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Investors in long-term bonds feel like they are repeating a bad song while investors in stocks are likely not doing as well as the media headlines assume.

In 2022, the Federal Reserve began its campaign to tame inflation by increasing the Federal Funds rate from zero to 4.25% by year end. The 10-year Treasury followed, ending at a yield of 3.88%, up from about 1.5% at the start of the year. Because the price of a bond moves opposite to yields, this dramatic increase in rates led to double-digit losses for bond investors.

After a bit of a reprieve in 2023, bond investors are feeling the pain again. The 10-year Treasury yield fell to 3.25% in April but has since steadily increased to about 4.8%, as the Fed has further increased the Federal Funds rate to 5.25%. With inflation still above the Fed’s 2% target and economic growth strong, it isn’t likely that bond investors will escape another year of losses.

As we head into the fall, 2023 has left egg on the face of most forecasters. The seemingly inevitable recession on the heels of a turbulent 2022 hasn’t materialized. The economy continues to grow, inflation is abating, and the stock market has had a remarkable year. Interest rate increases haven’t torpedoed the employment market. Government, consumers, and the market have coalesced around a “soft landing” narrative. However, as always, there are risks.

Since March 2022, the Federal Reserve has executed eleven separate increases to the Federal Funds rate, bringing it to a range of 5.25% to 5.5%. This rapid pace of increases is having the desired impact on inflation and a red-hot labor market.

Long-term interest rates were choppy with no clear trend in 2023 through the end of July but broke to the upside in August. The 30-year Treasury’s yield recently surpassed its 5-year high of 4.2%, with the 10-year also nudging above 4%. Long-term rates have not traded above these levels for an extended period since the financial crisis of 2008-09. It will be interesting to see whether investors treat this like a ceiling for rates or keep allowing them to rise.

Basic supply and demand for government debt may force a new equilibrium at higher rates, meaning lower bond prices, as the U.S. fiscal deficit will balloon to more than $1.5 trillion in the government’s fiscal year that ends in October. Deficits as a fraction of GDP have averaged 3.6% since 1973. This year’s deficit is likely to be more than 6% of GDP. That is a lot of supply.

Since early 2020 the economy has undergone a series of shocks. First came the Covid-19 pandemic, which continues to impact the economy more than three years later. Next came the war in Ukraine, impacting global oil and wheat markets.

Most recently the emergence of Generative Artificial Intelligence (GAI) is a technological development that some have said could be as profoundly positive as the invention of the internet, mobile devices and cloud computing. Only time will tell if GAI lives up to the hype, but these shocks have brought tremendous volatility to the economy and financial markets.

Unprecedented monetary and fiscal support in response to the pandemic has brought elevated inflation. Since March 2022, the Federal Reserve has been pursuing monetary tightening, resulting in the fastest pace of rate hikes in U.S. history, eleven separate increases bringing the federal funds rate to a range of 5.25%-5.5%. The Fed is attempting a soft landing for the economy, raising rates just enough to slow growth without causing a recession.

The U.S. economy is still feeling the after-effects of the Covid emergency more than three years after it began. In the early going, consumers hoarded items they feared would be in short supply like toilet paper and cleaning products. Demand for many types of services like travel and dining collapsed. In the next phase, component shortages caused prices of many goods to surge. Then, as Covid restrictions eased and demand returned, labor shortages led to further price increases. The war in Ukraine exacerbated growth and price challenges.

The government played a role as spending levels and easy monetary conditions were left in place for too long even as the worst of the crisis had clearly passed. The Federal Reserve was caught flat-footed, assuming the nascent surge in inflation two years ago to be “transitory.”  It has spent the last year and a half making up for its initial failure, raising short-term interest rates from around zero to 5.00%.

The chattering class in the media and in Washington D.C. is wailing about the debt ceiling, but stock and bond market behavior suggests little concern. Treasury Secretary Janet Yellen says that there is only enough financial flexibility to avoid default until early June, so this matter is coming to a head. President Biden and the Democratic Senate insist on a “clean” bill to raise the debt ceiling which seems unlikely to pass the Republican-controlled House. Republicans insist on spending cuts and a slowdown in future spending growth as a condition of raising the debt ceiling.

The concept of a debt ceiling has not always been part of U.S. finance. From the founding of the Republic until 1917, each and every bond issuance was approved by Congress. Article I of the Constitution specifically empowers only Congress “To borrow money on the credit of the United States.”  During World War I, Congress enacted the Second Liberty Bond Act, permitting the Treasury Department to borrow without prior congressional authorization, as long as total debt didn’t exceed the approved amount. The debt ceiling was born.

