Time Matters

“It takes a long time to bring the past up to the present.” – Franklin D. Roosevelt

Hofstadter’s law makes a simple observation: things always take longer than expected, even when taking into account Hofstadter’s law. We all know this adage to be true even for the simple tasks, like the kids’ homework or small home improvement projects. But Hofstadter’s law is most prevalent in complex tasks, like taming inflation while avoiding a recession in the world’s largest economy.

Most economists would agree that the Federal Reserve has handled this historic bout of hyperinflation relatively well, evidenced by the fact that labor markets are still strong, the economy has not experienced a recession, and inflation is heading in the right direction. But the job is not done, and has undoubtedly taken longer than expected. To be sure, the once-touted “transitory” term has been all but forbidden.?

The U.S. economy, along with others around the globe, has proven resilient up to this point, absorbing 5.25% of interest rate hikes in just over a year without any widespread repercussions. But time matters, and the longer inflation remains well-above the Fed’s target, the longer rates will remain higher, elevating the risk of collateral damage.

When analyzing what the future holds, our Investment Team relies on history over headlines, and facts over forecasts. To that end, we examined historical hyper-inflationary periods to see how those cycles ultimately unfolded. At the risk of stating the obvious, what we found was that taming out-of-control inflation is difficult, even after initial containment. Of course, history doesn’t necessarily repeat itself, but we also know the danger of the quote “this time it’s different.”

Inverted Yield Curves and Recessions

At a recent investment conference in Washington D.C., Dr. Jeremy Siegel stated that “inverted yield curves don’t predict recessions, they cause them!” And while perhaps this was merely semantics, the point was clear: the longer short-term rates remain above longer-term rates (inversion), the higher the probability of a recession. This makes sense, considering banks are at the core of the U.S. economy, and banking is effectively a perpetual carry trade. Meaning, banks borrow at short-term rates (deposits) and lend at long-term rates (commercial loans, mortgages, etc.), collecting the difference. This difference is known as net interest margin. The model works well, economically speaking, when short-term rates are lower than long-term rates, as seen with a normal yield curve. But when the yield curve is inverted and short-term rates are higher than long-term rates, the appetite for banks to lend is spoiled, which can constrict the money supply and slow economic growth.

The U.S. Treasury yield curve has been inverted for some time now, as measured by the 10-Year Treasury yield minus the 2-Year Treasury yield, shown in the chart below, spurring predictions of a recession that started over a year ago. Now, more than 15 months later, the yield curve remains inverted and the recession averted. But time matters, and the longer short-term rates remain higher than long-term rates, the higher the probability of an economic slowdown.

Whenever yield curves initially invert, headlines are fraught with the same phrase: the inverted yield curve has preceded each recession since 1978. This is true, and provides great backing for Dr. Siegel’s quote that these inversions cause recessions rather than predict them. But the anatomy of the inversion-to-recession has looked quite different each time. Our team looked at the history of yield curve inversions in the U.S. and the length of time it took for the recession to take place, shown in the table below.

As illustrated, previous recessions were preceded by an inverted yield curve by about 480 days on average, excluding the highly anomalous recession in 2020, with a range of about 300-670 days. In other words, each of the last six recession prior to 2020 arrived between 10-22 months following the initial sign of an inverted yield curve, with the average right at 16 months.

Putting history into today’s perspective, the current yield curve initially inverted in July 2022, or about 460 days ago, meaning we are about 20 days away from the historical average between initial inversion and the start of a recession. By no means is this analysis meant to be predictive, and many would be happy to argue that the U.S. economy is nowhere near a recessionary period currently. However, the longer this inversion lingers, the higher the chance of history repeating. Our team will continue to monitor the economic data for signs of slower growth, as we believe this is an important variable to consider when establishing asset allocations today.

Higher for Longer

Turning to interest rates, we are likely in for a period of “higher for longer,” according to the Federal Reserve’s most recent Summary of Economic Projections published in late September. As shown in the graphs below, the Fed increased its projections for both interest rates and inflation from its prior expectations, indicating that inflation may be stickier than originally thought. As a result, interest rates are expected to remain elevated longer than anticipated, with one more 25 bps hike possible before cutting only 50 bps next year. At the June 2023 meetings, the expectation was that the Fed Funds level would be a full 100 bps lower in 2024. In other words, the Fed now expects the process of taming inflation to take a little longer than originally planned, even when considering Hofstadter’s law.

What does this mean for markets?

Equities have responded negatively to the updated projections thus far, as investors have had to come to terms with the idea of higher discount rates being used in their asset valuations and slowing growth. The volatility of interest rates over the past couple of years has put the inverse relationship between yields and equity prices on full display. This trend continued, as the 10-year U.S. Treasury yield rose by nearly 25 bps in the week following these updated projections, weighing on valuation multiples and driving equity prices down, as shown below.

