The Federal Reserve has come a long way since Chairman Jerome Powell dismissed inflation as “temporary” nearly three years ago. To their credit, Powell and the Fed governors finally confronted this massive miscalculation and have spent the last 12 months aggressively raising interest rates in their fight against inflation.
It’s fair to say that the Fed is now winning the war. The latest Consumer Price Index (CPI) released on Tuesday shows inflation at 6.4% yoy. Goods and labor costs remain stubbornly high, but peak inflation (9.1% in June 2022) is certainly behind us.
However, the warning we keep hearing is that the economy will be an inevitable casualty of this struggle. Finally, to kill inflation, demand must be subdued, and that’s not a recipe for strong economic growth. Based on Powell’s public comments, the Fed is likely to make a few more rate hikes, which would take the fed funds rate above 5%, which has not happened since 2007.
Elevated inflation, the highest interest rates in 16 years and a still hawkish Fed are far from an ideal market environment. And yet the economy is still standing and in relatively good shape despite the repeated body blows.
GDP grew at an annualized rate of 2.9% in the fourth quarter. The January jobs report revealed 517,000 new jobs, nearly triple the expected amount. The national unemployment rate has fallen to 3.4%.
As 2023 began, most financial forecasts predicted an economic recession in the second half of that year. Dampening inflation while avoiding a recession remains the optimistic alternative. Call it the Goldilocks Scenario. Or the Fed threading the needle. Whatever Wall Street cliché you prefer, it seemed like a long road to go.
The stock market has rallied since then. The S&P 500 gained 6.2% in January (despite another Fed hike). Only once in the last 33 years has the S&P got off to a stronger start. US stocks face another positive month in February. With a possible recession remaining on the table, a growing number of investors seem poised to see through the gathering clouds.
For market technicians, the S&P 500 recently broke through several levels of key resistance. In late January, the benchmark closed more than 1% above its 200-day moving average for the first time in nine months. Shares have also climbed above an established downtrend that stretches back to the all-time highs set in January 2022.
There’s a growing list of reasons to be optimistic.
The counterargument is that a resilient economy gives the Fed more ammunition to continue raising interest rates. This may seem problematic on the surface, but shouldn’t be a cause for concern.
The longest bull market in history (2009-2020) and the post-pandemic recovery were both fueled by near-zero interest rate policies. The incredible gains in US equities over these periods led investors to believe that bottoms create the most benign market environment.
But the challenges we face today are not the same as they were over the past decade. Unlike after the Great Recession, the current economy remains strong. It has already proven its ability to weather tougher conditions and warrants a different approach to central banks.
With that in mind, it’s entirely possible that policy rates close to 5% will still foster an environment conducive to favorable returns for equities for the foreseeable future. A strong economy, not low interest rates, will ultimately benefit investors the most.
Ben Marks is Chief Investment Officer at Marks Group Wealth Management in Minnetonka. He can be reached at [email protected] Brett Angel is a senior financial adviser to the firm.
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