3rd Quarter: 2023 Edition

Markets & Economics Commentary

 ©2023 Mark P Culver

 

Russell 1000 Index:: 2023 YTD +13.0%%
Bloomberg Aggregate Bond Index:  2023 YTD -1.2%

 

3rd Quarter: 2023 edition

Interest Rates Base Case

 

Thus far for the year, and really the past 24 months, the driving force for all capital markets has been higher interest rates.  Since it commenced its campaign in early 2022 to stomp out inflation, the Fed has raised the interest rate that it charges its member banks (the Fed Funds Target, Upper Limit) 11 times from 0.26% in February 2022 to its current upper limit of 5.50%.  In suit, its member banks have raised their prime interest rate over that same period from 3.25% to currently 8.5%.

The real target of the Fed’s campaign, in my opinion, is to bring down housing demand.  To that end, mortgage rates have also risen dramatically, from 3.11% to 7.63% currently for 30 Year mortgages.

 

The good news is that these efforts to cool the economy down and irradicate inflation seem to be working.  Inflation as measured by CPI (Consumer Price Index) has dropped from a peak in excess of 8.0% (8.52% in 3/2022) to its current level of 3.69%.  And home sales nationally have fallen by around 40% depending on which measure you look at (new homes vs. existing homes).  You’ve probably noticed that home prices in your neighborhood have likely settled down from a few years ago.

 

The needle that the Federal Reserve is constantly trying to thread when they engage on this kind of journey is knowing when to stop raising interest rates.  If they go too high, they will throw the US economy into recession which conflicts with their other responsibility, which is to pursue maximum employment.  Like all of us, they are limited by imperfect and lagged information.  Consequently, any adjustments to interest rates typically aren’t seen in the economic data for at least 6 months.  Think about how long it takes when you’re trying to refinance a mortgage or secure financing for a business loan.  It’s a long, sticky process.

 

Clearly, the Fed is a lot closer to their end game of 2.0% inflation.  We are certainly of the opinion that we are near the end of the Feds interest rate push to raise interest rates.  As the last increase in the Fed Funds rate was just in late July, the effect of those rates won’t really be realized for another 3 months or so.  As that higher cost of funds permeates through the economy, it might be just enough to bring Aggregate Demand for the macro economy down to a level consistent with the Feds inflation target of 2.0%.  Personally, I’m of the opinion we will likely need one more rate increase to 5.75% on the Fed Funds rate to bring money supply and money demand into equilibrium.  Either way, it really feels like we are in the final stages of the process and are now fine tuning.

 

Where I sense I’m perhaps a bit more bearish on the overall economy than many of my peers is my belief that interest rates won’t come back down anytime soon.  After all, equilibrium means just that.  It’s that point on the supply/demand curve where the two forces are balanced.  Without some exogenous force to knock them out of alignment, there’s no justification for the Fed to begin cutting interest rates.  In that kind of environment, cutting interest rates would only spark a new round of increasing inflationary forces.

 

I am surprised and encouraged that the broad equity indexes have held up reasonably well in such a protracted period of rising costs.  Obviously, there are examples of individual companies and securities that were built under a naïve assumption that interest rates would stay low forever that have been decimated.  That the US economy and US equities have held up well is encouraging that once we have established a normal interest rate curve (not inverted and positive), investors should regain confidence in investing in solid ideas and companies with strong cash flow, strong balance sheets, and good growth prospects.

 

In that light, our base case assumption regarding the matter is for a higher and more normal interest rate curve.  That is to say, an interest rate curve that rewards savers for saving and encourages investors to make sound investments based on long-term sustainable cost of funds assumptions.  Assuming the Fed is successful in engineering their 2.0% inflation target, nominal interest rates should look like:  2.0% 1-year US T-Bill yield, ≈3.5% 10-year US T-Note yield, ≈4.5% 30-year US T-Bond yield, ≈6.0-7.0% 30-year mortgage.  We will therefore endeavor to build portfolios with managers and securities than can be successful with those higher cost of fund assumptions.

 

Please feel free to contact us if you have any questions or if you need to schedule an appointment to discuss your account or financial plan with us.  This is particularly important if you have experienced a big change in your life recently (got married, retired, changed employment, bought/sold a business, etc.).

 

2023 Form ADV Notice and Offering – the firm’s 2023 Form ADV Part 1 & Part 2 filings with the Securities Exchange Commission was filed 03/10/2023.  If you would like a copy of this important disclosure document, please contact us at (303) 442-3670 or [email protected] and we will be happy to deliver it to you at no charge.

 

Privacy Notice – the firm’s privacy notice, which details how we handle and/or may share your private information within the firm and with certain partner firms in servicing your account, is included in the 2023 Form ADV Notice.  Please refer to that document to review our Privacy Policy.  If you would like a copy of this document, please contact us at (303) 442-3670 or [email protected] and we will be happy to deliver it to you at no charge.

 

Sincerely,

Mark P. Culver

Managing Partner

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