First Quarter 2024
Higher for Longer?

Bordeaux Wealth Advisors | April 12, 2024

On July 26, 2023, the U.S. Federal Reserve increased the Fed Funds interest rate by 0.25% (25 basis points). That marked the last of eleven increases to the Fed Funds rate that began in March of 2022. During that time, the Fed increased rates from a range of 0.25%-0.50% to 5.25% – 5.50%. Their campaign of rising interest rates was designed to battle inflation, which had increased in early 2022 to a high of 9.1% as the country emerged from Covid pandemic shutdowns and the injection of trillions of dollars into the economy via federal stimulus.

Since that last increase by the Fed, markets have focused and speculated on when the Fed would begin its next round of interest rate cuts. The initial thought was that such a substantial increase in interest rates would slow the economy, causing a recession and inflation would decline toward the Fed’s target rate of 2% quickly. Many economists were even predicting a recession in 2023 and aggressive rate-cutting by the Fed. Almost all these predictions have thus far been wrong.

As we entered 2024, interest rates had begun to decline as evidenced by the yield on the 10-year U.S. Treasury bond declining to 3.82% at the end of 2023, down from a high of 4.88% in October of 2023. Inflation decreased, and many investors expected continued declines in interest rates and inflation during 2024. Many economists predicted the Fed would cut rates as many as six times in 2024. This decrease in interest rates and inflation spurred a stock market rally in the fourth quarter of 2023.

However, the first quarter of 2024 offered many surprises. The decline in inflation has stalled and the government measures of inflation have ticked higher in the early part of the year. As of the end of February, the Consumer Price Index (CPI) came in at 3.2% year-over-year, up slightly from the 3.1% measure in January. Interest rates increased in the first quarter, with the yield on the 10-year U.S. Treasury increasing to 4.20% at the end of March, up from 3.82% at the end of 2023. Speculation regarding the number of interest rate cuts from the Fed has ranged from six or more, down to two or three, with some economists and Fed officials now speculating that there may not be any rate cuts this year.

STOCK MARKET REACTION

Collectively, the increase in longer-term interest rates, stalling progress on inflation, and the diminished outlook for interest rate cuts by the Fed would have historically resulted in a negative reaction by the stock market. However, the opposite happened. The stock market rallied strongly in the first quarter in almost all sectors.

Why did the stock market rally in the face of less encouraging news on inflation and interest rates? We believe the main reason is that the U.S. economy continued to perform above expectations. U.S. Real GDP increased 3.4% in the fourth quarter of 2023 and 2.5% for the full year. Early projections for the first quarter of 2024 indicate continued growth at a pace of 2.5%. Additionally, the labor market remained strong with the U.S. unemployment rate ending the first quarter at a continued historic low of 3.8%. Job growth was robust, with the jobs report released on April 5th showing 303,000 new jobs added in March of 2024.

The recent (slight) uptick in inflation and the continued strength in the economy continue to push out the market’s forecast for the date that the Fed is expected to begin cutting interest rates. The Fed has a dual mandate: Price Stability (low inflation) and Full Employment. With inflation at 3.2% and moving higher in the short-term and unemployment below 4%, there seems to be little reason for the Fed to begin cutting rates. At the beginning of the year, the Fed Funds futures market was predicting up to six cuts, with the first cut expected in March. As inflation and economic data were released during the quarter, the number of predicted cuts kept decreasing and the projected start date was pushed farther out. The market is now predicting the first possibility of a rate cut in June. During the week of April 1st, Neel Kashkari, the President of the Minneapolis Federal Reserve Bank, said in a speech that he was still expecting two rate cuts this year. But he raised the possibility of no rate cuts this year if the inflation numbers do not improve.

The title of this quarter’s market update is “Higher for Longer?” – meaning we caution that interest rates may remain higher for a longer period than expected. The U.S. economy is still adjusting from its previous, extended period of ultra-low interest rates.

From the beginning of the Global Financial Crisis in 2008 through 2022, the Fed Funds rate was mostly below 2%. For nine of those years (2009-2016 and 2020-2022), the target rate was essentially zero. But over a longer period, the Fed Funds rate has generally been much higher. From 1980 to 2000, the rate was typically above 5% (other than a few years in the early 1990’s).

