DAC Market Perspectives: June 2023

Hop, Skip, Jump, or Pirouette…

What Will the Fed Do Next?

After months of contentious negotiations, the global financial markets can finally breathe a collective sigh of relief that Congress and the Biden administration reached an agreement to raise the U.S. government’s $31.4 trillion debt ceiling and avoid a default, which even the most entrenched politicians determined would be bad for both the economy and their political futures. Observing this capricious and often hostile legislative process reminds us of a famously paraphrased quote by American poet John Godfrey Saxe: “Laws, like sausages, cease to inspire respect in proportion as we know how they are made.” We will refrain from making additional comments about the debt ceiling agreement other than to note that both the equity and fixed-income markets reacted positively to the announcement – though it is limited to cuts in non-defense-related discretionary spending, which comprises only about 15% of this year’s $6.4 trillion federal budget.

Thankfully, by avoiding a default on the country’s debt obligations – and a significant disruption to both investor confidence and the global economy – we can now turn our attention to the Federal Reserve’s next move, which by all accounts, is most likely a “pause” rather than a “pivot” the markets had been expecting only one month ago. The reason is inflation, which remains well above the Fed’s 2% target. In fact, it is the persistence of some of these inflationary factors, or their “stickiness,” that we believe the Fed could raise rates once again – even though they chose to skip, as the market expected, an increase at their last policy meeting in June.

The latest inflation data from the Atlanta and St. Louis (FRED) Federal Reserves supports our expectation of a Fed “skip” rather than a permanent pause. Without delving too much into the minutiae of macroeconomic theory, inflation is actually a function of two distinct forces: a longer-term “sticky” inflation component that measures the inflation expectations of consumers and another shorter-term component that measures the amount of slack in the economy. The sticky-price (yes, this is an official inflation measurement) consumer price index (CPI), which is a weighted basket of items that change price relatively slowly, increased 4.1 percent (annualized) in May, following a slightly higher 4.7 percent increase in April. Even more telling, the same “sticky” CPI data showed that inflation increased 6.1 percent year-over-year – well above the Fed’s 2% inflation target. However, the narrative is more positive if we consider the Fed’s shorter-term inflation measurement, the flexible-price CPI. By this measurement, inflation decreased by 4.5 percent (annualized) and declined by 0.2 percent year-over-year – the 1st decline in the flexible-price CPI since March 2020. Therefore, if there is any good news about the number and size of future rate hikes, inflation finally seems to be slowing for goods and services with pricing flexibility.

Adding to the Federal Reserve’s inflation challenges, the U.S. labor market continues to show signs of strength, adding nearly 340,000 jobs in May – well above Wall St. estimates. However, the latest employment data from the Bureau of Labor Statistics (BLS) Household Survey indicates that the U.S. labor market may be finally weakening. The BLS report, released in early June, showed a sharp decrease in the number of employed workers, translating into a corresponding rise in the unemployment rate to 3.7%. Even though unemployment remains low by historical standards, we believe a weakening labor market gives the Fed more flexibility to pause its rate increases – and allow it time to see how its ten rate hikes have impacted inflation and the U.S. economy. Unfortunately, if history is any guide, the more the Fed feels it needs to use its crude but effective monetary policy tools, the greater the likelihood it overshoots its mandate and pushes the economy into a recession.

For now, investors seem to be shrugging off those recession fears – perhaps after looking ahead using an early, rose-colored version of Apple’s recently announced Vision Pro™ mixed-reality headset. And while it may not feel like it to most investors, it may be time to celebrate. Recent gains have put the S&P 500 into “official” bull market territory – more than 20% above its October 2022 lows. Even more impressive, the technology-heavy Nasdaq index is up more than 30% from the lows it reached last December. Perhaps every cloud does have a silver lining.

Whether the current market rally continues will depend on the Fed’s ability to navigate a challenging course on inflation and the pressing need to replenish the U.S. Treasury’s Trillion-dollar General Account (TGA), which is the account at the New York Federal Reserve from which the Treasury pays the country’s bills. Secretary Yellen recently admitted that because of the extraordinary measures Treasury had taken during the debt ceiling crisis, the agency’s TGA account had been depleted to dangerously low levels. She further stressed that the account must be replenished as soon as possible. As a result, the U.S. Treasury will sell hundreds of billions – some estimate it will be over $1 Trillion – in new U.S. Treasury T-bills, which will absorb liquidity (i.e. dollars) from the U.S. banking system and, by extension, the U.S. economy. Because of the large scale of these bond sales, there is an active debate on how this could impact the U.S. banking system and the broader economy. However, even in the most benign scenario, the Treasury’s actions will lead to higher short-term interest rates and reduced liquidity within the U.S. banking system. If we could ask the current Fed Board members one question, it would be how many times they think the Fed can tighten monetary policy before overshooting their mandate or, as some past Fed Boards have done, break something. This is especially true at a time when many smaller financial institutions and the commercial real estate market remain under stress. With Silicon Valley and Signature banks a recent memory, what could possibly go wrong? We sincerely hope the Fed is listening.

Therefore, as we all enjoy this market rally and hope it continues, there are reasons to be both cautious and optimistic at the same time. In the near term, despite recent data showing that inflation is slowing, if the Fed remains focused on its 2% inflation target, we expect interest rates will remain higher for longer, raising the potential risk of a slowdown in the U.S. economy. Yet even if we assume the most pessimistic economic forecasts into our investment outlook, we believe any future recession would be mild by historical standards – if one even occurs at all. This could be why, since the start of the year, investors have continued to shrug off several Fed rate increases, a debt ceiling crisis, and a string of banking failures to remain focused on the long-term investment opportunities in the U.S. economy. We would add our optimistic outlook to those on that list.

Since its founding 20 years ago, DAC’s investment philosophy has focused exclusively on quality companies with solid and consistent dividend growth. Perhaps this is why, whether it was during the Global Financial Crisis of 2008 and 09, or the more recent COVID pandemic in 2020, our investment portfolios continued to deliver an ever-increasing stream of cash flow to our clients in the form of rising dividends.

So regardless of whether the Fed decides to hop, skip, jump, or pirouette in the coming months, our focus remains unchanged: providing our clients with the solid cash flow they need to fund their retirement and other important life goals. Because, at the end of the day, isn’t that what investing is all about?

Best,
Marc

Marc D. Saurborn, CFA® | Chief Investment Officer
T 843-645-9700 x239 | F 843-645-9701 | msaurborn@dacapitalsc.com

References:

1. https://newenglandhistoricalsociety.com/whimsical-world-johngodfrey-saxe/
2. https://www.wsj.com/articles/senators-seek-to-fast-track-debtceiling-vote.
3. https://stlouisfed.shinyapps.io/macro-snapshot/#
4. https://www.atlantafed.org/research/inflationproject/stickyprice/
5. https://www.wsj.com/articles/may-jobs-report-unemployment-rateeconomy-growth-2023
6. https://www.forbes.com/sites/simonmoore/2023/06/01/what-thefed-will-be-looking-for-in-junes-cpi-report
7. https://www.atlantafed.org/research/inflationproject/stickyprice/Are
   Some Prices in the CPI More Forward Looking than Others? We Think
   So.
8. https://www.bls.gov
9. https://www.politico.com/news/2023/06/12/fed-rate-hikes-pause00101349