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  • The Fed signals higher rates for longer.
  • Conflicting signs on inflation.
  • Lots of signs the economy is slowing.

The Fed signals higher rates for longer.

The Federal Reserve, as expected, raised our base interest rate another 0.5% (that’s 50 basis points, which is the term more commonly used in financial economic reports). On the face of it, that would indicate good news as it means the Fed is slowing the pace of their rate increases and may be reaching a peak. Many investors are betting that the Fed will “pivot” very soon as the economy quickly worsens, and start lowering rates again in early 2023.

However, investors intent on second-guessing the Fed’s resolve to lower inflation through this quantitative tightening and restrictive rate strategy have had the rug pulled out from under them three times so far this year as markets tried rallying on the hope of a pivot, only to have those hopes dashed. Our view is that the Federal Reserve has been very clear about its expectations before any sort of policy reversal will be forthcoming (sustained path of dropping inflation toward a target inflation rate of 2%, for instance). We believe in taking Fed Chairman Powell, and other members of the Fed’s FOMC (Federal Open Markets Committee – the group that votes on interest rate and money supply changes) at their word and not being contrarian in this regard. If the Fed does not do enough to curb inflation, it can rise again like it did in the 1970s, when we had three progressively worse waves of inflation throughout the decade. In fact, so far, our path looks surprisingly similar to those days:

What the Fed did wrong back then was not making the money supply sufficiently restrictive for long enough. Every time the central bank “took its foot off the brake”, inflation roared back. It was only under the leadership of new Fed Chairman Paul Volcker in 1980-1981 that the U.S. finally broke the inflationary cycle by massively raising rates in a short amount of time, deliberately crashing the economy into recession. Inflation pressure “popped” and the United States had not seen a serious inflationary cycle again until this current one.

Last week, Chairman Powell said again in public comments that the Fed has learned much from the past and will not make the 1970s mistakes about underestimating inflation again. He signalled that while the Fed may slow and eventually pause rate increases and other measures, they expect rates to stay higher for longer and there will be no change in direction until the inflationary “bubble” has indeed popped.

The other members of the FOMC concur with Powell. Each member projects where rates will be each quarter of the next few years on what is called a “dot plot”. You can see below the voting members’ estimates of where interest rates will be at the end of  2023 and 2024 below. These graphs show you not a rate of increase, but how the Fed voting members have changed their opinions about where the rates would be at the same end-date over time. The Fed now believes the base interest rate will be above 5% at the end of 2023, and above 4% at the end of 2024:

Obviously, the investment markets weren’t thrilled with this sentiment, and we had several days of market sell-off last week as a result.

What does this mean for you?

We believe you need to be data-dependent, as the Fed is, in making investment decisions over the next few years. Restrictive money policies typically slow down the economy (sometimes harshly), and this can wreak havoc on corporate profits, jobs, tax revenues, etc. This is why nVest Advisors looks less at market movements (which can change in an instant, as they did last week after weeks of rallying on false hope of a Fed pivot) and instead focuses much more on the general trends in the broader economy. For example, the markets have not fully “priced in” a longer and higher rate scheme, which means that just the chance of higher interest rates for longer, let alone all of the economic damage it will bring, still needs to be included in investment price valuations. The purple line shows the estimated interest rates over time, based on the FOMC’s voting members. The black line shows how the investment markets have assumed interest rates would be.

Rather than second-guessing the economy like so many of our peers do, all of our models include some element of economic research into their holdings, which we adjust regularly.  Our Macro Model is 100% driven by real-time, real-world conditions.

Conflicting signs on inflation

So is inflation finally trending down? While the headlines and many Wall Street analysts say, “yes”, our view is, “maybe” but we believe inflationary pressures still exist, particularly as the dollar’s value declines after an historically strong summer and early autumn, and with the continued problems with food staples and energy supply around the world.

The PPI (Producer Price Index) monitors inflation’s impact on the costs companies have in making the products and services we consume. If the PPI is elevated, companies have to pass those added costs on to us in the form of price increases on their products. PPI was trending down again last month:

The Consumer Price Index or CPI, the main inflation figure (not the Fed’s preferred one, but the one most often reported) did show upward pressure slowing again last month:

But a few of the other major Fed analysis reports showed that the inflation most affecting us consumers remained at or near all-time highs:

When you total up all of the possible inputs to this inflation crisis, we get what is called an Absolute Inflation figure. This is basically how it feels to the average family and small business. As you can see from this graph, literally every angle that inflation can impact us has been consistently rising since 2020 (when all the stimulus spending from Covid began):

At nVest Advsiors, we believe inflation will tame somewhat but major headwinds persist. Sadly, the only fix to this problem will likely be the sharp economic recession that we believe is imminent.

