Episode 5 – Interest Rates

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Hello, everybody. Thank you for tuning in to Market Perspectives, a Mercer Advisors podcast where we provide a data driven, common sense perspective on the economy, on markets, and on investing. I’m your host, Don Calcagni, Chief Investment Officer at Mercer Advisors.

Today’s topic will focus on inflation and interest rates. These are two themes that have dominated headlines over the past year and in our view, will likely continue to dominate headlines for the remainder of 2023. Now, why are these two topics important? Let’s begin with inflation.

Number one, inflation erodes the purchasing power of our income and our savings.

Interest rates are how the Federal Reserve combats inflation or economic stagnation. And interest rates impact us both as savers and as spenders. So if you think back over the past 15 years where the Fed engaged in quantitative easing. They took interest rates to zero, and they pumped a lot of cash into the economy. That pushed stock bond prices up. It also pushed up home prices and the prices of other assets.

So interest rates are important. They impact stock and bond prices. They impact what we earn on our savings accounts. Over the past 15 years, prior to the Fed beginning to raise interest rates in March of last year, the reality is trying to earn anything on our savings was quite difficult because rates were virtually zero. That’s not the case today.

So again, interest rates impact us both as savers and as spenders. If we think of when you go to buy a home or when you go to buy a car, naturally interest rates, if you are borrowing for those large purchases, naturally higher interest rates could make it harder to buy a home and perhaps even put purchasing a home out of reach for many families. That is a significant concern these days.

So again, these are critically important topics. So let’s look at a little bit of data. Last week, the Bureau of Labor Statistics released their May CPI report. And what we see in the data is that last month, May 2023, inflation declined to about 4.1%

year over year. So what does that mean in English? What it means is inflation over the past 12 months ending in May of 2023, inflation was 4.1%. So when you hear year over year, what they mean is over the past 12 months, that was the inflation rate.

Now if we go back and look at a little bit of history, we see that in June of 2022, inflation peaked at 9%. Highest inflation that we’ve seen in over 40 years. Now to combat that, to rein in inflation, the Fed took interest rates from virtually zero, up to where they are today, which is a target range of between 5 and 5.25%. So a very significant increase in interest rates over the past year.

In fact, the Federal Reserve, prior to their June meeting, which occurred last week, prior to last week’s meeting, the Fed had raised interest rates at 10 consecutive FOMC meetings. FOMC is the interest rate setting committee of the Federal Reserve.

Now, if we look inside the May CPI data, we actually see a little bit of deflation.

If we look at, for example, energy gasoline declined 3.5% for the month of May. So we’re actually seeing some deflation in select categories. Now that’s nothing to get excited about. Energy prices are notoriously volatile. There’s times when they go up quite significantly, and there’s times when it comes down quite significantly.

The interesting point is that despite the war in Ukraine, despite the start of the summer driving season, we’re actually seeing gas prices actually come down overall. So that’s an interesting development. But again, that is deflation. Now, to be fair, there are categories within the consumer price index where we are still seeing high inflation. And the number one category that jumps out to me that jumps out to economists is that of shelter.

Now shelter is a bit of a weird category. I’ve written on this in the past.

But the reality is shelter makes up 35% of the consumer price index, and it continued to run hot in May. It was up about a half of a percentage, 0.5%.

Economists still expect that to come in. We’re still expecting that to come down as lease agreements, as rental agreements for homes, for rentals, for apartments.

As those things renew, these are typically 12-month long lease agreements, when they renew, we’re expecting that to soften, to start to come down. So much so that most economists at the moment forecast that inflation overall will fall to about 3% year over year by the end of December 2023.

Some are actually forecasting that could happen sooner. That we could actually see 3% year over year inflation sometime in Q3 or early in Q4. The reality is, inflation continues to come down. Over the past 11 months, inflation has continued to come down. I already referenced that in June of 2022 is when inflation peaked at 9%.

So the Fed has made significant progress in bringing in inflation.

But at the end of the day, 4.1% is still too high. It is not where the Fed wants inflation to be. The Fed continues to communicate that they are committed to their long-term 2% average inflation target. So 4.1% obviously still too high. The Fed is focused on reining that in.

So what did the Fed then decide to do at the June FOMC meeting? Well, they decided not to raise interest rates.

Now, why they didn’t raise interest rates, there’s a lot of reasons we could point to. We started to see some cracks in the banking system. In March, we saw the failure of Silicon Valley Bank. First Republic Bank didn’t fail but was ultimately acquired. Another bank Signature Bank had failed.

So we were starting to see some cracks in the financial system. And I think that gave the Fed a little bit of pause. On top of that, we’re also seeing some signs that the economy is perhaps starting to slow down a little bit. To be fair, we still have really low unemployment of about 3.5%, but there is some signs that perhaps the economy is beginning to slow down.

So the economy is slowing, perhaps some stress in the financial system. I think as a whole, when you combine that with the fact that inflation has continued to come down over the past 11 months, I think the Fed looked at all that and said, there’s probably no harm in just not raising rates at this particular meeting. And so that’s what they did. They did not raise interest rates.

