Economic Update May 2023: Video automatically transcribed by Sonix
Economic Update May 2023: this mp4 video file was automatically transcribed by Sonix with the best speech-to-text algorithms. This transcript may contain errors.
Shawn Lawson:
Hello, everyone. Thanks for joining us as always. My name is Sean Lawson, Client Solutions Officer at Executive Wealth Management, joined by our chief investment Officer, Nathan Larson. So April Hard to make it through a month. Nathan Without talking about inflation as we come into May, it's no different today. We'll dive into inflation. We'll talk about the dramatic changes in interest rates that we've seen, talk about if there is an opportunity in rates where the Fed might be pausing or potentially even lowering what that could mean to investors. And then a couple of things that we look forward to. But let's get started with inflation. As we look at inflation and we talk, Nathan, and a lot of times you say in order for inflation to go up, it has to go up. Is it still the case?
Nathan Larsen:
Absolutely. You know, we've seen inflation come from a peak in June of 2022 of 8.9% to the most recent reading was just slightly under 5% on a year over year basis. And, you know, the reason for that is we had a lot of big headline inflation prints in that year leading up to June. And we've seen that inflation has slowed. And so when inflation slows and you replace a big print. Coming off the back end with a smaller print coming out the front end or coming out of the front end, you get inflation slowing down. And so that's what's caused the rapid decrease in year over year inflation. And it's what we've seen in the past. If we observe inflation in the 70s and in the 50s and 40s, when inflation goes up quickly, it usually just turns around and comes back down just as quickly. And so that's what we're seeing. And, you know, there's a lot of things that go into that. But that's, you know, that slowing of inflation has given the Fed a little bit of cover to pause.
Shawn Lawson:
Now, as you said, there's a lot of things that go into inflation, and those are some of the things that that we've been looking at the last handful of months, actually going back to post pandemic of, you know, what were some of the things that we felt like were transitory And then those things that have evolved over time. We look at at rental income, we look at a number of durable goods, things like that. As we look at the components of inflation right now and where we are at this phase, month over month inflation, we've got a couple of big numbers that will be falling off the next couple of months. What are some of the things inside of inflation that that you and your team are looking at that would be relevant to investors as we go into what are traditionally some of the slower summer months?
Nathan Larsen:
Yeah. So there's a couple of things. So we'll talk about core inflation because we can't really do much about energy prices or food inflation. Those move around very quickly and they don't tend to be sticky with inflation. And you know, just going back to when the Fed was talking about inflation being transitory, one of the reasons that really undergirded their their thoughts as to why inflation was quote unquote transitory was that most of the inflation was happening in consumer durables and the durables. Inflation since the late 90s has actually been deflationary most of the time. And that turned around, you know, after the pandemic when everybody's spending patterns shifted and you saw something that was usually putting up about a -1% on a year over year inflation in terms of durables spike up to about 20% year over year in terms of inflation for for durables around the pandemic. And that, you know, everybody kind of knew that that would come back down and indeed that has come back down and durables are again deflationary. But what what we've seen is that services have picked up and and for the most part, you know, services picked up around the same time that that sort of overall inflation picked up. And if you look at services, the biggest component of services is housing services, housing as a service, and that's rent income and owners equivalent rent.
Nathan Larsen:
And that has continued to go up, although it is starting to to slow down and slow its ascent. Um, but the rest of the services have actually rolled over and are trending, you know, steeply back down just like the rest of inflation is. So the only thing that's really left in terms of kind of that core inflation moving higher or the main thing that's still moving higher is owner's equivalent rent. And we're going to see probably, you know, in the June print, I'm sorry, in June with the May print, that some of that owner's equivalent rent will start to to stop going up. And we've seen, you know, just like with the rest of inflation for owners equivalent rent to keep going up it has to keep going up at increasing levels And we've seen those levels start to Peter off. And you know, the trend is definitely down. And so these are some of the things that will give the Fed the ability to pause interest rate hikes. And, you know, that's going to be sort of a boon for for, you know, definitely the fixed income market and it has been already. Um, but that's sort of what we're looking at in terms of inflation on a going forward basis.
Shawn Lawson:
No, you brought up a couple of great points there. So we we transitioned the narrative around October of last year from transitory to hire for longer. And we've seen the overnight rate go from near zero to over five. Now there's this idea that is it going to stay or as we've seen in the past, just like inflation goes up fast and comes down fast, so does the overnight rate. You know, a couple of things that that I would ask you here. One, the idea of higher for longer, But two, you mentioned fixed income and how it's changed. So when you think about higher for longer, I'd love your thoughts on as we made that transition last fall to where we are now and then what that might mean as we go from a tightening to either pause or potentially I'm seeing now somewhere even up in the 50% range of a Fed cut coming, what that would mean to investors.
Nathan Larsen:
Yeah. And, you know. The Fed. The Fed funds futures market, which is the the way the market sees the Fed going with their with their future rates. That's predicting cuts before the end of the year. And one of the things that that does is that affects the reinvestment rate. And so we've seen a lot of people pour a lot of money into cash and cash right now is is has a has a good yield. It's yielding more, in fact, than something on the intermediate term part of the curve in terms of if you're just looking at government debt. And so people have been pouring into cash because that's that's, you know, that's an easy trade to to take for 4 to 4 to 4.5% on a three month. And instead of taking 3.5% on a ten year. But what we see is that when interest rates start coming down and when the Fed starts cutting, you know, they usually cut pretty quickly. And then you've got reinvestment risk, which means that that three month or six month CD or cash that you have goes from yielding four and one half percent to yielding three and a half to maybe 2.5% pretty quickly, while the rest of the curve usually stays stays where it is or moves down just a little bit.
