely to spend less on goods and services, which could cause the rate of inflation to slow further in the months ahead.

What it All Means for Your Investments

So, where does all of this leave us in terms of the market outlook for the coming quarter? Well, market participants so far have been able to look through all of the worries about the banking sector which is evidenced in the positive performance we saw in risk assets in the first quarter.

Even so, inflation continues to remain the dominant catalyst for whether the markets manage to move higher throughout the second quarter of the year and beyond. That's because investors are primarily focused on what the Fed will do next, and taming inflation remains the Fed's number one priority for the year.

Now, some may argue that inflation is, in fact, coming down, but the reality is that it's not falling as fast as policymakers would like. And that's one reason why so many Fed officials remain vocal about the central bank's need to continue raising interest rates this year.

Nevertheless, many investors are looking past what the Fed will do in anticipation that tightening bank lending standards and the potential for lower spending amidst recession worries could give the Fed less of a reason to continue raising interest rates later this year. And when the Fed stops raising rates and finally signals that it's ready to ease its grip on a tight monetary policy, that likely will be the moment when investors begin to breathe a sigh of relief, and risk assets subsequently take off.

With that said, history has shown that sustained market rallies generally do not take place until the Fed begins cutting its key policy rate. And, again, based on what we've been hearing from various Fed officials in recent weeks, rates hikes are still on the table.

So then, where does this leave the markets? Well, you'll recall that markets are often considered to be discounting mechanisms because they incorporate all available information and, more importantly, expectations about future events into current asset prices.

In other words, market participants use all available information to make informed decisions about the value of a particular asset, and these decisions are reflected in the market prices.

So, then, from this perspective, we can argue that risk asset prices have been moving higher in recent months because investors anticipate an eventual rate cut by the end of the year. Now, whether inflation is tame enough by year-end to warrant rate cuts is hard to say. That's because few things about how the economy functions have been standard textbook over the past few years.

Either way, market participants are likely now betting that a credit crunch and the prospect of an economic recession could be enough to cause policymakers to finally pivot to rate cuts, confirming investors' expectations and supporting the current market rally through the end of the year.

So, what does this mean for your investments?

Well, a great deal of uncertainty remains about the timing of the change to Fed policy. Remember, markets have been betting that the Fed would "pivot" and cut rates for nearly a year now. And every time they were wrong, risk assets sold off sharply as a result.

Indeed, what last year's market experience taught us is that even the brightest and most talented professional investors got many of their bets wrong. Therefore, if you're trying to time your way into and out of the markets, it will likely cost you more than you will gain over the long term.

At the same time, what this outlook means to you is that it's essential to stay invested for the long term and avoid the temptation to hide in cash. To be sure, while concerns about a broader banking collapse and the prospect of recession are warranted, it's worth remembering that we've been through worse over the past few years, and markets have nevertheless charged higher.

Either way, the big takeaway here is that there's reason to remain optimistic about the markets in the year ahead. But until we get clarity on the path of inflation, and hence Fed policy, trying to get cute in the markets likely will cost you more than it's worth.

Financial Planning Housekeeping Items for the Quarter

Now, as we wrap up our outlook for the quarter, let's quickly cover some financial planning topics that will set you up for success into the remainder of the year.

Rebalance Your Investments

To start, take a moment to review your investment and retirement portfolio. You know, the recent positive market performance has offered a unique opportunity to rebalance as asset prices have moved higher this year. So, if you haven't done so already, take a moment to consider your current holdings versus your target allocations and sell positions that have done well, and add to those that are underallocated.

Now, why would you want to do this? Well, remember that over time, the performance of different asset classes can vary, causing your portfolio to deviate from its target allocation. And with many risk assets rallying into the start of the year, now may be the time to check whether your current holdings, especially in your employer-sponsored retirement accounts, reflect your long-term asset allocation strategy.

Make Your Quarterly Tax Payment

The next planning topic to consider is your estimated quarterly tax payments. Now, with tax season largely behind us, now is a great time to ensure that you're prepared to make your estimated quarterly tax payment for the month of April if you haven't done so already.

And why is this important?

Well, making estimated quarterly tax payments to the IRS can help you avoid any penalties for underpayment of taxes, help you better manage your cash flows, and stay organized with your finances.

And by making regular payments, you can track your tax liability and avoid any surprises at tax time, as well as spread out your tax payments throughout the year to avoid a large, unexpected tax bill next April.

