The first half of the year was rough on investors, with the S&P 500 Index off to its worst start to a new year since 1970. Bonds also fared badly as inflationary pressures provoked a strong policy adjustment by the Federal Reserve. We are now mid-way into a series of interest rate hikes that are designed to slow economic activity and stabilize prices. We are keeping an eye on three main topics – inflation, corporate profits and employment. Progress in these areas will determine the length and depth of a recession that now seems priced into the economic forecast. 

Inflation registered at 8.6 percent in the most recent report, with food and energy costs rising at an even faster clip. The Federal Reserve is now in an all-out battle to stabilize prices, and Fed Chairman Jerome Powell has made clear a willingness to put the economy through a recession if that is necessary to calm inflationary pressures. It is widely expected that the Federal Open Market Committee (FOMC) will raise interest rates again at the meeting scheduled for later this month. Further actions at the September, November and December meetings will depend primarily upon how consumer spending reacts to higher rates on mortgages and other consumer loans. Yields on 10-year Treasury securities now top three percent, and mortgage rates have roughly doubled to nearly six percent. By making money more expensive, the Fed expects consumer spending to ease, which should bring inflation figures back down in the second half of this year. There is evidence consumers are already turning cautious. According to the University of Michigan survey, consumer sentiment plunged in June to the lowest number ever recorded, and 79 percent of consumers are bracing for tougher conditions in the upcoming year. Inflation is their top concern.

Companies report profits on a quarterly basis, typically in the first couple weeks following each quarter-end. Those reports have generally been strong this year. While there are anecdotes of companies experiencing rising inventories and margin pressures from wages and material costs, Wall Street analysts currently forecast profits generated by companies that comprise the S&P 500 Index will grow by 9.6 percent over last year’s figures. We are concerned those estimates could be a bit optimistic, and companies may guide those numbers lower in the upcoming weeks. Profits are an important part of the equation, because hiring plans and dividend payments to shareholders are based upon management expectations for the trajectory of their company earnings.

Perhaps the best indicator that our economy can weather a rough patch comes from employment. People with jobs can pay their bills, and the economy continues to generate a robust employment environment. The official unemployment rate is currently very low at 3.6 percent, and the latest monthly report indicated 399,000 additional jobs were created. Employment is a critical factor, and we need to see those figures remain on track. Some technology companies have recently announced hiring freezes. A short recession is unlikely to derail most company plans to hire and compensate their employees, but the Fed needs to act quickly to tackle inflation so that companies maintain growth plans for 2023 that are good for workers. 

These recent years have been difficult. Markets performed better than expected in 2020 and 2021, given the enormity of the economic challenges of a shutdown and reopening. It seems to have caught up to us this year, with inflation spiking and the Fed taking drastic actions to reign in money supply. From a timing perspective, we believe it is likely to take a few more months to sort out the trends for inflation, interest rates, corporate profits and employment. We have taken some defensive actions with portfolios, such as purchasing U.S. Treasury Bills as short-term cash equivalents providing higher yields with a good portion of fixed income holdings, and favoring more conservative dividend-paying companies with stock holdings. There will be a lot of important information coming our way in the next few months that should provide clarity on how far the Fed needs to raise rates and whether companies will maintain favorable hiring plans for the upcoming year.

Shutting down our economy to combat the COVID pandemic was an extraordinary experiment with consequences that could reverberate for years. Reopening was like releasing a spring that caused an abrupt surge in economic activity, generating employment and supply-chain bottlenecks. Rising demand and limited supply sparked a corrosive bout of escalating prices that has become our dominant economic challenge. Tighter monetary policy by the Fed is aimed at curbing demand, which should give the supply side an opportunity to catch up. The most likely scenario appears to be a short, sharp contraction in activity that will stabilize in the coming year. We expect a heightened level of uncertainty to remain part of the picture until the Fed is confident they have inflation under control. Capital markets have proved resilient to all kinds of economic setbacks over the years, and we will get through this one too.

Our best wishes to you and your family for a happy summer. We always enjoy talking with you, so please give us a call if you have any thoughts you would like to discuss.