Nathan Larsen:
And so you get a lot more price appreciation in the intermediate term side of the curve. But now you also have to redeploy that that cash, You either deploy it at lower cash levels or you have to go out and you have to buy the intermediate part of the curve, which has already come down some and you've already missed a lot of the price appreciation. So that's what we talk about when we talk about reinvestment risk. And there wasn't much reinvestment risk coming out of the pandemic. You know, rates were so low across the board that, you know, it didn't pay for you to go out on the on the curve. Now it pays for you to go out on the curve. You can get three and one half percent on a ten year government. You can get more on an investment grade corporate. And so there's there's yield to be had elsewhere on the curve now. And, you know, that's where some of the some of the dynamics if you do feel that, you know we're going into a recessionary period, holding cash will soon become less advantageous for you.
Shawn Lawson:
Well, absolutely. And for a long time, I mean, going back to 2008, it's been tough to get yield in fixed income. And we look at the changes in interest rates and what the overnight rate has done. Yes, we started out last summer again talking about an inverted yield curve and that did that mean a recession and what was coming. But for investors, what it meant was for the first time in a long time, you could get yield on fixed income investments. Now, we saw the AG bond down about 15% last year. Those rising rates, interest rates go up, the price goes down. We saw that depreciation. So if you're held a bond fund or an ETF, you did have that sticker shock. We look at this year coming out of the end of October where rates peaked, they're still at a healthy level. They're off those October highs up a tick today. But if you are an investor and you're looking it's easy to say my my money market is paying me more than what I can get in a five or a ten year bond. Why would I buy that instead? And just to your point, as the Fed gets into a loosening cycle, that cash, those three month CDs, what you're reinvesting at will be a lower rate.
Shawn Lawson:
So something to keep an eye on as we as we enter these summer months and we see what those inflation numbers are. And if we start to to find that inflation, which now is much lower than what it was, if that continues to be the trend and we navigate the idea of of higher unemployment rates or wage cuts, things like that, where the Fed does want to to loosen things, what that will mean to investors is to consider longer options and especially in that intermediate space, which typically has better yield with with less volatility. Speaking of volatility, it's it's debt ceiling time. So as we go into May, you know, that's the talk of the town. We have an inflation number, we have earnings, we have this. And then we have the government trying to solve the debt ceiling as we look forward. How do you and your team think about the debt ceiling?
Nathan Larsen:
Yeah. So, you know, we're not as concerned about what the politics are surrounding the debt ceiling. What what we're really concerned about is what does this mean for you, for your pocketbook, for your investment portfolio. And so, you know, looking at that, we have to say, you know, there are a lot of things that look scary in the future that don't come to pass. You know, our base case is that the debt ceiling gets solved and that, you know, nothing bad happens if the debt ceiling doesn't get solved, if the US defaults. Nobody really knows what's going to happen with that. But let's just take a look at what happened the last time we we saw the debt ceiling kind of be a really big issue. And that was 2011. And, you know, the reality is, is most people don't remember 2011 from an investment perspective because, you know, looking back, it was such a minor event. From an investment perspective, though, you know, those of us who lived through it know that it was a huge event. It was daily pounding us in the in the financial media. And, you know, what happened during that entire time is yields continued to go down, you know, slowly.
Nathan Larsen:
But the bond never really had a big hiccup. Um, now there was a big, you know, somewhat big drawdown in the S&P 500 about 18%. But, you know, it moved immediately back up. And so from an investing perspective of walking to the brink, didn't do anything too bad to your portfolio. Again, we don't know what would happen if if they go over the line and the US defaults and what that actually means and what they would default. Nobody really knows at this point in time what that means. But walking to the brink and not getting there doesn't do too many bad things to your portfolio. If we take 2011 as an example, again, an 18% drawdown in the S&P 500, it was damaging, but it could be lived with. And again, a quick rebound happened right after that. And we saw a, what was it, 18% in 2010. And we saw a huge decline in 2009, 2008. So we've seen declines like that before. But. You know, in the long run it's just a line on a chart and it wasn't that big of a deal. Looking backwards at it.
Shawn Lawson:
That's the perspective, the looking backwards in the moment. We always feel like when there is uncertainty, we need to do something. And that's the challenge in in opportunities like this is to change the way that you do things, to change your portfolio, to navigate headline risk. And should it not become the thing that you thought it was that where you were trying to protect yourself or it becomes that thing and then reverts quickly back to the mean you have missed opportunity. And that's one of the biggest things that we really feel like for our clients that we try to do at executive wealth management is build that plan so that regardless of the current weather or the current environment, that we can withstand that and stay the course. Nathan, I appreciate your time as always. For anyone out there that has more questions, we would love to spend some time with you. Give us a call, look us up online, schedule a meeting, and we look forward to talking to you next month. Thanks, Nathan.
Nathan Larsen:
Thank you, Sean
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