Manage Your RSUs

Next, if you have RSUs (restricted stock units) that have vested in the first quarter, now may be a great time to consider your options for your holdings. And if you need pointers on understanding or managing your equity award, be sure to check out the resources we published last quarter about managing this critical component of your overall compensation.

Either way, the recent runup in risk assets may provide you with a great opportunity to lock in your company stock price at a higher level, given that we anticipate increased levels of market volatility into the rest of the year.

Check Your Cash Reserves

Finally, with market and economic volatility likely to remain elevated in the months ahead, given the prospects of a credit-induced recession this year, it's crucial now more than ever to have an adequate cash buffer that you can rely upon.

Why?

Well, picture this: you run into an emergency, like a medical bill, your furnace needs replacing, or you're dealing with an untimely car repair. 

How are you going to pay for these expenses?

And in a recession, job loss or reduced income can happen to anyone, and it's not fun. But guess what? With a cash buffer, you've got some breathing room. You can cover your living expenses while you search for a new job or adjust your budget, all without the stress of piling on more debt.

And here's another thing: having that cash buffer means you won't need to rely so heavily on credit. With tighter lending standards already underway, getting credit becomes more difficult anyway. So, by having your own financial cushion, you're taking control of your financial life, and that's something to be proud of.

Inflation, Banking Crises, and Recession: Position Your Money for Success

Taken together, the first quarter of 2023 demonstrated that markets can, at times, remain resilient despite ongoing challenges, such as high inflation, bank crises, and a potential recession looming in the background. That's why as we move forward into the rest of the year, it's essential to keep a close eye on these factors and remain vigilant in monitoring how they may impact your finances.

Now, despite the uncertainty, it's essential to maintain a long-term perspective and avoid knee-jerk reactions based on short-term market fluctuations. Indeed, by focusing on a holistic financial planning approach, you can prepare yourself for both the ups and downs of the market and ultimately, build a secure financial future.

This approach includes revisiting your investment portfolio to ensure it aligns with your long-term goals, making timely quarterly tax payments, managing your RSUs wisely, and checking in on your cash reserves. And by addressing these financial planning housekeeping items, you can optimize your finances and navigate the potential market and economic volatility ahead with greater confidence and peace of mind.

In the end, while the markets may continue to test your nerves with its unpredictable twists and turns, a well-rounded financial plan, coupled with a steadfast commitment to long-term goals, can help see you through even the most challenging of times, but more importantly, take you one step closer to becoming the master of your financial independence journey.

by Peter Donisanu

Can a Credit Crunch Be a Positive for the Markets?

Yesterday the Federal Reserve (Fed) raised its policy rate by a quarter-point and signaled that the central bank was open to pausing rate hikes sooner rather than later. And while just a month ago it seemed like policymakers were going to keep interest rates higher for longer, the fact is that a lot has changed in the past few weeks.

Indeed, given the events unfolding with the likes of Silicon Valley Bank, Silvergate, First Republic, Credit Suisse and others, it’s quite possible to say that the Fed has met its objective to cause “pain” as systemic concerns and the risk of recession are all but assured in the current economic environment.

So, what’s changed in the past couple of weeks to cause such an about face with respect to the interest rate outlook for 2023? Certainly, just a month ago we were expecting higher rates for longer throughout the course of this year.

Even so, what’s likely changed the rate calculus is what could be the beginning of a credit crunch-induced economic recession.

Now, you’ll likely recall that Fed Chair Jerome Powell drove home the point of bringing economic “pain” during his comments at the Jackson Hole Economic Symposium last summer. Back then, the Fed had aggressively raised interest rates and the markets were hoping that the velocity with which policy was implemented at the time would usher in a rate pause from the central bank.

Nevertheless, with consumer spending and the jobs market still strong, it was clear that the fight against inflation was not over. In a sense, policymakers were desperately trying to jawbone, or talk down the economy, in a bid to get inflation under control. Even so, the Fed ended up raising interest rates another 9 times, leading to one of its quickest periods of rate hikes than we’ve seen in recent history.

With that said, the trouble with the Fed’s policy was that no matter how much it communicated how high rates might need to go, demand in the economy remained solid. That’s because household spending shifted from stimulus checks and tax credits in the years following the pandemic, to charging up credit cards and borrowing against their homes to spend more, which caused inflation to largely remain unchecked.

Indeed, government data show that in 2022, total household debt rose by a full trillion dollars as individuals charged up credit cards and used their homes as ATM machines in full force. What this suggested to many observers was that households were less sensitive to higher borrowing costs than some policymakers had predicted, and potentially pointing to a tough road ahead for the fight against inflation.

