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February Newsletter

Feb 27, 2024

U.S. ECONOMIC OUTLOOK: The Potential for a “No Landing” Scenario

As we progress into 2024, the U.S. economy presents a unique picture, diverging from the widely anticipated “soft landing.” Instead, we’re observing what might be termed a “no landing” phase. A “no landing” scenario refers to a situation where the economy avoids both a hard landing (a sharp slowdown or recession triggered by tight monetary policy) and a soft landing (a gradual slowdown to stable growth), but instead continuing to grow without significant interruption, despite expectations of a slowdown or downturn. This scenario challenges conventional economic forecasts by sustaining above-trend growth and inflation, defying the anticipated effects of tightening monetary policy. This current trend has implications for inflation, Federal Reserve (Fed) policies, and investment strategies.

The resilience of the U.S. economy can be attributed to several factors that have reduced its sensitivity to interest rate changes. These include strong household balance sheets, considerable savings, and robust corporate profitability, all of which have underpinned positive employment trends. These elements have led to a scenario where economic growth and inflation have consistently outpaced the expectations based on previous decades’ trends, which were mistakenly labeled as “transitory.”

Despite a tightening in monetary and financial conditions last fall, the economy was not heading towards a recession. However, recent months have seen a notable easing in monetary conditions, thanks to lower bond yields (chart right), adjusted interest rate expectations, and improved conditions in corporate bonds and mortgages. This liquidity, mirrored across major asset classes, suggests a continuation of above-trend economic growth, a viewpoint supported by recent economic data.

· The Dallas Fed’s Weekly Economic Index, points to a reacceleration of the U.S. economy. Corporate executives, while cautious in forecasts, report positive current business operations, a sentiment echoed in the Business Activity Index of the ISM Non-Manufacturing survey and improvements in the service sector confidence and the ISM Manufacturing survey.

· On the employment front, the U.S. job market remains strong (chart right), contradicting more pessimistic market narratives. Recent job reports, along with wage growth, underscore the ongoing strength and tightness of the labor market, with companies still eager to hire and increase wages.

· Consumer sentiment mirrors this trend, with current conditions and job prospects driving spending,       despite a more pessimistic future outlook. This is reflected in the strengthening of consumer confidence indicators and retail sales indices.

· The housing market, has shown signs of resilience, with increasing housing permits and homebuilders’ confidence. This sector’s recovery, despite being sensitive to interest rates, adds another layer of complexity to the economic landscape.

However, this “no landing” scenario poses challenges for the Fed’s dovish stance and for bond investors, implying that inflation may remain more persistent than anticipated, limiting the scope for interest rate cuts. The Fed’s approach, focusing on easing despite potential inflation due to strong economic demand, might lead to a policy misstep.

In summary, the U.S. economic landscape is suggesting continued growth, with inflationary pressures warranting close monitoring. As the year progresses, the bond market’s expectations for deep rate cuts may need to be recalibrated, potentially leading to a sustained environment of higher bond yields. “Higher for longer” is still a possibility.

STICKY INFLATION: IS 4% THE NEW 2%?

 A significant shift is emerging, challenging the long-held Federal Reserve and global central banks’ inflation targets. The long-held policy goal of a 2% inflation rate, now appears increasingly elusive. Instead, a narrative is unfolding where 4% inflation could become the new norm, a development with profound implications for investors, policymakers, and the broader economic landscape.

The Federal Reserve, alongside global central banks, finds itself at a crossroads, with the potential for yet another policy pivot. The anticipation of inflation reverting to the 2% target is fading into the background, overshadowed by the reality of persistent, ‘sticky’ inflation (chart next page). This shift is underscored by continued U.S. economic growth and improving economic conditions, complicating the Fed’s trajectory towards easing monetary policy beyond a nominal rate cut or two this year.

The reassessment of inflation expectations places direct pressure on government bond markets, which remain vulnerable to a significant unwinding of rate cut forecasts. With bonds on downgrade alert, this environment suggests a reevaluation of bond strategies, with an eye towards navigating the impending volatility as economic realities recalibrate interest rate expectations. We have continued to favor bonds on the shorter-end of the yield curve as they have less interest rate risk than longer term bonds.

UNPACKING INFLATION TRENDS

Inflation, often referred to as the economy’s thermometer, continues to be a key financial narrative in 2024. Its pervasive influence on purchasing power, investment returns, and overall economic health makes understanding its nuances crucial for investors.

The distinction between “core” and “headline” inflation becomes significant here. Core inflation, which excludes the volatile food and energy categories, offers a clearer picture of the underlying inflationary pressures within the economy. Observing this measure, investors can gauge more persistent trends that may influence the Federal Reserve’s policy decisions.

The resurgence of inflation has sparked debates among economists and policymakers about its longevity and impact. Factors contributing to this scenario include increased consumer spending (chart right) fueled by pent-up savings and government stimulus, alongside supply bottlenecks that have not yet fully resolved.

Inflation’s resurgence has far-reaching implications for investment portfolios. Traditional fixed-income investments become less attractive as inflation erodes real returns, pushing investors to reconsider their asset allocation strategies.

Equity markets may respond variably as sectors with fixed income streams, like real estate and utilities, might face valuation pressures under rising interest rates. Considering assets that provide a hedge against rising prices, investors can navigate this uncertain environment with confidence.

FINAL THOUGHTS

We remain committed to providing you with the insights and guidance needed to navigate these complex times. Your trust in us is invaluable, and we look forward to continuing to support your financial goals and aspirations.