What Do You Want First? The Good News or the Bad News?Review of the Financial Markets - Summer 2023
July 2023
Government funded studies find that most people want the good news first. The good news is the economy is strong, the unemployment rate continues to be historically low and corporate profits are up. The bad news is the economy is doing very well, the unemployment rate continues to be very low and corporate profits are up. Economically speaking, good versus bad is in the eyes of the beholder. In the eyes of the Federal Reserve a strong economy with low employment is highly inflationary. That means interest rates have to go higher and be kept there longer. There is a 97% expectation that the Reserve will increase the federal funds rate on July 26 by one quarter of a percent.
Economic cycles have always been and will always be. The Roman Empire had them. The Panic of 1792 was the initial challenge for the First Bank of the United States. There are continuous cycles of expansion and contraction. The pattern is primarily the result of changes in levels of employment, productivity and the demand for and supply of goods and services. Expanding demand eventually peaks. Prices rise as suppliers struggle to keep up. A quick way to reduce demand is to raise prices. Sometimes consumers taste simply change. Consumers, who are responsible for 70% of the economy, may run out of money and hit the limits on their credit cards.
The financial markets also have their own cycles. Usually short. Sometimes “risk is on” and other times “risk is off”. Generally, it’s a matter of investor sentiment in reaction to recent events, for example a bank failure. Prudent investors don’t guess about what may be on or off. They know it’s better to maintain a suitable (for them) allocation and diversified portfolio. Bonds normally do well when risk is off, but that has not been the case dating back to the financial crisis of 2008. In an effort to help the economy recover the Federal Reserve increased liquidity in the system (called quantitative easing) and lowered interest rates. Rates were kept low right up to and through the Covid pandemic. The return on bonds since 2008 was so low, some investors gave into temptation, reduced their bond allocation and took on more risk. They concluded stocks were the only game in town.
In 2022 a big and not unexpected increase in inflation caused the Federal Reserve to increase interest rates at ten consecutive meetings, the fastest pace ever. Bonds, which are usually the place to invest when risk is off, never had a chance. They were hit with both nemeses at the same time: higher interest rates and inflation.
Government intervention can be a good thing if it helps people keep their jobs, protects bank savings and stabilizes sections of the economy. The bad news is it can’t go on forever because deficits matter.
The future performance of bonds is looking up. Yields on intermediate bonds are averaging above 5%. Yields are set by supply and demand in the bond marketplace. Yields represent expectations, in other words a prediction of the future. Treasury Secretary Janice Yellen just announced she believes the strong labor market will help the US avoid a recession. The prevailing opinion on Wall Street is there will be a mild recession.