The Federal Reserve focuses on price stability, that is, keeping inflation low. For several reasons, the U.S. economy had been in an extended period of low inflation prior to 2022. Many observers assume that we will soon return to a similar environment of inflation at or below 2%. However, there are several structural reasons to question that assumption:

• • In many parts of the U.S., there is a structural shortage of housing. Housing costs are one of the largest components of most people’s budgets and one of the largest factors in the inflation metrics. This problem will not be fixed quickly.
  • Cheap imported goods, specifically from China, have caused deflation in many consumer goods categories, such as electronics and clothing. With changes in Chinese leadership and a more strained relationship between China and the West, that trend may reverse.
  • Oil prices have increased sharply lately, primarily due to geopolitical tensions in the Middle East and Russia. How long these conflicts will last is unclear, but their effects on energy prices may keep prices higher for an extended period.
  • The U.S. Federal Government continues to run significant budget deficits and the accumulated debt is now over $34 trillion. The government may find itself having to pay more to borrow in the future, which could flow through to broader interest rates.

While the Federal Reserve and many economists still predict inflation will return to the 2% target level, market indicators of inflation are flashing warning signals. The week of April 1, Gold prices closed at nearly $2,350 an ounce, a record high. Oil closed at $86.73 on Friday, April 5th. Oil prices were up 16% in just the first quarter and have continued to increase in April. The prices of silver and copper also hit 52-week highs in the first week of April. All these factors indicate the risk of inflation continues to run hot.

REAL ESTATE WORRIES

One of the few asset classes that struggled in the first quarter of the year has been real estate. Although a few select sectors of the real estate market continue to do well, commercial real estate has struggled, particularly office buildings. Occupancy in many U.S. cities has never recovered from the Covid shutdowns and the growth in hybrid and remote working arrangements has led many companies to reduce the amount of office space they lease.

One significant risk for the overall economy is the amount of debt on commercial real estate that is coming due in the next few years. Some estimate that nearly $1 trillion of debt backed by real estate will come due in 2024, followed by another $1.5 trillion in 2025. Unlike the financial crisis of 2008-2009, much of this debt is not held by the largest financial institutions, but by small and mid-size banks.

During the first quarter of 2023, we witnessed a “mini” banking crisis as Silicon Valley Bank and First Republic Bank experienced significant outflows of cash when depositors started worrying about the banks’ capital positions after taking write-downs for losses in their bond portfolios. A comparable situation could occur with small and mid-size banks that hold much of this struggling commercial real estate debt, not to mention the deposits of many small businesses and rural communities.

STOCK MARKET RECAP

While the headline returns for the U.S. stock market in 2023 were impressive, the actual performance was quite narrow. The much-discussed “Magnificent Seven” stocks (Microsoft, Meta, Alphabet, Amazon, Nvidia, Apple and Tesla) drove most of the return of the S&P 500 index.

In the first quarter of 2024, stock market returns have broadened beyond these seven. Tesla and Apple were both down for the quarter. Overall, while technology and communication services sectors continued to do well, the financial services, energy and industrial sectors were all up 10% or more for the quarter. The Morningstar chart below recaps the performance of various market sectors through March 31, 2024.

While some sectors of the stock market may be overvalued, if the economy continues to grow, the job market remains strong and the Federal Reserve remains neutral or even accommodative, the outlook for equity returns the rest of the year could be positive.

CONSIDERATIONS FOR THE REMAINDER OF 2024

The U.S. stock market has demonstrated 15 months of impressive performance. It would not be surprising for there to be a pullback at some point in 2024. Bordeaux will work with each of our clients to maintain discipline and adjust your asset allocations to avoid being overweight in equities or other interest rate sensitive assets.

Lastly, although interest rates may stay higher for longer, should the Federal Reserve begin to cut interest rates sometime this year or next, locking in longer-term bonds with higher yields will make sense.

We do not pretend to be able to predict the future paths of inflation or interest rates and it is almost impossible to predict changes consistently and correctly in these areas. Over the next few months, as market commentators focus on when the Fed will start cutting rates, Bordeaux will prioritize issues that we can help clients control and manage.