Larry Summers, former Secretary of the Treasury, recently said, “It’s as difficult an economy to read as I can remember.” To cut to the chase: we would retweet that sentiment. Jerome Powell, Federal Reserve Chair, has practically all but said “READ MY LIPS: NO RATE CUTS.” And yet, investors seem to have a different vision for how the year ahead plays out. One could imagine that we’re all reading effectively the same economic data, but the data itself is a mixed bag, and interpretation of the data (and the importance of each piece) leaves a lot of room for divergence of opinion as well.
You’ve probably heard many times by now that the Fed is aiming for a soft landing. What exactly does that mean?
It means that the Fed, which decides and controls the federal funds rate (which in turn impacts most other interest rates), is attempting to fix the inflation problem (too many dollars chasing too few goods) by taking some of the excess dollars out of the economy. Now, that part of the equation is easy to do—but that part, if done with no restraint, leaves us with a hard landing—and economic spending, growth, and investment would come to a grinding halt. Inflation fixed? Sure, but we’d also find ourselves in a full-blown recession. So the soft part of the landing refers to the Fed’s attempt to fix the inflation problem by slowing things down just enough without knocking the economy off course entirely. That is the needle the Fed is trying to thread; that is the needle economists and analysts have been pontificating about since the Fed started to raise rates in early 2022. Threading that needle sounds hard enough, but one of the very hardest things about it is that we cannot measure the effect of a rate hike right away, and there’s no way of knowing exactly when that increase in interest rates has actually been digested by the economy.
However, things are going pretty well. Inflation (by nearly all measures) has been slowing down (although the degree to which it’s slowed depends on what prices you measure), but it’s still higher than the Federal Reserve would like it to be. Remember, the Fed, historically speaking, likes inflation to be around 2% for things to feel healthy. That is why Jay Powell continues to remind us without parsing words that the Fed is nowhere near cutting rates. The Fed has been crystal clear about its intentions to keep rates higher for longer. And maybe it’s just in our blood to not “fight the Fed,” but we tend to take the Central Bank for its word. Looking to history again, rate hiking cycles have often resulted in a recession. The Fed typically tends to overtighten. In fact, those rate hiking cycles that led to an inversion in the yield curve have led to a recession some months later nearly every time. Put another way, we don’t have much experience with sticking the soft landing.
Let’s dive into the notion of the yield curve.
According to Investopedia, the yield curve is a line that plots the interest rates of bonds of differing maturity dates (typically, 3-month, 2-year, 5-year, 10-year, and 30-year U.S. Treasury bonds). In a typical economic environment, the longer the bond (measured in time until maturity), the higher the interest rate it pays because investors would like to be rewarded for loaning their money for longer periods of time. If you know someone is going to pay you back for a loan next week, you would probably demand less interest than if you loan someone money knowing they aren’t supposed to pay you back for 30 years. Where will that person even be in 30 years? Will they be able to pay me back then? What will have changed between now and then? Lots of unknown, lots of unanswered questions, and therefore more risk. However, an inversion in that curve refers to rarer economic times where investors, or bond buyers/owners, demand a higher interest rate for the money they’re locking up for shorter time periods because of how much uncertainty or anxiety or doubt there is about the state of things in the near term. This is called an inversion in the yield curve. And such a phenomenon has predicted recessions very reliably—as in, nearly every time since the 1980s. What’s been less consistent historically is the timing of such recessions after yield curve inversions—will a recession happen 3 months or 6 months or 18 months after the inversion first occurs? This has varied with each recession.
And on this topic, what do we mean by a recession?
There are several definitions at this point, some more technical and others more high-level, but a recession is generally defined as a broad slowdown in economic activity for an extended period of time. Factors such as manufacturing activity slowing down for several months in a row now and a less strong consumer are typical leading indicators of recession as well. And in this particular environment, perhaps the indicator garnering more attention than any other is the health of the labor market. It is nearly impossible to imagine a significant economic slowdown or recession without significant unemployment or labor distress. We have the opposite of significant unemployment in the current environment. The unemployment rate is at 3.4%—the lowest level since 1953, and that is on the heels of headlines riddled with “job cuts” and “layoffs,” leading many to believe the employment picture is wavering. While it might be in isolated instances so far (a “white collar” recession as some have described it), we are just not yet seeing it in the data in a meaningful way. Perhaps it is just that—isolated (and insulated). Perhaps on a relative basis the layoffs aren’t very impactful—it’s a small number of jobs relative to the labor market at large given that S&P 500 companies make up only 19% of the labor market—but because it’s such heavy-hitting companies with an enormous public persona like Amazon, Google, Goldman Sachs, Disney, etc. it feels all-encompassing. Or, perhaps it’s the start of a domino effect, and other industries and sectors will soon follow suit. We don’t know, and no one truly knows. But employment remains strong. There’s still a huge gap between the number of jobs (high) and the number of people looking for jobs (low), and for now the employment data tells us that jobs are still being created and jobs remain unfilled.
We tend to echo Larry Summers’ sentiment that in a world where the future is always tough to predict, this mixed bag of confusing economic data feels particularly difficult to unpack. We don’t believe we’re out of the woods, and yet, the stock market has spent much of 2023 rallying. The stock market is not the economy, so understanding how it behaves and why can be difficult to make sense of. But investors seem to be latching onto the more positive economic indicators and data points and dismissing the clouds on the horizon. They are challenging the Fed’s outlook and are poised for optimism, seemingly believing the somewhat dangerous notion that This Time is Different. It’s impossible to know, so we’re focused on what we can know: the companies we own and our thesis for why we choose to own them, despite economic headwinds.