And so, with markets rallying into the start of 2023 on an expectation that rates would have to fall, but inflationary pressures nevertheless remaining stubbornly high, central bank officials doubled-down on their “higher-for-longer” narrative. 

That is, however, until the events over the past few weeks finally gave policymakers the “pain” they were looking for that could finally subdue stubbornly high inflation as the risk of a recession becomes more all the more palpable.

Crisis of Confidence

Now, it’s important to recall that for the past year many economists have been saying that a recession has been in the making and could arrive sooner rather than later. Nevertheless, household spending has been generally solid and the labor market conditions have been robust. And, as we pointed out earlier, a key factor contributing to the resilience of the US economy has been consumer’s ability to borrow money to keep up with spending and inflation.

But now, with fissures forming in the broader banking system, it’s very well possible that an individual’s ability to borrow and spend could come to a rapid end as many banks today aren’t willing to lend even to themselves.

Indeed, the issues facing Silicon Valley Bank, Silvergate, First Republic Bank and others not only led to a run on these banks by their very own depositors, it’s once again leading to a crisis of confidence among the banks themselves, and setting the stage for a broader interbank lending freeze.

And why does the interbank lending system matter to the average individual?

Well, interbank lending is when banks share money with each other for a short time. This approach helps financial institutions to have enough money to do their daily jobs, like giving people their money when they ask for it.

And when banks need to quickly tap into cash, they’ll often share their own reserves with each other through the interbank market. This is like a big meeting where banks talk and decide who will lend money and who will borrow it. Sometimes, banks use a special way to share money called a "repurchase agreement." It's like borrowing money from a friend with a promise to pay them back later with a little extra on the side.

Now, during times of heightened uncertainty, these borrowing agreements between banks seize up as healthier banks hoard liquidity to mitigate their own risks of depositor flight.

And when this happens, central banks step in to help ensure that financial institutions have enough money so that they can meet their daily demands, which makes central banks the, “lender of last resort.”

Now, you’ll likely recall that during the height of the Global Financial Crisis in 2008, the Fed stepped in as the lender of last resort as credit markets froze up following the collapse of Lehman Brothers.

And today, following the failure of Silicon Valley Bank, the Fed stepped in with another set of measures to restore normal functioning to the financial system, including important changes to how the Fed’s discount window works and the introduction of the Bank Term Funding Program (BTFP).

Bank Crisis: Credit Crunch a Silver Lining for Inflation

With all this said, it’s critical to note that while issues in the interbank lending channels likely won’t spark a Great Depression type slowdown, a sharp decline in lending conditions has the potential to lead to a sudden economic deceleration that could put a damper on inflation overall.

And by now, you’re likely asking yourself, “haven’t we been talking about a recession for the past year, what’s different this time?”

Well, as we mentioned earlier, for the past year, the Fed has been trying to “talk” the economy into a recession. Indeed, policymakers have been vocal in their threats to aggressively raise interest rates so long as households keep spending, businesses keep hiring and prices keep moving higher.

And rather than talking the economy into a recession, policymakers have raised rates to a point where it has caused something to finally break in the financial system, which could likely give way to a credit crunch as the likeliest route to the long-awaited economic downturn.

So, how does what’s going on with the banks affect the broader economy and inflation itself?

Well, if banks are less willing to lend to each other, then they’ll likely be less willing to lend to you and your employer. This is what we call a credit crunch. And it’s one reason why, during the Global Financial Crisis, and again this month, that central bankers introduced several measures to return the financial system to regular operations in an effort to avoid what could be a severe economic downturn.

That’s because in response to increased credit risk and heightened uncertainty, banks may become more cautious in their lending practices. This means that as they tighten their credit standards, it makes it more difficult for borrowers, including other banks, to access credit. As a result, as interbank uncertainties persist, overall supply of credit in the economy could begin to dwindle.

And as credit becomes less accessible, businesses and households may cut back on borrowing and spending, leading to a decline in overall economic activity. As this happens, confidence tends to diminish, leading to lower overall spending and investment. And this decline in economic activity can result in lower revenues for businesses, ultimately leading to layoffs and cost-cutting measures. And, when unemployment rises, households have less income to spend, further exacerbating the decline in demand.

So, how does this play into the fight against inflation?

