Highlights:
· A resilient labor market continues to keep the widely predicted U.S. recession at bay, but small cracks are starting to emerge.
· The European Central Bank cut its benchmark rate during the quarter, bucking the trend that has seen it lag the actions of the Federal Reserve.
· We are not able to predict the future direction of inflation or interest rates, but are confident that equities remain the best investment to beat inflation over the long-term.
Commentary:
“Invest in preparedness, not in prediction.”
-Nassim Taleb, Author and Scholar
The second quarter of 2024 showed that there is still work to be done to get the proverbial inflation tiger back in its cage as inflation proved to be stickier than reports from 2023 had led investors to believe. Nevertheless, the recession predicted by business executives, economists, and investors, continues to refuse to show up. Steady hiring and rising wages continue to fuel consumer spending in the face of higher borrowing costs and persistent inflation, which has resulted in an economic expansion unlike any the U.S. has ever seen.
Through May, the unemployment rate stayed at or below 4% for 30 straight months, something that most working-age Americans have never experienced because it last occurred during the Vietnam War in the late 1960s and the Korean War in the early 1950s. However, the Labor Department’s June report showed the unemployment rate ticking up to 4.1% for the first time since 2021, with average hourly earnings showing their smallest year-over-year gain since 2021. In addition, companies are posting fewer job openings and employees are quitting less. A cooling of the labor market could help temper inflation and allow the Federal Reserve (Fed) to lower interest rates. The tricky part is not allowing too much weakness in the labor market, which coupled with consumer spending, is the bedrock of the U.S. economy.
Just because those who predicted a recession have been wrong to this point does not mean that they will not be proven correct eventually. Though the unemployment rate remains historically low, it has risen by 0.7% from its post-pandemic low of 3.4% in April 2023. Furthermore, the rate at which companies hire workers has fallen to levels last seen seven years ago, and job vacancies have returned to pre-pandemic levels. There is a good chance that the unemployment rate will continue to tick upwards if job vacancies fall much lower.
Investors entered 2024 believing that the central bank might lower interest rates up to six times, but data in the ensuing months showed persistent price pressures. Although inflation has slowed the last few months and, in fact, May’s year-over-year core personal consumption expenditures price index figure was the lowest reading since March 2021, the Fed is not expected to begin cutting rates at its July meeting. In a testimony prepared for a Senate hearing, Fed Chair Jerome Powell did however hint at a possible rate cut before the end of the year as he expressed satisfaction with the progress on both the inflation and labor market fronts:
“Elevated inflation is not the only risk we face. Reducing policy restraint too late or too little could unduly weaken economic activity and employment...More good data would strengthen our confidence that inflation is moving sustainably toward 2%...The likely direction does seem to be as we make more progress in inflation and as the labor market remains strong, we begin to loosen policy at the right moment…[The labor market] appears to be fully back in balance [and recent data send] a pretty clear signal that labor market conditions have cooled considerably.”
While the U.S. economy has proven resilient despite the sharp interest-rate increases of the past two years, Europe’s economy has largely stalled since late 2022. This was likely a driver behind the European Central Bank’s (ECB) decision to lower interest rates by a quarter point during the quarter, its first cut in almost five years. The rate cut sent a signal that relief is on the way for consumers, indebted governments, and businesses that have reduced spending in the face of high borrowing costs.
The ECB’s rate-setting committee emphasized that future interest rate decisions will be based on incoming economic data and that it “is not pre-committing to a particular rate path.” ECB President Christine Lagarde added that while inflation had come down, wage growth remains elevated and inflation is likely to stay above its 2% target “well into next year.” She also said, “There’s a strong likelihood” that the ECB will continue to cut rates in the months ahead but “what is very uncertain is the speed of travel and the time it will take.”
The ECB’s rate cut also bucked the trend that has historically seen the ECB lag the actions of the Fed, which is not expected to lower rates for at least a couple more months. This potentially put the ECB and Fed on different tracks and widens the existing gap in borrowing costs between the U.S. and Europe. This could boost Europe’s growth in the short term, but would risk reducing the Euro’s strength against the dollar, pushing the cost of imports up, and lifting the eurozone’s inflation higher.
The Bank of England (BoE) kept its main interest rate unchanged at a 16-year high of 5.25% despite official figures showing the country’s inflation was back at its 2% target for the first time since July 2021. On the decision to hold rates steady for the time being, BoE Governor Andrew Bailey commented, “we need to be sure that inflation will stay low and that’s why we’ve decided to hold rates at 5.25% for now.”
A surge in China’s exports has alarmed leaders in both the U.S. and Europe, who blame the country’s excessive manufacturing subsidies and bloated industrial capacity. The biggest factor, however, may be the devaluation of China’s currency. China’s real effective exchange rate, which adjusts for differences in inflation between China and its major trading partners, is back to where it was in 2014. This is boosting China’s overseas sales at the expense of other exporting nations. Therefore, while China may be flirting with deflation, which most economists advise avoiding at all costs because it weighs on spending and makes debts harder to tolerate, it has a hidden benefit in that it makes Chinese exports more competitive on world markets, especially when inflation remains high in the U.S. and other parts of the world.
The future direction of interest rates, along with the AI narrative, continue to factor heavily into the short-term movements of the equity markets. At this point, it is anyone’s guess where interest rates are headed next. Arguments can be made in favor of both a return to pre-pandemic levels and a higher-for-longer outcome. Likewise, despite the bold proclamations you will continue to hear from “experts”, no one really has any idea where markets are headed and arguments can be made in favor of both the markets crashing and compounding at reasonable rates of return over the next several years. Albert Einstein once said, “The only thing you can count on in life is uncertainty.” This uncertainty underscores the importance of refraining from attempting to time markets and to adhere to your investment policy, which is designed with an acceptance of uncertainty and volatility, and emphasizes an asset allocation based on comprehensive cash flow planning and diversification.
Likewise, we have no idea how inflation plays out from here, but we are confident in saying that equities remain the best investment to beat it over the long term. We are also confident in saying that trying to time the top of a bull market remains a value-losing proposition over the long-term for almost all investors. Consider that the four worst times to buy equities over the last four decades were in September 1987 before the Black Monday crash, March 2000 before the bursting of the dot-com bubble, October 2007 before the Great Recession, and February 2020 before the Covid-19 pandemic. Yet, even if you had invested at each of these junctures, equities have still outperformed bonds and inflation since each entry point. This supports the core tenet of our investment policy that time in the market, and not timing the market, is the best way for investors to benefit from the long-term potential of equities to add a return premium vis-à-vis cash and fixed income investments.
Urban Financial Advisory Corporation – July 2024
Disclaimer:
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