Time matters here as well. The longer rates remain elevated, the more severe the downward pressure on asset valuations could be, creating a more sustainable headwind to equity returns. On the other hand, rising yields create more opportunities for those investors who have an allocation to fixed income in their portfolios. And, as we have written about before, these “higher for longer” environments can present great opportunities for active managers who focus on thoughtful asset allocation and diligent security selection. Along these lines, our team believes we are entering a new investment environment that could look much different from recent history.

Consumer Concerns

We, the people, drive the U.S. economy. Consumer spending represents nearly two-thirds of total economic activity, and much of that spending is financed through debt. Because of this impact, investors and economists pay close attention to the health of the U.S. consumer. Ultimately, this spending is what translates into corporate revenues and earnings, which is what drives equity prices. Since the pandemic, household balance sheets have been very strong for a few reasons: fiscal stimulus via direct transfers, rising incomes from a tight labor market, a pause in student loan payments and less opportunities to spend as the pandemic kept people at home for several months. This led to increased excess savings levels, defined as the difference between actual savings and the pre-pandemic trend.

As seen below, these levels are being drawn down rapidly as household balance sheets normalize and the excess savings are spent. According to a report published in August by the Federal Reserve Bank of San Francisco , households then held less than $190 billion of the $2.1 trillion of total excess savings accumulated since 2020. Further, the report indicated that all the remaining excess savings could be depleted during the third quarter.

At the same time, household debt levels are increasing, suggesting consumers are turning to financing to fund their spending as savings dwindles. In August, The Federal Reserve Bank of New York released its quarterly report on household debt for Q2.

As illustrated in the table below, total household debt increased to more than $17 trillion in the second quarter, fueled partly by a 4.6% quarterly growth in credit card balances, which surpassed $1 trillion, a series high. While generally not a good idea to bet against the willingness of the U.S. consumer to spend money, there are clear signs of potential constrain. The longer the consumer draws down savings balances and funds incremental spending with debt, the higher the risk of a sharper slowdown in GDP. After all, consumer spending makes up nearly two-thirds of economic activity. Finally, adding to the reduced excess savings and elevated credit card balances is the resumption of student loan payments which begin in October. Put together, these three factors point to a more limited spending environment, which could weigh on corporate earnings in the near-term.

Moving from the expense side to the income side, things look a little more encouraging. Household income continues to grow around 5%, on a three-month moving average basis. While lower than experienced over the past two years, wages are still growing at a higher rate than much of the past two decades. Rising incomes could help alleviate some of the pressure being put on household balance sheets.

Time In, Not Timing

Time matters, whether it be a lingering inverted yield curve or elevated interest rates. The amount of time for which these factors persist may ultimately determine how this economic cycle unfolds. Like any complex task, taming inflation while maintaining maximum employment may have caused the Fed to fall victim to Hofstadter’s law. In fact, this entire economic cycle may simply be taking longer than expected to play out, but one thing appears all but certain: the next 10 years may look quite different from the last 10 years for investors. With interest rates higher than they have been in more than a decade, bonds are back in the mix. At the same time, equity valuations are relatively high, reducing the equity risk premium – the amount by which the return on an equity investment is expected to exceed the return on a risk-free asset. This new environment is likely to be more challenging for investors aiming to deliver superior risk-adjusted returns, as elevated interest rates allow other asset classes to be viable alternatives to equities again. And although more challenging, we believe this environment will offer more opportunities for the active investment manager who focuses on three key elements: thoughtful asset allocation, prudent risk management, and diligent security selection.

Time also matters when investing. Successful investing has very little to do with timing the market, and almost everything to do with time in the market. In other words, exercising patience, discipline, and fortitude is far more important than knowing precisely when to sell tech stocks at their high or buy bonds at peak yields. History demonstrates that the longer you stick with your investment strategy, the better chance you have of quality return outcomes.

Since 1950, stocks have provided an annual average return of about 11%, while bonds have returned about 5.5%.? There has also never been a rolling 20-year period of negative returns for either asset class. Over the short-term, however, the outcomes are less certain.

Focus on your long-term objectives rather than short-term obstacles. As Warren Buffet has said, “the stock market is a device that transfers wealth from the impatient to the patient.”

Disclaimer:?Trust and Investment Management Services are not a deposit, not FDIC insured, nor insured by any federal government agency, not guaranteed by the bank or its affiliates, and may lose value. This general market commentary is intended for informational purposes only and should not be considered investment, financial, or legal advice.?

We believe the information contained within this material to be reliable but do not warrant its accuracy or completeness. Opinions and views expressed herein reflect our judgement based on current market conditions and are subject to change without notice. Past performance is not indicative of future results. Additional risk considerations exist for all strategies, and the information provided is not intended as a recommendation, or an offer or solicitation to purchase or sell any investment product or service.