Well, as demand falls, businesses may lower their prices as a way to attract customers and maintain sales volumes. This can contribute to deflation, as the general price level of goods and services in the economy decreases. Indeed, a recession can lead to lower inflation (or outright deflation) through a combination of factors, including lower aggregate demand, tighter credit conditions, and a decline in interbank lending. And when left unchecked, these factors interact in a feedback loop, reinforcing the downward pressure on prices and economic activity.

A Silver Lining Supportive of Risk Assets

So then, from a markets perspective, what does this potentially negative economic outlook mean for risk assets this year? Well, where the markets go from here likely all comes down to the Fed’s rate policies.

That’s because if the Fed has finally caused the pain that it has been seeking for so long, then the recent events in the banking sector likely suggest that the Fed has less of an incentive to continue pushing rates higher from here.

Indeed, the key risk now is that policymakers overtighten, creating a deflationary environment that could be worse than the inflationary one they’ve been fighting for the past year.

That’s why after this week’s meeting, markets are pricing in rate cuts by July, and speculating that the credit crunch likely already underway will be enough to not only curtail inflation, but ultimately lead to an economic downturn that finally forces the Fed to “pivot” as so many market participants have been waiting over the past year.

And while this perspective might make getting back into the markets attractive at this point in time, there are several reasons for investors to remain cautious in the current environment.

First, it’s not yet clear yet whether we’ve seen the end of stresses in the global financial system. While the factors contributing to Silicon Valley Bank can be attributed to poor risk management, a crisis of confidence ultimately sparked its demise and triggered troubles for other flagging banks.

Second, while it’s possible that a credit crunch could be the answer to the Fed’s inflation problem, only time will tell whether the inflation fight is largely over. Indeed, policymakers are walking a fine line between preserving systemic stability, and taming inflationary pressures. That’s why incoming data over the next couple of months will be crucial to determining how much leeway policymakers have to cut rates as growth slows.

Finally, even if inflationary pressures finally appear to be under control, there’s a risk that stocks likely won’t move higher in a straight line. Indeed, in the months following the collapse of Lehman Brothers and the introduction of government rescue programs, the markets continued to sell off sharply before finding their footing and setting the stage for a broad bull market rally.

That’s why as you’re looking over the current environment and considering your investment decisions, your most prudent choice likely will be to avoid market timing and stick with your long-term disciplined investment strategy.

That’s because accurately predicting the direction of the market is inherently challenging due to the multitude of factors that influence market movements. These factors can include macroeconomic indicators, policy changes, corporate earnings, geopolitical events, and investor sentiment. And the complex interplay of these factors makes it nearly impossible for investors to consistently predict the optimal entry and exit points in the market.

What’s more, market timing often relies on emotional decision-making, which can lead to irrational behavior. That’s because when market volatility is high, fear and greed could drive you to make impulsive decisions, such as selling assets during sharp declines or buying during periods of rapid appreciation. Such decisions are often driven by short-term market fluctuations rather than a long-term investment strategy, which can result in suboptimal outcomes, especially if the risks we mentioned earlier come to the foreground.

Ultimately, it’s essential to remember that some of the best days in the market have occurred during periods of high volatility, and missing out on these opportunities can have a detrimental impact on long-term investment performance.

That’s why focusing on the most crucial aspects of investing, such as proper asset allocation, portfolio diversification, and long-term investment planning can help mitigate unnecessary financial risks and improve your chances of mastering your path to financial independence.

by Peter Donisanu

Don’t Hold Your Breath: Rates Aren’t Coming Down Anytime Soon

If you've been hoping for interest rates to fall this year, I've got some bad news for you: borrowing costs will likely only go higher from here.

At least, that's what we've been hearing from various Fed officials over the past couple of weeks. More specifically, these individuals have been telling us that the central bank should continue raising rates into the foreseeable future, and the fact is that incoming data supports their case for future rate hikes.

To this point, inflation data for January showed that prices accelerated at a faster-than-expected rate, rising 0.5% on a month-over-month basis. What's more, the data also show that US labor market conditions remained robust in January, as employers added over 500,000 jobs to their payrolls, besting economist expectations of a slowdown.

And if that wasn't enough to dash the market's hopes of lower interest rates this year, government data just recently showed that households spent at a faster-than-expected rate of 6.4% last month compared to a forecast of 4.5% for January.

If we're in a recession at this moment, then this is possibly one of the strongest economic environments we've experienced in a while heading into the start of an economic downturn. This perspective is relevant because history tells us is that the Fed tends to pause interest rate hikes as the data begins to turn to the downside. And so far, while there is some evidence of slowing economic activity, the data does not yet make a solid case to prevent policymakers from raising rates higher from here.

