One More Reason to be Thankful This Thanksgiving: The Fed May Be Finished Raising Rates

As we all look forward to celebrating Thanksgiving with family and friends this week, we would add one more reason to give thanks this year – The Fed may finally be finished raising interest rates.

This may come as a shock to many investors who, earlier this year, had been expecting a sharp deceleration in the U.S. economy in 2023 – with several notable economists predicting the dreaded “R” word, recession. Even more surprising has been the latest GDP data, which showed that the U.S. economy grew at an annualized rate of 4.9% in the third quarter – a “blowout” number in absolute and historical terms. Despite active conflicts in both Eastern Europe and the Middle East, another narrowly averted government shutdown, and eleven, yes eleven, Fed rate increases, the juggernaut known as the U.S. economy seems hardly impacted. Unfortunately, the picture is not nearly as rosy as we look forward to the fourth quarter, and from an inflation perspective, that might be a good thing. The latest forecast by the Atlanta Fed’s GDPNow economic model suggests that Q4 GDP is tracking at a slower pace of 2.2%. Still solid, but a sharp decline from the better-than-expected results in the third quarter.

On the surface, it is starting to look like the Fed has a better-thanaverage chance of engineering the most challenging and elusive of monetary policy outcomes – a soft landing. Therefore, despite Federal Reserve Chairman Jay Powell’s recent hawkish commentary that the Fed is “not confident” interest rates are sufficiently high enough to reduce inflation to its 2% target, the latest data on consumer prices would indicate otherwise. In fact, the most recent Consumer Price Index (CPI) data released by the U.S. Bureau of Labor Statistics, which measures the price of a broad basket of goods and services, was flat, or 0%, for the month of October and the same data showed that inflation had decelerated to “only” 3.2% from a year ago. However, core CPI, which the Fed watches more closely because it excludes volatile food and energy prices, seemed to get the most attention. Both investors and market pundits alike were excited by the less-than-expected 0.2% month-over-month and 4.0% core annual inflation rate for October, which even though it remains well above the Fed’s 2% long-term inflation target, is still the lowest year-over-year reading in over two years.

So why have investors suddenly become more optimistic despite clear signs that the U.S. economy is slowing? Because they, as we believe should all investors, are anticipating what is likely to occur in the future. When financial markets are most efficient, they tend to discount nearterm news quickly while simultaneously looking forward to predicting what is most likely to happen in the future. This is why, since business cycles were first measured, financial markets have always bottomed and started their recoveries well in advance of any positive economic data. This time, however, the Fed didn’t make it easy for themselves. After its initially slow response to increases in core CPI data as “transitory,” the Fed finally seems to be making progress toward achieving its goal. This is why, as the current inflation data continues to trend lower, many believe the Fed may be at or near the end of its rate-tightening cycle. On this point, we would agree with the market’s current optimism – the Fed is likely finished raising interest rates.

Unfortunately, as Fed Chairman Jay Powell warned during his keynote speech at the Jackson Hole Economic Symposium in August of 2022, even if the Fed pauses at this “higher for longer” level, their prior rate actions will cause “some pain” for the economy. To that end, we expect U.S. consumers, particularly those at the lower end of the economic spectrum, will continue feeling the pinch from inflation and higher interest rates. This financial strain is just starting to show up in the economic data in the form of rising default rates for credit cards, auto loans, and even student debt. More troubling is that because higher prices have forced many Americans to rely on their credit cards to make ends meet, the average American now has more than $7,900 in debt. With the average APR on those cards now at over 20%, according to data from the Federal Reserve Bank of St. Louis, this could impact consumers’ ability to pay down their current credit balances. Combining this with a recent CNBC survey that found that 61% of Americans live paycheck to paycheck, at the very least, we expect this could certainly restrict their future spending behavior.

This is why we believe the Fed will tread more cautiously when balancing its dual mandate between full employment and price stability. Historically, the Fed has continued to raise rates “until something breaks.” But the current Board of Fed Governors has stated repeatedly they are willing to be patient – provided that the inflation data, as it is now, is trending in the right direction. With that part of their mandate covered, they can now focus on employment, which has started to see weakness in some areas. In fact, according to the latest unemployment report by the U.S. Department of Labor (DOL), there were 231,000 new unemployment claims last week, an increase of 13,000 from the prior week and more than triple what forecasters had expected. Even though unemployment claims remain relatively low, this trend could signal that the labor market is finally tightening, which would further strain consumer spending and the U.S. economy. Again, this is yet another reason we believe the Fed is done raising rates if they hope to have any chance of achieving a soft landing.

Given all of the current challenges facing U.S. businesses and consumers, why do we remain so confident about the equity markets heading into 2024, which, did I mention, is likely to be a highly contentious election year? The reason is the result of our disciplined investment process – one that focuses exclusively on companies that pay a growing stream of dividends from their ever-increasing levels of cash flow. While there’s a chance the U.S. economy will enter a mild recession in 2024 or slow to a level that feels that way, we see a clear path to a future recovery as we anticipate the Fed will begin to cut interest rates next year. However, having learned their lesson after COVID, we expect the Fed and other global monetary governing bodies will resist the urge to return to a period of “free money” as they did after the Global Financial Crisis. In this new environment, one in which all investors – equity and fixed income alike – will demand higher returns on their capital, companies that demonstrate strong cash flows and prioritize returning value to shareholders will become the leaders of the next market cycle.

Fortunately, because of DAC’s focus on dividend growth investing, we are well prepared to take advantage of this future market expansion for the benefit of our clients. This is also why we remained confident earlier this year when so many of our financial advisory peers were calling for a deep recession and predicting steep market declines and invested their clients’ portfolios based on a misguided belief in their ability to time the markets. Now that the Fed appears to be gaining control of inflation and its current ‘pause’ becomes an ‘end to’ and eventually a cut, we continue to add companies to our clients’ investment portfolios that can deliver superior long-term returns while providing rising dividends – regardless of market timing. For that, we believe we should all be thankful for this Thanksgiving

Happy Thanksgiving!

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

References:

  1. https://www.msn.com/en-us/money/markets/jerome-powells-fed-speech-today-brought-interestrate-commentary-and-a-hot-mic-moment.
  2. https://www.bls.gov/cpi/
  3. https://www.atlantafed.org/cqer/research/gdpnow
  4. https://www.bea.gov/data/gdp/gross-domestic-product
  5. https://www.reuters.com/markets/us/feds-waller-calls-q3-us-gdp-growth-blowout-number-thatwarrants-watching-2023-11-07
  6. https://www.atlantafed.org/cqer/research/gdpnow
  7. https://www.cnn.com/2022/08/26/economy/federal-reserve-jerome-powell-jackson-hole2022/index.html
  8. https://www.foxbusiness.com/personal-finance/fed-rate-pause-credit-card-debt
  9. https://www.cnbc.com/2023/11/20/60percent-of-americans-live-paycheck-to-paycheck-before-theholidays-study.html
  10. https://seekingalpha.com/news/3799294-billionaire-jeff-gundlach-fed-will-keep-raising-rates-untilsomething-breaks
  11. https://www.investopedia.com/jobless-claims-spike-is-unemployment-rising-for-real-this-time8403470

Disclosures:

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