Celebrating 17 Years of Service

May Newsletter

May 31, 2024

FEDERAL RESERVE – RATES UNCHANGED

In its May 1st meeting, the Federal Reserve decided to keep the federal funds rate unchanged at 5.25% – 5.50%. Given the mixed signals from recent economic data, this decision was anticipated. The Fed’s statement emphasized the need for greater confidence that inflation is moving sustainably toward the 2% target before considering rate cuts.

Federal Reserve Chair Jerome Powell highlighted that while a rate hike is unlikely in the near term, the Fed remains committed to its ‘higher for longer’ stance to combat persistent inflation. This cautious approach underscores the Fed’s balancing act between controlling inflation and supporting economic growth.

The Fed Minutes

The minutes from the recent Federal Reserve meeting provided further insights into the central bank’s thinking. The key takeaway from the minutes was the Fed’s continued focus on inflation control. Several members expressed concern about the persistence of inflationary pressures and the risk of inflation expectations becoming unanchored. There was a general consensus that maintaining a restrictive monetary policy stance was necessary to ensure inflation moves back towards the 2% target.

The minutes also revealed discussions about the potential impact of higher interest rates on economic growth and employment. While there was recognition of the risks, the prevailing view was that the benefits of controlling inflation outweighed the potential costs. The Fed’s data-dependent approach means that future rate decisions will be closely tied to incoming economic data,  particularly inflation and labor market indicators.

ECONOMIC INDICATORS – MIXED SIGNALS

Recent economic data presents a complex picture. Inflation remains high, with the Consumer Price Index (CPI) rising 0.4% month-over-month and 3.5% year-over-year in March, and the Producer Price Index (PPI) up 0.5% in April. These persistent inflation figures reinforce the Fed’s decision to maintain higher interest rates for a longer period.

The labor market shows strength with solid job gains, but slower wage growth and reduced hours worked indicate potential cooling. The April employment data showed payrolls increasing by 175,000, which was below the consensus estimate of 240,000 but viewed positively by markets as it indicated a potential easing in labor market tightness.

The Atlanta Fed’s GDP Now model forecasts a 3.3% annualized growth rate for Q2, above the long-term average. However, ISM manufacturing indexes signal contraction, reflecting ongoing uncertainty in the economic outlook.

INFLATION     

Persistent inflation challenges the Fed’s ability to cut rates in 2024, underscoring the need to understand its drivers. Energy and housing costs, particularly rental inflation, continue to drive prices up, with core inflation excluding food and energy also rising.

Energy prices have been a significant contributor to recent inflation trends. In April, energy prices rose by 1.1%, contributing to the overall increase in the CPI. While energy prices can be volatile, their upward trend reflects supply constraints and geopolitical tensions.

Housing costs, particularly rental inflation, have also been a significant driver of inflation. In April, rental prices increased by 0.4%, continuing a trend of strong growth over the past year. Housing makes up a substantial portion of the CPI, and persistent increases in rental costs suggest that inflationary pressures in the housing market are not abating.

Core inflation, which excludes food and energy, rose by 0.3% in April and is up 3.6% from a year ago. This measure provides a clearer picture of underlying inflation trends, as it excludes the most volatile components.

The persistence of core inflation above the Fed’s target underscores the challenge of bringing overall inflation back to 2%. The persistent inflation data implies that the Fed may need to maintain its higher interest rate policy for longer than previously anticipated. Higher interest rates can help cool demand by making borrowing more expensive, thereby reducing spending and investment. However, this also risks slowing economic growth and potentially leading to higher unemployment.

EARNINGS SEASON HIGHLIGHTS

Q1 2024 earnings were generally positive, with an 8% growth rate exceeding expectations. At the sector level, seven of the eleven sectors witnessed an increase in their EPS estimates for Q2 2024 from, led by the Energy (+8.6%) sector. Four sectors recorded a decrease in their bottom-up EPS estimate for Q2 2024 during this period, led by the Industrials (-2.6%) sector. Technology, healthcare, and consumer staples sectors had the widest breadth of companies that exceeded earnings estimates. Healthcare also had the second-highest beat rate for  revenues.

The utilities sector also had the highest percentage of companies missing revenue estimates. The poor earnings performance of utilities contrasts with the sector’s recent outperformance, driven by bullish narratives about increased electricity demand from A.I.-driven data center growth. The low earnings beat rate of utilities is a reminder that the sector’s earnings are prone to disappoint given the difficulty in forecasting regulatory decisions and legal expenses, as well as electricity and natural gas prices.

Overall, the positive earnings growth across   various sectors underscores the resilience of the corporate earnings despite economic challenges.

Earnings Have Remained Positive
 * Smoothed; source: Refinitiv I/B/E/S Global Aggregates
** Source: Federal Reserve Bank of St. Louis

ARE WE IN A GOLDILOCKS SCENARIO?

The concept of a “Goldilocks” economy—one that is not too hot and not too cold—has re-emerged in recent discussions. This scenario is characterized by moderate economic growth, low inflation, and accommodative monetary policy. While the current economic environment presents challenges, there are signs that we may be heading toward a more balanced growth trajectory.

Key Indicators of a Goldilocks Economy

· Strong labor market. Despite slower job growth in April, the labor market remains robust with positive real wage growth and healthy household balance sheets. The low savings rate is not a significant concern, given the substantial savings accumulated by households during the pandemic.

· Resilient consumer spending supported by strong balance sheets and low debt servicing costs. The depletion of pandemic-era excess savings is not seen as a significant risk, as households continue to have a robust savings buffer.

· Global economic prospects are gradually brightening after a sluggish 2023. Inflation is less of a threat outside of the U.S., and economic growth is expected to level off above pre-2020 levels in most developed economies. This positive global outlook, combined with the U.S. economic resilience, supports the idea of a return to a Goldilocks economy.

Challenges and Opportunities

While a Goldilocks economy is appealing, it is essential to recognize the challenges and risks, including persistent inflation and the Fed’s higher for longer interest rate policy potentially weighing on economic growth. Additionally, global supply chain disruptions and geopolitical tensions pose risks to the economic outlook.

However, the positive earnings growth and resilient labor market provide a strong foundation for continued economic expansion. The key for investors is to navigate these challenges strategically, focusing on sectors and companies with strong fundamentals and growth potential.

FINAL THOUGHTS

The current financial landscape presents a mix of challenges and opportunities. While inflation remains a concern, positive earnings growth and a resilient labor market support the outlook for   continued economic expansion. The concept of a Goldilocks economy offers hope for a balanced growth trajectory, but it is crucial to navigate the uncertainties with a strategic approach.

At Pacific Coast Investment Advisors, we remain committed to providing you with the insights and strategies needed to make informed investment decisions. As always, we are here to help you navigate the complexities of the financial markets and achieve your financial goals.