The Economist, a British news magazine, put a cowboy on the cover of its April 15 issue and sang the praises of America’s resilient economy. They wrote, “America remains the world’s richest, most productive and most innovative big economy. By an impressive number of measures, it is leaving its peers ever further in the dust.”

Indeed, while Britain and much of continental Europe are experiencing recession, U.S. GDP expanded 2.6% in the fourth quarter, with the Federal Reserve Bank of Atlanta forecasting 2.5% growth for the recently-completed first quarter. After a volatile period during the pandemic, we appear to be regaining our old form of consistent real GDP growth above 2%. Although some forecasters are contemplating a late-year recession, almost no one expects a deep or long-lasting one.

The bill has seemingly come due for the Federal Reserve’s mistaken belief inflation was “transitory.”  A late start in tightening policy to combat inflation led to the fastest rate hikes in forty years, and it should come as no huge surprise the stress from such a move might break something. The collapse of Silicon Valley Bank (“SVB”), the 16th largest bank in the U.S., was the headline casualty, but Signature Bank was also shut down by regulators and the impact was evident across the sector, notably regional banks where share prices declined sharply.

Given the potential for widespread market disruption, regulators stepped in with a package of emergency measures to calm fears among depositors and help prevent contagion. The actions taken brought back unwelcome memories of the financial crisis. The government announced the FDIC would guarantee all deposits held at SVB and Signature Bank, even those beyond the $250,000 limit, by invoking a “systemic risk exception.”

The year is off to a better start for equities than many expected following a difficult 2022 when aggressive rate hikes to counter inflation weighed on sentiment. The move higher for stocks in 2023 has been prompted by the expectation that the Federal Reserve is nearing the end of its rate hike cycle as inflation retreats from its recent peak. Combine that with optimism regarding a reopening in China and a resilient labor market in the U.S., increasing hopes for a “soft landing” for the economy, and the move higher for equities is understandable.

To battle persistently high inflation the Federal Reserve has raised its benchmark interest rate by 4.5% since last March, to a range of 4.5%-4.75%. This represents the fastest pace of rate increases since the 1980s with the intention of cooling off the economy to bring down inflation. The tagline the Fed uses is that its policy operates with long and variable lags, but still, its efforts have not yet had quite the bite many expected.

Last summer, there was a brief wave of optimism among investors that the Federal Reserve’s pattern of interest rate hikes would be short-lived.  It was illogical given rampant inflation, but investors could let their imaginations wander during the lengthy eight-week lull between the Fed’s July meeting and its September meeting.  However, midway through the lull the Fed became concerned investors weren’t getting the message, using the annual “Jackson Hole (WY)” monetary policy conference in late August to reiterate its determination to raise rates until inflation is back to its 2% objective.  Investors got the message and stock and bond prices wilted for about a month and a half afterward.

A greater disconnect between markets and the Fed emerged after markets bottomed in mid-October, persisting even in the face of two more Fed meetings that resulted in rate hikes.  Notes from its November meeting indicate Fed governors raised their terminal Fed Funds rate in this tightening cycle compared to their consensus after the previous meeting.  Markets initially flinched on this news, but quickly resumed their ascent.

No year is without surprises. As we look back at 2022, probably the two most disruptive surprises were Russia’s war in Ukraine and the persistence of Covid lockdowns in China. Both caused complicated knock-on effects for the global economy. Embargoes on Russian imports stressed European energy markets and briefly caused oil and gas prices to spike worldwide. That Russian energy did not disappear, it just got rerouted, and energy commodities have pulled back significantly, although regional prices can vary compared to global averages.

Chinese demand for imports has dropped, while its export machine continues to hum despite the lockdowns. China’s balance of trade (exports minus imports) has risen to new highs. Chinese companies reselling cheap Russian energy at a markup may exaggerate this statistic.

The stock market continues to be driven on a daily basis by the outlook for interest rates. Data suggesting inflation is easing or the economy is slowing is favorably received by stock investors who are looking for, or more precisely hoping for, signs the Federal Reserve is ending its aggressive rate hikes. Every speech from Fed Governors is scrutinized for these signs.

