Summary, Last Quarter:

In its Federal Open Market Committee meeting this September, the Federal Reserve essentially declared the battle against inflation over as it shifted monetary policy from tightening (raising interest rates) to easing (lowering interest rates). The Fed lowered its Federal Funds rate by 0.50%, which was generally expected but a larger decrease than many had projected. Unemployment—the other half of the Fed’s dual mandate—has been increasing, and consumer confidence has been below average for the past couple of years. These readings surely factored into the Fed’s decision to lower rates. Interestingly, mortgage applications increased to their highest level since February, an early indication of the power of lower interest rates to spur economic activity.

Our Commentary:

Mission Accomplished? It depends on how you define the mission. If the mission was to tame inflation temporarily, then that goal has been achieved, but we aren’t out of the inflation woods yet. The economy is in good shape, but both of this year’s presidential candidates are discussing inflationary fiscal policies, which could reignite inflation. While a lot of attention has been on the Fed, we must remember that the Fed, Congress, and president are not the economy—the rest of us are. Entreprenuers, workers, and consumers ultimately drive the economy, and productivity looks strong today. Unit labor costs have been slowing while inflation comes down, which we view largely as the final phase of healing from the Covid era.

While inflation is decreasing, productivity and corporate profits are increasing and predicted—or “forward”—earnings per share estimates for the S&P 500 Index have been going up. Excluding any external influences, that is good news, because stock prices ultimately follow earnings. However, there is one potental outcome we are worried about: a “melt up,” which is when asset prices get too far above their fundamental value, leading to a correction. The private sector is handling things very well, and the Fed has gotten inflation down and is now tackling unemployment. Inflationary fiscal policy is the last thing we need—it could negate this progress and threaten the economy.

The Fed’s move to decrease rates had an interesting impact on the bond market. The fundamental story hasn’t changed much; bonds remain a good choice for both income and diversification benefits. At a more granular level, this change in policy means a drop in yields for short-term bonds, thereby shifting the attractiveness towards longer term bonds, but not necessarily the longest-term bonds—at least not yet. Yields appear to have peaked already, and the ten-year treasury rate is expected to hover around 3.75% to 4.50%, which we believe is a reasonable range. For now, it appears that a sweet spot is emerging in the short-to-mid range of the bond market, and it could be time to consider bonds in that area rather than overweighting short-term bonds. Still, for the risk taken on, short-term bonds offer an attractive value proposition. As this process plays out, we expect to see the yield curve disinvert and return to a normal posture, which would be welcomed by both bond and stock market investors alike.

Until next quarter,

Leelyn Smith Investment Committee

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Investing involves risk including loss of principal.  No strategy assures success or protects against loss.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

Bonds are subject to credit, market, and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.

The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.