Hope for a Fed Pivot (Continued)

Now, if you've been following along with the markets, you likely know that some investors anticipated interest rates to rise only modestly this year. Thereafter, the hope was that the Fed would pause its rate hike cycle and eventually begin cutting rates by year-end as the expected recession unfolded.

This market narrative was a key factor driving risk asset outperformance in the first few weeks of this year. Indeed, US stocks in January had one of their best starts to the year in a long time on hopes that the Fed would eventually pivot away from aggressive rate policies and pave the way for a market rally this year.

For example, at the start of the year, markets were pricing in 0.25% rate increases by the FOMC in February and March, followed by a pause in rate hikes and then an eventual rate cut by year-end.

Nevertheless, as January came to a close and key economic data began rolling in for the month, it became clear that economic conditions do not yet warrant rate cuts this year.

Indeed, the incoming data suggests that a severe economic downturn hasn't presented itself yet if we look at the health of the household as a key barometer of activity. To be sure, this activity is critical to note because nearly two-thirds of gross domestic product (GDP) is made up of household spending alone!

From this perspective, a case can (and in some instances already has) be made that policymakers will need to continue raising rates until something breaks in the economy or financial system that would eventually warrant a rate cut.

So, then, what are some conditions that likely need to be present for policy rates, and hence borrowing costs, to fall later this year? For now, developments in the housing and labor markets likely will be critical indicators for confirmation that economic conditions have slowed to levels that support lower inflation over the near-term, which could give policymakers the cover they need to take their foot off the policy brakes.

Housing Market Developments

And why is housing a critical factor in the Fed's rate calculus?

Well, that's because what happens in the housing market is critical to measures of inflation. That's because housing costs, as it relates to its contribution to overall inflation, make up a sizable portion of the consumer price inflation (CPI) basket. Indeed, over the past couple of years, owner's equivalent rent, or the cost of housing, has skyrocketed from an average rate of around 3% from 2010 to 2020 to nearly 8% in January of this year.

What this means is that it's becoming more expensive for households to pay to keep a roof over their heads as the cost of servicing a mortgage has risen and average rents nationally continue to climb. And while activity in the housing market has slowed over the past year, incoming data show that conditions have actually stabilized.

For example, while inventories of new and existing homes went up mid-last year as buying activity slowed as the Fed began raising interest rates, the number of homes available for sale presently is falling back to levels we last saw just a year ago. What's more, homebuilders' sentiment improved in January at a better-than-expected rate as homebuying activity remained resilient in the face of rising borrowing costs.

Resilient Labor Market

And shouldn't have rising borrowing costs killed consumers' appetite for homeownership?

Well, one of the reasons why homebuyers have remained resilient is because wages continue to rise and hiring in many parts of the labor market remains robust. Data released in early February showed that employers added another 500,000 jobs in January, nearly double the rate that many economists had predicted for the month.

And with interest rates rising and the economic outlook seemingly so uncertain, why would we continue to see more jobs added from one month to the next? Or, put a different way, why is the labor market still so strong even when other indicators have suggested for months that the US economy could be headed for a recession?

While there is a myriad of explanations for this uncertainty, the fact is that there are many demographic shifts that have taken place over the years that have led to a stubbornly strong labor market today. 

For example, even in the pre-pandemic era, employers had been looking for qualified workers and had difficulty filling open positions. This reality is exhibited in the upward trend in JOLTS time series data. And given that employers were once challenged to bring on new workers, they're likely less willing to let go of these same workers even as slowing economic conditions put pressure on margins.

And recently, with prices increasing and labor market shortages abounding, business owners have used inflation as a cover to raise the prices of their goods and services, pay higher wages, and pass those costs on to consumers. Indeed, in January, average hourly earnings grew 4.4%, a slowdown from nearly 6% in early 2022 but remains well above the less than 3% average over the past decade.

What this means is that households increasingly have more money to spend as employers pay new workers higher wages or offer outsized cost of living adjustments to existing employees as a means to keep them on board.

What it Means for the Markets

The conditions that would have justified just two more rate hikes this year and that led to a solid risk-asset rally in January are likely no longer present. To be sure, as it stands today, market participants are, in fact, pricing in three more rate hikes this year. What this means is that we're likely to see heightened market volatility in the months ahead as investors look for a new narrative to support the nascent cyclical bull market rally for the year.

