Can the Fed Stick the Landing?

By Pacific Life Fund Advisors

While many economists and market participants anticipated the U.S. would enter into recession this year, the economy has thus far avoided one despite a few bumps along the way. In the spring, the government was able to avoid defaulting on its debt as President Biden and House Speaker Kevin McCarthy negotiated a deal to lift the debt ceiling and pare back spending. Furthermore, the failures of Silicon Valley Bank, First Republic and Signature Bank did not lead to a major contagion throughout the wider banking system. And above all, the Federal Reserve (Fed) decided to skip a rate hike in June, giving some time to allow the past hikes to work their way through the economy.

Inflation Has Been Rolling Over in 2023

Although the Fed could deliver more hikes, it paused an increase in rates in June as it walks a fine line in engineering a soft versus a hard landing for the economy. History suggests that the Fed tends to overtighten when the economy overheats, causing recessions to follow. Given its desire to avoid past mistakes, the Fed has decided to take a break from more hikes as CPI, excluding shelter, has come down to the Fed’s target rate of 2%. But again, the Fed also signaled that two more hikes may be soon in store.

Excluding Shelter, Inflation Has Fallen Significantly in 2023

The main culprit that’s keeping core CPI relatively high is the shelter component. Low supply and inventory of available homes for sale or rent have inflated housing costs. Shelter costs (which represent about two-thirds of CPI) remain elevated and have yet to slow down. However, the Fed likely realizes that CPI’s shelter costs tend to lag home prices by roughly a year.

Home prices have considerably decelerated since the start of 2022. If past trends hold, we could see the shelter component of CPI come down as well in the near future.

Shelter Costs Have Remained High, Home Prices Have Dipped in 2023

As the Fed weighs future options, Chair Jerome Powell and his fellow central bankers may be contemplating whether past rate hikes are sufficient to bring shelter costs down. With 30-year mortgage rates hovering around 7%, mortgage applications for home purchases have remained relatively muted as levels remain below where they were when the pandemic started.

With Higher Interest Rates, New Mortgages Have Slowed

While markets earlier in the year had expected the Fed to start cutting rates in the second half of 2023, those expectations have been likely quelled by now. At best, we believe the Fed will stand pat after the anticipated hike in the July 26 meeting and hold rates steady until shelter inflation comes down, as home prices have already fallen.

In the meantime, a select few stocks have surged in this narrowly driven market. Excitement over artificial intelligence (AI) breakthroughs and its potential to improve productivity have fueled mega tech stocks higher. On the other hand, the rest of the market has been relatively muted as economic challenges remain. This is clearly evident in the performance between the market capitalization weighted S&P 500 and the equal weighted S&P 500 indices, as the former outperformed the latter by nearly 10% over the first half of 2023.

While this AI enthusiasm has been compared to that of the dotcom era, valuations on large-cap growth remain well below levels seen during the late ’90s. We recognize that valuations on these tech stocks are relatively elevated and fundamentals are weakening for many companies. However, the mania surrounding AI could potentially support the rally, especially given the lack of growth expectations among other segments of the domestic equity market. Nevertheless, it remains very important to be selective in these market conditions.

Although the overall economy remains relatively healthy, the effects from the Fed’s aggressive rate hikes are making their way through the economy, particularly in the housing market. While we anticipate the economy to slow down, we do not foresee a major crisis to unfold. In the meantime, we believe markets will likely remain modestly volatile until the Fed has a firm grip on inflation. Given the tradeoff between generating economic growth and maintaining inflation with interest rates, the Fed must carefully walk a fine line to bring the economy back in balance. In this environment, we think it remains prudent to maintain a relatively defensive allocation in large-cap stocks versus vulnerable ones such as small-cap value.

Past performance does not guarantee future results.

The views in this commentary are as of the publication date and are presented for informational purposes only. These views should not be construed as investment advice, an endorsement of any security, mutual fund, sector or index, or to predict performance of any investment. Any forward looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are subject to change without notice as market and other conditions warrant. All third-party trademarks referenced belong to their respective owners.

All investing involves risk, including loss of principal.

Investors should consider a fund's investment goal, risks, charges, and expenses carefully before investing. The prospectuses contains this and other information about the funds and can be obtained at www.aristotlefunds.com. It should be read carefully before investing.

Foreside Financial Services, LLC, distributor.