By Avi Deutsch
December 7, 2023 – Occasionally, economic periods coincide with the annual rhythm of life, and this December appears to mark one of those instances. A feeling of transition is in the air, marked by cooling inflation, a loosening labor market, and the expectation that the Fed is done raising interest rates.
While it may be too soon to declare a successful soft landing, the gradual pullbacks of both consumer and business spending suggest that inflation has been brought under control without sending the US economy into a deep recession. With this, the eyes of Wall Street, and perhaps Main Street, turn towards the future. For many investors, that future holds interest rate cuts as soon as March.
I’ve been asked many times in the past weeks what would prompt the Fed to begin lowering rates. After nearly two years of being in the shadow of inflation, many expected a more resolute ending instead of a whimper. Like Covid, macro events rarely have a clear ending, and instead are made up of a messy array of smaller signals, in this case economic indicators, that herald a change that’s only obvious in retrospect. Still, lower rates are finally on the horizon.
Two interest rate pathways appear likely from here. In the first, the economy continues to gradually slow, and the Fed starts to gently lower rates. Most economists believe today’s rates are restrictive, meaning the Fed has its foot on the brakes and is actively slowing down the economy. If this is indeed the case, the Fed will want to start lowering rates before the car comes to a screeching halt and GDP growth turns negative. For more on what interest rates might look like in this scenario, take a look at my article on natural interest rates.
The second scenario is one in which an unexcepted event turns a mild slowdown into a deep one, forcing the Fed to take immediate action and lower rates dramatically to a point where they are stimulating the economy. Historically, this is how most interest rate cuts play out. There are no obvious contenders for what this event might be, but global macroeconomic conditions continue to loom, with Europe and China’s economies continuing to struggle, and the conflicts in Gaza and Ukraine risk larger conflagrations.
A third increasingly less likely but not to be ignored scenario is that cooling inflation turns out to be a head fake. While small deviations from a downward trend could be acceptable, any sign of rising inflation amid an economic slowdown would put the Fed in a difficult position. The cooling labor market and decreasing commodity prices make this scenario unlikely, but vigilance is warranted.
There’s no better sign of the optimism prevailing among investors than the equity markets. The S&P 500 returned 9.1% in November, driven both by the economic headlines, and by earning reports suggesting that companies’ profits grew year-over-year for the first time since the fourth quarter of 2022. If true, this would mark the end of what investors call an earning recession, and another sign of a new period in the markets. The bond markets also performed well in November, as expectations of lower future rates brought the entire yield curve down (recall that bond prices go up when rates come down).
For the time being, the optimism in the markets appears grounded in the data. Still, sentiment is fickle, and things could look different in the new year. Stay tuned for more on the state of the markets and expectations for 2024 in my January newsletter.
With hope for a year of peace and prosperity, I wish you all happy holidays and a happy new year.
— AMD
Source: Robertson Stephens Investment Office
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