So, what factors will market participants likely be watching to evaluate market direction looking out into the rest of the year? Well, as recent data have demonstrated, the health of the consumer will likely be central to the market narrative this year. And directional data points relevant to these measures include resilience in the labor and housing markets.

The hope is that as activity in these sectors of the economy begins to weaken, so will inflation. And as inflation data (which tends to lag as an indicator of price momentum), confirms what the housing and labor market tells us, investors likely will have the confidence they need to move ahead of policymakers once again and drive risk-asset prices higher.

What it Means for Your Finances

Until then, we continue advocating for an investment strategy that is consistent with your long-term risk tolerance, goals, objectives, and, most importantly, your financial plan. Indeed, now may not be the time to take on additional investment risk. In fact, given the strong rally this year and renewed macroeconomic uncertainties, we continue advocating for a disciplined cash management plan, especially for those investors who are currently drawing down on their savings to fund their post-employment living expenses.

Outside of investing, it's vital to note that financial markets are pricing in rates to go up another 0.75% this year. What's more, policymakers have indicated the interest rates likely will need to stay higher for longer. Therefore, if you need to borrow to make a purchase, consider your options as the potential to refinance at lower rates likely may not come for more than a year or more from now.

On the flip side, higher interest rates have finally made it beneficial for individuals to hold cash. While the purchasing power of cash continues to be eroded on an inflation-adjusted basis, you now have more options in today's environment to put your money to work in a relatively risk-free manner.

For instance, many financial institutions now offer savings and Certificate of Deposit (CD) accounts that pay interest of over 4.5%. This reality is especially salient given that if we are headed for a recession in the second half of the year, then preparing an adequate cash buffer to weather an economic downturn is essential now more than ever.

Make no mistake, borrowing costs are only likely to go up from here. As a result, we're likely to see higher levels of market volatility and economic uncertainty in the months ahead. That's why even after a solid start to the year in the markets, it's essential to avoid financial complacency. Indeed, taking a few steps right now to position your finances properly likely will put you one step closer to mastering your journey to financial independence.

by Peter Donisanu

Markets in 2023: It's All About Inflation

To say that 2022 was a disappointing year for investors is an understatement.  US stocks gave up more gains to close the year than they have since the height of the Global Financial Crisis.  And even bonds, which tend to move higher when stocks fall, saw their worst declines in decades in 2022.  And while some investors sought out cash as a haven of sorts, double-digit inflation and a rising cost of living ate into the purchasing power of most savers.  Ultimately, investors had no safe place to hide from this year's economic and market carnage, and it's arguably all the Fed's fault.

Understandably, after this year's market volatility, many investors are ready to throw in the towel and move to the sidelines as there appears to be no end to the ongoing economic and market uncertainty.  Even so, as we look ahead to the coming year, there are some early signs that we may finally receive the long-awaited relief rally sought by so many investors.  And that's why getting out of the markets now could mean potentially missing out on the start of the next bull market rally.  To get to that rally, however, we’ll likely need to move through more uncomfortable periods of market ups and downs.

While it feels like the floor is coming out from under the markets, the unwinding that we're seeing across the financial system today is arguably not primarily driven by bubbles bursting as they did in 2000 or 2008.  Instead, what's different about this selloff is that policymakers, namely the Federal Reserve (Fed) and central banks globally, are purposefully engineering an economic and market decline by raising interest rates in a bid to combat out-of-control inflation.

What this means for many investors out there is that, once policymakers are sufficiently convinced that inflationary pressures are under control, their next likely move could be a pause in interest rate hikes before lowering them once again.  Now, this outcome is essential for financial markets because, typically, in a bear market, risk assets tend to find their footing and rally higher when economic conditions are prime (like when inflation is falling and the economy is stalling) for the Fed to cut interest rates.

And as you'll likely recall, this expectation led to fits-and-starts in 2022 as many market participants prematurely held out hopes for a "Fed Pivot."

So, if the Fed is engineering an economic slowdown that led to the recent market selloff, what needs to happen in the coming months before the central bank finally starts cutting interest rates again and giving the markets a chance to rally higher? 

Well, policymakers likely will need to see three economic conditions play out before changing their approach, including:

• a drop off in consumer spending,
• a reset of inflation expectations, and
• a persistent declines in services inflation. 