Now, what they did communicate is they did jawbone the market a little bit, by communicating that they still expect that they’re going to have to raise interest rates two more times between now and the end of the year. And to be fair, that caught the market off guard last week. The market has largely looked past it now that we are a week later. But the reality is, when that was first communicated, that really caught the market off guard.

And the reason why is the market has been forecasting for quite some time that the Fed would be cutting interest rates sometime by the end of this year. And I’m in that camp. I was actually surprised to hear the Fed communicate that they’re expecting to have to raise interest rates two more times between now and the end of the year.

Now, to be fair, they are expecting to raise rates only a quarter of a percentage point each of those two times. So we’re not talking significant rate hikes. Nothing on the order of what they were doing last year, where they were raising rates a half point, three quarters of a percentage point for a number of meetings. So we’re talking much lower interest rate hikes between now and year end.

I think the Fed is communicating that because they want to be clear to the market and to policymakers and to Congress, that they are not going to quit the inflation fight prematurely.

Remember, the Fed has two mandates. Number one is maximum employment. By most measures we’re there. We have unemployment at 3.5%

But number two is price stability. And the price has an official target, an average inflation target of 2%. 4.1% is obviously too high. So they want to make it clear to the market that they are committed to that 2% target. They have not given up on that 2% target, so they are still going to aim for that if they need to.

But there was no harm in skipping raising rates at the June meeting. I think the Fed saw that. They want to see how all the rates that they’ve implemented thus far, they want to see all of that filter through the economy. Most economists would argue it takes probably about six months for interest rate hikes to filter their way through the US economy.

So the reality is there’s really no harm in waiting and just seeing how the economy evolves over the next month or so. It could be that we see rate hikes in June. We could see some more here before the end of the year. At the moment, the market is still expecting that next year and even the Fed themselves next year, they were forecasting as many as four interest rate cuts in 2024.

So that’s the new news. The report from the Bureau of Labor Statistics, the CPI report, and the fact that the Fed met and chose not to raise interest rates. But they are now communicating that they’re going to have to raise rates probably two more times between now and the end of the year.

So what does this mean for investors? And oftentimes when we hear the prospect of interest rate hikes, I get inquiries from advisors, from clients asking, hey, what does this mean for our portfolio? What should we do? Should we reallocate? Do we need to make any big changes? And before we have that conversation, I would just encourage investors to hit the pause button.

And let’s back up for a moment. And let’s not forget that 18 months ago, that even for diversified investors who had any allocation to fixed income, to bonds, to CDs, to cash savings accounts, that we were earning virtually nothing on those holdings for a very long period of time.

Fast forward to where we are today, and now US Treasury bonds are paying anywhere between 5% and 5.5%

to investors. That is a significant increase. Corporate bonds are paying over 6%. High yield bonds are paying 7%, 8%, 9%. These are dramatic increases in interest rates.

Now as borrowers, that’s certainly no fun. I think all of us probably know somebody who would love to buy a home. And unfortunately, mortgage rates are now a lot higher than they were 18 months ago. The other side of that coin, as an investor, we’re now earning significantly more on our fixed income holdings, on our savings.

I was just looking at a money market fund a little while ago that’s paying over 5%. We haven’t seen that in well over a decade, a decade and a half.

That is a substantial increase. So as investors, I think it’s important to keep that in mind. I think many of us have heard or read stories that these diversified 60/40 portfolios that are 60% stock, 40% bonds, we would read these articles that would say, oh, the 60/40 is dead.

Well, if it was dead two years ago, it has certainly come back alive in a very big way today, given where interest rates are. So I think these higher interest rates are actually a good thing for us as investors when we look at our long-term portfolios. Naturally, bonds went down last year. But if you’re holding bonds as part of a diversified portfolio, for any length of time, 1, 3, 5, 10, 30 years, you’re going to do quite well now that we have these much higher interest rates, that’s good news.

From a stock investor perspective, higher interest rates, I believe, are great news. Because I believe that that now forces corporate managers of the companies that we own in your portfolios S&P 500 companies, the corporate managers of those companies to be more judicious, more prudent, more mindful when they borrow capital to invest in their companies.

Whether it be building a new factory, investing in a new product line.

It brings discipline. Higher interest rates, bring discipline to corporate managers. And we should expect to see that manifest itself longer term in better returns for stock prices.

Finally, the fact that interest rates were near zero for the better part of a decade, decade and a half, ever since the global financial crisis, what it really means is that many investors in global stock markets would throw caution to the wind. Prices didn’t matter. When money is free, price doesn’t matter.

However, today, money is obviously not free. Interest rates are substantially higher. What that means is we should start to see more prudence, more focus on valuations in global stock markets, not just the US, but globally. So that should bring more discipline to market participants, to investors. We should start to see greater distinction in prices between good companies and less good companies in the broad market.

And I think that’s an opportunity for better, longer term outperformance for scientifically focused investors who focus on things like valuations and profitability of the companies in their portfolios.

Well, that’s all for today. Thank you for listening. Should you have any questions, please feel free to reach out to your advisor here at Mercer Advisors. I’m Don Calcagni and we look forward to seeing you next time. Thank you.

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