The Federal Reserve is confident that it can engineer a rare “soft landing” for the U.S. economy, essentially a slowdown that beats inflation without causing an outright recession.  Capital markets are increasingly worried that the Fed will overdo its policy of tight monetary policy.  Consequences of higher interest rates are rippling through the banking and small business communities, and consumers appear to be running out of savings to maintain high levels of spending.  Pressure is building for the Fed to lighten up before something breaks.

Stock prices are still positive for the year, but they trimmed their gains over the summer as the Fed continued to give hawkish testimony about keeping interest rates high for an extended period.  The S&P 500 Index gave back roughly three percent, and prices for small company stocks, real estate and international stocks also retreated from recent peak levels as interest rates continued to migrate upward.  By the end of September, the yield on 10-year Treasury securities reached 4.59 percent, the highest level in more than 15 years.  The average rate on 30-year fixed mortgages is now approaching eight percent.  In the meantime, higher rates are having the desired effect to restore price stability to our economy.  The latest reading on the Consumer Price Index shows inflation moderating to mid-three percent, calming down toward the Fed’s target level of two percent.

The banking industry has suffered as rising interest rates impair the value of existing loans on their balance sheets.  In simple terms, a loan made at three percent becomes less valuable when current rates are around eight percent.  There is another challenge headed for banks as major cities are expected to endure rising defaults for commercial loans made on office buildings that now suffer high vacancy rates. According to a study by Morgan Stanley, office and retail property valuations will be under severe pressure as roughly $1.5 trillion in loans are due for repayment by the end of 2025.  Refinancing these loans is more difficult now that banks have tightened lending standards.  Banks are on the hook for most commercial mortgage-backed securities, with about 70 percent of all commercial real estate loans held on their books.  The top five regions considered at risk for potential defaults are New York, Los Angeles, Miami, San Francisco and Las Vegas.  In San Francisco, the office vacancy rate has shot up from around five percent before the pandemic to more than 30 percent.

Small businesses are having a tough time with a more difficult financing environment and rising operating costs.  Capital is more expensive, and the variety of covid-relief funding programs have run their course.  Bankruptcies are rising, and loan delinquencies and defaults among small businesses have surged beyond pre-pandemic levels.  Even large companies are experiencing pressure on margins.  Expectations for the upcoming third-quarter earnings reports are muted, with analysts saying companies that comprise the S&P 500 Index will likely see profits slip from a year ago.  If so, it will mark the fourth consecutive quarter of year-over-year profit declines reported by companies in the index.

Consumers are running out of wiggle room.  According to a study by the Federal Reserve Bank of San Francisco, U.S. household savings benefitted from covid relief funding and surged to a record $2.1 trillion in 2021.  That money has now been spent, with household savings declining every month for the recent 23 months.  All that buffer is now gone, and the personal savings rate, at 3.5 percent, is below pre-pandemic levels.  Credit card debt is rising, and a growing number of households are unable to pay off their cards each month.  For the first time in history, credit card balances now top $1 trillion.  According to the American Bankers Association, roughly 56 percent of all active credit card accounts now carry a balance, with interest accruing at an astounding average rate of 22.16 percent.  Rising mortgage rates and a more subdued housing market mean the opportunity to do a cash-out refinancing of their home is no longer practical.  So far, the job market has remained a bright spot.  While rising slightly in recent months, overall unemployment at a mere 3.7 percent is a very strong number.  However, employers are not likely to be in a position to provide the generous raises and bonuses that helped household budgets last year.  Also, while the pace of price increases has slowed, prices still remain at elevated levels.  Stubbornly high prices are one reason for waning consumer confidence, according to a University of Michigan survey.

The Federal Reserve is winning its battle to tame inflation.  However, higher interest rates are putting pressure on banks, small businesses and consumers.  There is a risk that that the Fed maintains their policy of tight monetary policy too long, causing the economy to drift into recession.  The reaction of capital markets over the summer to the Fed’s ongoing hawkish commentary suggests high rates are reaching a pain threshold.  Wall Street is eager to see the Fed lighten up at some point relatively soon.

On a happy note, West Oak Capital celebrated our 20^th anniversary of serving clients.  It has been a dramatic couple decades in the capital markets, with some notable challenges along the way.  Fortunately, with some patience, clients have been able to benefit from rising market values of their portfolios over the years.  We are grateful for the opportunity to help with the important task of investing for your future.

Our best wishes to you and your family for a wonderful autumn and upcoming holiday season.