When consumers are feeling good, they are typically spending money. Further, when consumers transition from feeling quite cautious to feeling better, what often follows is the start of a new economic growth cycle. Last July, we saw record-low levels of consumer sentiment as measured by the University of Michigan’s Index of Consumer Sentiment. Since then, improving sentiment, we believe, may be a major tailwind for economic growth.
The economy and corporate profits tend to grow at approximately the same rate of the long-run – so the idea of a new period of economic growth sounds rewarding.
Of course, there are many concerns related to higher interest rates imposed by the Federal Reserve (the “Fed”) and inflation. The Fed’s rate hiking cycle is indeed intended to stabilize prices, but the impact of higher rates is generally understood to slow both inflation and economic growth. As inflation is declining, it seems the Fed Funds rate is now higher than many measures of inflation – including the broad Consumer Prices Index (CPI).
Historically speaking, the Fed Funds rates is typically higher than inflation. As a result, we believe the Fed is quite close to pausing rate hikes. Further, economic growth may well be intact given the rather robust labor market and improving sentiment. This is also the consensus among Wall Street economists (https://www.cnbc.com/rapid-update/).
While our view is generally positive for earnings and overall growth, we remain cautious in one area primarily. As short-term rates are higher, bank costs effectively rise making it more difficult to create loans. An overall shrinking of loans and other forms of debt (collectively “credit”) tends to be an economic headwind. Currently, bank credit growth is indeed at rather low levels.
Regardless, we believe this headwind will not create a recession at this time. Further, stock valuations and bond yields seem reasonable overall – leading us to believe investors should stay the course and maintain their long-term asset allocation.
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