The economy continued to show surprising resilience in the face of higher interest rates, with third quarter real gross domestic product rising by a 4.9% annualized rate. We know that Fed hikes operate with variable and sometimes long lag times, but investors have begun to wonder when we might see the slowdown in growth that the committee has been looking for. We may be on the verge of answering this question. After the most aggressive rate hike campaign since the 1980s, the Fed stood pat at their last two meetings. It appears that a Fed Funds rate of 5.25-5.50% has a good chance of being the peak of this cycle.
It is certainly possible that inflation reaccelerates and the Fed will ultimately need to hike further, but we are finally seeing signs that rate hikes are doing their intended job. First off, the unemployment rate has been ticking up and now sits at the highest level since January 2022. At 3.9% it is still quite low, but we are close to triggering the so-called “Sahm Rule”, which has been a very reliable indicator of past recessions. This rule states that the start of a recession occurs when the three-month moving average of the unemployment rate rises by a half-percentage point or more relative to its low during the previous 12 months. We aren’t there yet – but we are very close. Second, mortgage demand has collapsed to levels not seen since 1996. This isn’t much of a surprise, given that we saw conforming mortgage rates climb from a low of 2.65% (Jan. 2021) to a recent 23 year high of around 8%. The third piece of evidence we would point to is estimates for fourth quarter GDP growth, which are currently showing something around 1%.
Two things keep us optimistic. First, bad markets are paid for through a combination of price and time. The S&P is essentially flat since the second quarter of 2021 – six months before the Fed initiated their first interest rate hike. This has been a 30-month period with no progress to speak of. While a recession would most likely drag markets lower, the average stock is ~12% below its peak in January, 2022. The Russell 2000 is currently ~30% below its peak in November, 2021. We also went through the worst bond market on record last year. The average investor may not realize just how tough of an environment it has been. Additionally, a recession is not a forgone conclusion. Another positive development is that higher rates have a very positive silver lining. As total return investors, with mostly balanced accounts, the ability to earn 4-5% on short-term US Treasuries is something we haven’t been able to do for fifteen years. The post financial crisis period of zero interest rates boosted valuations, but it also essentially eliminated an entire asset class: fixed income.
We are not in the prediction business. While we can say that the odds of a recession are elevated, that isn’t necessarily prescriptive. As we frequently point out, even if we knew what was going to happen, that wouldn’t tell us with any certainty how markets will react. See Trump’s election, Brexit, COVID etc. Offsetting these elevated risks are the fact that the market has been dealing with rate concerns for nearly three years. It is also a fact that the S&P has not declined in a re-election year since 1952. Regardless of how the next few quarters play out, we continue to focus on adding high quality fixed income and dividend growth opportunities for the long run.
Past performance is not indicative of future results and diversification does not ensure a profit or protect against loss. All investments carry some level of risk, including loss of principal. An investment cannot be made directly in an index. Robert W. Baird & Co. Incorporated