As these conditions are met, we likely will see a bottom formation in the current market selloff, which, holding all else equal, paves the way for a higher market close in the year ahead.  As we move towards these conditions, we will likely face increased market and economic volatility in the first half of 2023.

Household Spending Needs to Slow

Now, one question you may be asking yourself is, "why would the Fed care about curbing household spending when its key concern is inflation?" Well, if you think back to your college Economics 101 courses, then you'll likely recall that high inflation tends to happen when there are either too few goods to purchase (or a supply side inflation) or too much money chasing too few goods (demand side inflation). 

And following the pandemic in 2020, we did experience the effects of supply-side inflation as global supply chains came to a screeching halt, and prices for some goods on store shelves moved higher.  But you'll also recall that the Federal Reserve and US government as a whole injected trillions of dollars into the financial system and economy to stave off what could have been an economic downturn worse than the Great Depression. 

Now, while money printing helped to stave off what could have been a devastating recession, all of that extra money, combined with global supply chain bottlenecks, ultimately led to more money chasing too few goods.  Adding insult to injury, as supply chain issues were resolved, households continued to spend at historically high rates while businesses further raised prices on goods and services sold. 

One reason for this is that the pandemic led millions of individuals to retire early or quit the labor force altogether.  And a lack of qualified workers in several key economic sectors ultimately led employers to raise wages to entice individuals to come back to work.  So, combine extra cash available from higher savings (stimulus checks) coupled with higher incomes, and now you have a recipe for higher household spending.

Now, policymakers can’t directly determine how you or I spend our money.  Still, they can influence our spending decisions by introducing economic uncertainties that prompt questions like, "should I save more money because I could lose my job" or by ultimately making it more expensive to purchase big-ticket items like a home or automobile.  This point, arguably, was likely one of the reasons why Fed Chair Jay Powell alluded to the central bank's need to inflict "economic pain" during his comments at the Jackson Hole Symposium back in August.

So far, the economic data suggest that one indicator of consumer spending, retail sales, remains robust.  Even broader gauges of spending, like the government's measure of personal consumption expenditures, show that while slowing recently, spending continues to grow at a steady clip with little sign of abating. 

Now, with all that said, there is hope that the Fed's policies are beginning to have an effect.  That's because the data show that households, after spending through pandemic-era stimulus cash, are seeing their personal savings rates fall to their lowest levels in recent history.  This low level of savings suggests that some individuals are finally achieving the limits of their spending ability. 

Another sign that households are becoming financially tapped out is what's happening in the lending market.  For example, outstanding revolving debt balances, including credit cards, are now back to their highest levels in history.  In fact, in less than two years following the pandemic, consumers charged up nearly $200 billion worth of spending to their credit cards and other revolving lines of credit.  To put this figure into perspective, it took households seven and a half years to charge up the same amount of money to their credit cards in the years following the Great Recession!

Taken together, what the data likely means is that while households are earning more today, their savings are being depleted, leading some individuals to use credit cards to pay for non-essentials as prices rise and, in some cases, to spend beyond their means.  And as the Fed continues to raise rates, higher interest charges will likely make it more difficult for individuals to live off borrowed money, potentially putting a damper on economic consumption in the months ahead.

Expectations need to Fall

Another factor that Fed officials closely watch is expectations.  That's because your and my expectation of where we think inflation is headed often shapes how inflation plays out in the months and years ahead.  Indeed, what we believe about inflation often turns it into a self-fulfilling prophecy. 

For example, suppose you expect the costs of maintaining your household to rise with no end in sight.  In that case, you and your coworkers will demand your employer to give you a raise to cover your cost of living adjustment, or you'll likely seek a new job that pays you more to cover your rising expenses. 

So, how do we measure this sentiment?  Well, several outfits conduct their own surveys to gauge household inflation expectations.  And one of the most prominent surveys comes to us from the University of Michigan, whose latest reading shows that household inflation expectations remain among their highest levels in decades. 

Similarly, if businesses expect costs to continue rising in the years ahead, they'll likely raise their prices now to compensate their workers and pad their margins.  This expectation of higher inflation among business leaders is evident in the Richmond Fed's recent CFO survey.

For example, in its latest print, business leaders indicated that they expect unit costs to rise 9.2% in 2022 and a further 6.7% in 2023.  Adding insult to injury, executives surveyed also predict wage growth to rise another 6.9% in 2023! 

