As many Americans shift from leisurely summers back to work and school this Fall, we are monitoring another meaningful change in the economy, with Jay Powell and the Federal Reserve steering the ship. Powell has made a major course correction that seems to have halted runaway inflation and avoided the rocky shoals of surging unemployment, enabling a smoother ride for our economy and capital markets. With incomes, inflation, and stocks performing well so far this year, this quarter’s letter will evaluate scenarios for what’s next on the horizon.

Before we look ahead, let’s take a quick look back at how and why the Fed changed courses over the past two years. In mid-2022, rising consumer demand and tight supply chains coming out of the pandemic fueled a spike in inflation that the Fed incorrectly identified as temporary. However, Jay Powell saw the U.S. economy sailing in the wrong direction, and he quickly tightened policy to steer away from inflation. As price levels moderated last month, Powell began another shift in policy to lower interest rates—a move that he hopes will combat rising unemployment.

Wall Street favors Powell’s strategy

Investors are cheering the timing and magnitude of Powell’s change in course, especially the Fed’s half point interest rate cut in September, which was bigger than a typical quarter-point cut. The Fed’s momentum is helping to drive U.S. equity markets up by an impressive 22% this year, overcoming several waves of recession fears that triggered two equity market corrections in the third quarter. Along with disappointing jobs data in July and August, investors were also worried about semiconductors and currency volatility in the Japanese market that could create a spillover effect on the U.S. However, favorable Fed action helped U.S. equity markets reverse these losses.

Even the sometimes-grumpy bond market is giving Powell’s strategy a “thumbs up,” as seen in a nearly 5% total return this year for a basket of high-quality government and corporate bonds. In general, bond investors are expecting the U.S. economy to have mature growth and low inflation, which usually leads to lower interest rates on bonds. Easing bond yields have driven up prices slightly and added to total returns from bond coupon payments this year.

Will there be another change in course for the Fed?

The U.S. economy and markets appear to be in better shape compared to two years ago when investors worried about sky-high inflation and rising interest rates that could push the economy into recession. However, we are in the early innings of the Fed’s new rate-cutting policy intended to stimulate the economy and prevent a wave of layoffs. Disappointing retail sales from companies serving lower income consumers, for example, is a glimmer of weakness in an otherwise decent consumer outlook. With that in mind, our sense is that Jay Powell will be watching the jobs market closely and will consider more aggressive rate cuts if unemployment exceeds mainstream expectations.

Looking further out, we would expect the economy to follow the business cycle and get either too hot or too cold at some point, triggering another round of “climate control” from the Fed as it tries to limit big swings in the economy. Still, current economic and market trends suggest to us that the next round of major changes in Fed policy will be a few quarters or years away.

Favorable macro and micro

In addition to favorable Fed policy, corporate earnings continue to grow, supporting total returns for stocks. A wave of artificial intelligence (AI) semiconductors and related cloud computing that kicked off in late 2022 has fueled performance in technology and other growth sectors, although the rest of the market is starting to catch up.

Stocks in the tech sector are taking a breather after hitting a near-term peak in July, while other parts of the equity market continue to reach new highs. Sectors such as utilities are doing well as investors favor steady growth and growing dividends, which appear more attractive as bond yields fall.

How are we positioning? 

With the economy and markets performing well, it can be tempting to take on more risk with the hopes of greater returns if the good times continue. However, we prefer to keep a disciplined approach to owning a diversified set of companies that can grow and expand market share over a multi-year period. This diversification gives us exposure to growth companies when the economy is expanding, but also keeps us in defensive companies, such as consumer, healthcare, and utilities, in case the economy contracts unexpectedly.

As we enter the last quarter of the year, we may continue to benefit from the Fed’s course correction, as Jay Powell stimulates the economy through lower interest rates. We believe a gradual economic expansion may support steady growth in corporate earnings across a wide range of sectors, highlighting the importance of our strategy of diversification. As these micro and macro factors continue to drive markets, we continue to maintain a fully invested approach and a preference for stocks and bonds that can meet or exceed investor expectations, ever mindful your long-term goals and objectives.

We wish you all the best this fall.

Michael Bailey, CFA                        Michael Mussio, CFA, CFP®
Director of Research                      President

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