Economic and Market Environment

The outlook for near-term GDP growth is clouded by conflicting indicators.

Half-Full:

• GDPNow, the Atlanta Fed’s measure, is projecting 4.9% growth in Real GDP for the third quarter. This is extraordinarily high and is likely to be revised lower.

Half-Empty:

• The Purchasing Managers Index composite is indicating slowing growth.
• Blue chip forecasters see negative GDP growth in the fourth quarter.

Short-term trends are often confusing. We believe the best way to look at GDP growth is to estimate its sustainable growth rate based on population and immigration trends, plus productivity. The consensus view is for 1.8% growth over the longer run, but it is possible this number could increase if Artificial Intelligence turns out to be a major productivity enhancer.

A soft landing would be accomplished if inflation were to promptly approach the Fed’s 2% target without a significant rise in unemployment, thus allowing the Fed to reduce rates to sustain growth. This would be very desirable.

Half-Empty:

• Soft landings almost never occur.
• Coordinating two key unknowns is very difficult.
   
  • Unknown: What is the natural rate of interest?
  • Unknown: What is the lag time for monetary policy to take effect?

Half-Full:

• The causes of the current inflation are different from previous inflations, perhaps making it less entrenched.
• Employment is so strong, perhaps it can resist the impact of monetary tightening.

The soft landing scenario is more half-empty based on history and the difficulty of coordinating policy accordingly.

A negative yield curve in U.S. Treasury securities has almost always resulted in a recession. Is this time different?

Half-Empty:

• Note above that history is on the side of a negative yield curve. Recessions almost always follow.
• An inverted yield curve discourages lending, leading to lower or negative GDP growth.
• An inverted yield curve reflects the aim of the Fed to reduce demand in the economy.

Half-Full:

• The longer the economy resists the influence of an inverted yield curve the greater the possibility that this time could be different.

The weight of evidence suggests that the inverted yield curve glass is half-empty.

• The natural rate of interest is a theoretical interest rate at which the economy is in balance, primarily with regard to supply and demand, and where growth is neither stimulated nor constrained.
• The rate, though unknown, is extremely important because the Fed uses it as a level that it wishes to be above when tightening and below when easing.
• There are a number of estimations of the natural rate. Prominent among these are those of the New York Fed and the Richmond Fed. Note the difference above.
• The fact that the natural rate is unknown and can only be estimated can easily lead to policy errors by the Fed.
• Because of the uncertainty in determining what the natural rate is, it has to be viewed as half-empty.

A bull market in stocks?

Half-Full:

• The S&P 500, the most widely followed index, is up 13% this year.
• Other indexes are positive, but less so.

Half-Empty:

• The S&P 500 is highly concentrated with a handful of stocks representing inordinate size within the index.
• Concentration, by its very nature, increases risk.

The stock market glass appears to be more on the half-empty side. A healthy market tends to have more internal unity and moves upward with wide participation among sectors.

Summary

• The outlook for the economy and markets is never crystal clear, thus
   
  • Judgement regarding the future outcomes is required.
  • It is helpful to approach the future with some foundational assumptions.
  • We rely on:
     
    • The resilience and adaptability of the U.S. economy as a foundational reason for optimism.
    • The resilience and adaptability of high-quality companies as a foundational reason for optimism.
  • For us, while not full, the economic and market glass is at least half-full. That’s enough to keep us invested, especially with high quality as our essential investment characteristic.

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