Now, if we measure inflation as the realized price consumers expect pay for goods or services, it's hard not to see how these rising expectations flow through to inflation.  That's why policymakers are keen to make economic conditions so unbearable for individuals and businesses alike, that workers remain grateful for having a job during an economic downturn and business leaders are willing to put their goods and services on sale to entice the next marginal buyer so they can, at the very least, cover their operating expenses. 

Inflation Trends Need to Confirm

Finally, in terms of conditions that policymakers likely will be watching before changing their policy stance in the coming months is actual incoming inflation data.  These data include the headline CPI (consumer price index) and the Fed's preferred measure of inflation, PCE (personal consumption expenditures price index). 

Now, the trouble with using price indices as inputs to direct policy is that they tend to lag behind the mechanisms that drive inflation in the first place.  That's why measures of inflation, like the consumer price index, are best viewed as confirmation that policies have taken effect rather than leading indicators of future household or business activity. 

So, what's the data telling us?  Well, incoming data suggest that Fed policies are having their desired effects on inflation to a certain extent.  Indeed, recent data shows that headline inflation in November fell to 7.1% from its peak of 9.0% earlier in the year.  To put this number into context, however, the current inflation reading is still five percentage points above average and remains well outside the Fed's 2% inflation target.  This current trend means that the Fed still has work to do to get inflation under control. 

And while we've seen food and energy prices begin to ebb to a certain degree, one of the most significant components of inflation is shelter prices, which remain stubbornly high.  In fact, shelter accounts for a full third of CPI.  But, there's hope among some policymakers that the Fed's restrictive policies could take the air out of the overheated housing market and bring overall inflation back down to ground. 

Indeed, recent data show that home prices are now falling but remain elevated from where they were a year ago.  Even so, lender Freddie Mac projects that home price growth will decline on a year-over-year basis next year, and many other economists predict a decline of between 3-4% by year end 2023.  Such price declines could be a welcome development for price inflation overall, but that likely won't be enough to curb the current effects of inflation.

Another critical factor influencing current price levels is what's happening in services inflation.  What is services inflation, you ask?  Services inflation includes the prices we pay for housing (rent), health care, eating out, transportation, and online subscriptions.  While headline CPI has fallen from record levels this year, services inflation in November, on the other hand, marked one of its fastest periods of growth in over three decades. 

And why is this important?  Because as a share of overall consumption, households today spend more on services over goods than they had over forty years ago.  So, while falling headline inflation likely will be perceived by some market participants as a hopeful sign that the Fed could eventually begin easing back on its rate hike policy, what happens with housing and services inflation likely will play a more prominent role in Fed policy decision making in the months ahead. 

It's All About Inflation in 2023

At this point you may be wondering, "what does all this talk about inflation have to do with my financial independence savings?" Well, the simple answer is that the Fed cares about inflation, and the markets care about what the Fed will do next.  Until the Fed stops raising interest rates, investors will likely be challenged to find a direction in this uncertain market, especially as an economic and earnings recession looms large on the horizon.  That's why, for the markets, it's all about inflation in 2023.

To be sure, how and when the Fed ultimately decides to exit this latest rate hike cycle is anyone's guess.  However, there are some guideposts that investors are watching to help provide some indication of the market's next potential move.  And these include household spending, price expectations, and headline inflation reports. 

So far, none of these indicators have fallen to levels that would prompt policymakers to shift gears, which is why market hopes of a "Fed Pivot" in 2022 have fallen flat.  This means that market volatility will likely remain elevated for the foreseeable future.  Indeed, for the first few months of the year, we expect market direction to be biased to the downside until we see evidence that inflation has sharply decelerated or a shock event (like a sudden economic downturn) takes the wind out of inflation's sails.

Until then, our guidance remains unchanged from where it has been in 2022: stay the course.  But as we head into another period of heightened market volatility, here are three things you can do to ensure that your goals stay on the right track. 

First, keep enough cash on hand to help you sleep well at night when the markets go south.  This approach could help you avoid selling securities at inopportune times in the markets. 

Second, stay committed to your disciplined investment strategy and avoid trying to time your way into and out of the markets. History has shown that the best days in the markets typically happen towards the end of a bear market selloff and missing out on those days could cost you. 

Finally, and most importantly, stay focused on the long-term purpose of your money and make grounded financial decisions.  We're more prone to make emotionally based decisions when the future appears uncertain.

When it comes down to it, there's little we can do to control inflation, the Fed's next move, or how the markets will respond.  Ultimately, you can rest assured that your financial plan exists to help you navigate your path to financial independence no matter what's going on in the world around you.

by Peter Donisanu