What this means for you:

The simple truth is, if you are anywhere close to retirement (say, the next five or so years), ignoring the coming economic challenges and letting your investments take the brunt of the market declines may delay your retirement plans. Even if your investment time horizon is further out than that, there is no reason to just “ride it out”, like so many advisors will tell you to do. The simple truth is, our industry does not train most of its agents to properly navigate events like what is coming (and almost none incorporate economics until their investment models). They train their reps to sell financial products, not manage money. You don’t have to just endure the coming recession but you must take urgent steps quickly to mitigate those risks to your portfolio. (We can help.)

Lots of signs the economy is slowing.

That recession may be closer than we think. In fact, we may already be in one, because the start and stop dates of recessions are always declared months after the fact (they wait on data from previous quarters to make the assessment).  But we don’t have to wait on an official declaration to get a sense of where the economy is heading. We get many indicators each month showing us how things are holding up.

The major indicator is one we’ve talked about before, the PMI (Purchasing Manager’s Index). This is a survey of all of the companies in a specific region of the United States to see how many orders are coming in and how many orders a company has placed with its own vendors. For example, a shoe company can report on its own sales and also on its upcoming orders for leather, rubber, thread, etc.

The November PPI numbers all showed an economy in, or at the brink of, a recession. Several regional reports already show recession taking place, but this is the aggregate US (entire country) PPI. It shows slightly up, but the trend is definitely down (lower high points, lower low points).

Investors are also signaling they believe we are about to head into a recession…

…as more and more investors exit their mutual fund investments:

And while never a perfect predictor, you can also get a feel for where investment returns are headed based on the inverse correlation (relationship) between bond yields and stock prices. Money doesn’t just vanish when stock markets decline: the money is just being moved into safer investments. The chart below shows that the 10-year US Treasury bond’s yield is dropping (its purple line is inverted on this graph), which means there is more and more demand for the bond, and it’s correlated with a drop in stock prices in recent days.  That divergence from what is normally a pretty tight relationship indicates a massive shift in money management (to a very defensive stance) is taking place.

The first industry to fall deeply into recession will be housing, as we’ve discussed several times before. We can see that our expectation for housing to collapse first is well underway:

Most analysts are expecting a 10-15% decline in home values next year, with an additional 10-15% drop in 2024. We expect this also, and believe it will be an amazing time for prospective home buyers in the next 12-18 months. Get your debt down and build your down payment, because a once-in-a-generation buying opportunity is soon approaching.

The last indicator for us today is a look at retail sales so far this holiday season:

Consumers are telling analysts that they intend to spend less this holiday season, and that reality is being reflected in retail sales reports so far.

Bottom Line:

We have hopefully been making the case for our clients that we need to prepare to endure a recessionary year in 2023. No one knows exactly when a recession will occur, or how long and painful one may be, but we do have most of the indications that we are very close.

Whether you are our client or not, you need to consider the broader economy (and much less so the daily market fluctuations) when making investment decisions. The economy is telling us clearly what is coming soon, and you need to have your investment accounts prepared before that happens.

Use these economic reports, and those of others working in this space, to prepare. You can not only avoid much of the pain that is coming, but you might actually profit from it, if your investments are properly positioned, and you’ve done what you can to shore up your business’ and family’s financial situation. If you need help with this, nVest Advisors has amazingly affordable personal financial planning and fiduciary investment management services to help you.

This is what we do for a living, and we’re very happy to partner with you on that endeavor.

Reach out to us for a totally free financial and portfolio checkup today if you’re concerned about where your finances sit for the coming few years, particularly if you are at or approaching retirement age. We’re delighted to offer you our thoughts. You can schedule that time with us below:

Watching This Week:

  • There will be no economic report next Monday, December 26, but we will start 2023 with a major report on January 2. Stay tuned!
The views and opinions expressed in this economic outlook are for information purposes only and are not intended to be financial advice. nVest Advisors, LLC does not provide specific investment or financial planning advice to a client without an executed client service agreement. nVest Advisors, LLC does not trade directly in commodities or cryptocurrencies. Economic data changes rapidly; no warranty is expressed or implied about the reliability of this data once published. Although the information provided here is derived from authoritative sources, we cannot guarantee the accuracy of this information. Please see our general disclosure page for additional details.