Throw Inflation in the Backseat

I’ve always thought of my pickup as a utility vehicle. Something to tow with, off-road with, fill with other people’s things when they’re moving and generally provide service to the family. I have a three-year old GMC and recently received a sales note from the dealership where it was acquired. They are excited to offer me a new truck, same model that I own for $23,000 more than I paid three years ago! That’s more than a 30% mark-up. Should a utility vehicle be a $100k investment? Not sure. I’ll date myself a bit, but my first house, a three-story Victorian on the East side of Milwaukee was “only” $125k.

This represents a problem for consumers, the Federal Reserve and investors. While inflation has come down, today running closer to 3.5% rather than the 9% high of a year ago, we’re still left with the high prices that stem from the post-pandemic increases we’ve seen over the last two years.

The Federal Reserve’s changing policy

To slow the economy, which really means reducing demand for goods and services, the Fed has raised interest rates by more than 5%. This is good news for investors who can now earn more than 5% on their cash balances and bond investments, though not good news for individual and corporate borrowers who are faced with a higher cost of capital.

The problem for the Fed is that the economy hasn’t slowed. The Federal Reserve Bank of Atlanta’s “GDPNow” forecast for economic growth is 5.8% for the third quarter. That doesn’t sound like any slowing; in fact, as you can see from the green line in the chart below, it is accelerating. It is also well above the consensus forecast.

This isn’t great news if you’re the Fed. The purpose of those higher interest rates is to slow things down, and with this growth forecast and unemployment still near 3.5%, we haven’t seen much slowing.

This suggests that these higher interest rates could be with us for longer. Longer than what is currently anticipated by the market? … that’s key the question. While the futures market shows little probability of another rate hike this year, it does suggest rates will begin to move down in 2024. Perhaps, that is somewhat optimistic. Or, are there other factors being eyed by bond investors that tell them the economy and labor picture will change?

Slower growth?

There are several factors that could lead to slower growth and possibly a recession in the next 12 months. The most important is monetary policy (the Fed’s work around interest rates and its balance sheet). Higher interest rates have yet to bite hard across the economy because of the stimulus undertaken by the Biden and Trump administrations. In the last six years, the Federal government and Fed have spent almost $10 trillion. As you can see from this chart though, that excess stimulus that went into people’s savings accounts is running out.

These savings have buoyed consumerism, however, as many large retailers have reported their earnings in the last two weeks (e.g., Walmart, Target, Lowe’s), they’ve guided future revenue growth down as they see the spending boom slowing dramatically. We’re also starting to see auto loan and credit card delinquencies increase, suggesting a tougher road ahead for consumers.

If the labor market softens as these funds wind down, the consumer will have a tough time carrying economic growth in 2024. As you can see from the chart below, unemployment claims have been rising since the fall of last year.

Our position

As a result of our view that risks remain high for both a slower economy and a higher interest rate environment for a longer period of time, we remain somewhat defensive in our investment positioning. We are extending our bond portfolios’ average maturity to take advantage of these higher interest rates, while remaining focused on better credit quality. Our stock portfolio positioning will emphasize value over growth. We believe it is too early to add to defensive names.

As for me, I’m sticking with my old truck for the foreseeable future—an example of why inflation can (and does) have a lasting impact on consumer decisions.