We saw a similar pattern during the summer, but it didn’t last. Some investors didn’t believe the Fed would continue raising rates by three-quarters of a percent each month past the first couple of months. Traditional rate hikes are typically one-quarter or one-half percentage point per month, but this time the Fed started very late and attempted to make up for lost time. Summer optimism is easier to perpetuate because the Fed doesn’t meet in August, allowing investor sentiment to go off on a tangent without a reality check. But Fed Governors saw this market optimism and in mid-August doused it with a bucket of ice water, sending stocks down to new lows by the middle of October.

Despite the Federal Reserve enacting the most aggressive interest rate hikes since the 1980s, inflation continues to run near 40-year highs. In September, the Consumer Price Index (CPI) rose a greater-than-expected 8.2% from the prior year, and 0.4% from the prior month. The annual increase was down slightly from 8.3% in August and 9.1% in June, which marked the highest inflation in 40 years. The “core” measure of inflation, which excludes food and energy prices, rose 6.6%, accelerating from August and representing the largest increase since 1982. This was not welcome news, as the Fed had hoped more restrictive policy would have had a greater impact. Instead, inflation remains well north of the Fed’s 2% target.

The Fed’s preferred inflation measure, the personal consumption expenditures price index (PCE), is also running well ahead of its long-term target, rising 6.2% in August, which is the most recently available data. This is down slightly from July, but the core measure jumped to 4.9% from 4.7% the prior month.

In the wake of lockdowns and restrictions that throttled the services sector, the U.S. economy in 2022 needs to return to form without aid from the fiscal and monetary stimulus that carried many consumers and businesses through the pandemic. The data has been volatile and sometimes contradictory. GDP contracted -0.6% in the second quarter, markedly better than the first quarter’s revised change of -1.6%. Unemployment ticked higher to 3.7% in August, but for the best possible reason—employers hired at a rapid pace while workers came off the sidelines and returned to the workforce even faster. Labor force participation has remained stubbornly below its pre-pandemic average, causing fears of a permanently lower equilibrium. Those fears may be overblown.

Inflation has slowed thanks to retreating energy prices. After a flat July, August’s CPI report showed a 0.1% month-over-month increase. The uptick dashed hopes that the CPI would politely roll over and recede back to its old normal. Energy declined 5% month-over-month but remains up 24% in the last twelve months. Food costs rose 0.8% and are up more than 11% in the last twelve months, their fastest annual increase since May 1979. Core inflation outside of energy and food was 6.3% for the 12 months ending August. The report all but ensures another 0.75% interest rate increase at the next Federal Reserve meeting. Interest rates rose and stocks fell. The U.S. dollar strengthened apace.

Timing the market is futile. Recall March 9, 2009. Unemployment was skyrocketing, large banks like National City and Washington Mutual had been shut down, and GM and Chrysler were teetering on the edge of bankruptcy and threatening to take down the whole automotive supply chain with them. Things were bad and more bad news was ahead of us. What a foolish time to invest in stocks! Yet, that was the bottom. Why? Because the sellers had finished their selling. However, they don’t issue memos to let others know it is okay to invest again. But from that point, in fits and starts, the market recovered. Eventually, the economy recovered as well.

The stock market hit its recent low on June 17th with the Dow dipping below 30,000 and the S&P 500 reaching 3,636. Since then, stocks have staged a significant rebound despite negative sentiment in the business and investing communities. At recent quotes, the Dow and S&P have risen 13% and 18%, respectively, from their June lows but remain 8% and 11% below their all-time highs. The tech-heavy NASDAQ, once down 35%, has rebounded 24% but is still down 19% from its high.

These days being an investor takes fortitude. Since the start of 2022 stocks and bonds have each generated double-digit losses, upending the conventional wisdom that when stocks fall bonds rise, cushioning the blow to an overall portfolio. Further, elevated inflation levels not seen since the 1970s erode the value of holding cash and further exacerbate stock and bond market losses.

The economy continues to produce mixed signals regarding whether it will enter recession. Because the stock market looks ahead 6-9 months, its bear market performance has endorsed the recession argument. Further, after the Fourth of July the bond market joined the recession camp as the 2-year bond yield surpassed the 10-year rate to create an inverted yield curve. These stock and bond market signals haven’t always led to recession, but the odds now seem better than 50/50.

There are mixed signals as to whether or not the economy will soon enter recessionary territory, but the odds appear to be rising with every week that passes. The stock market seems to be screaming “yes,” but economic statistics are saying, “Whoa, not so fast.” The difference is that the stock market looks forward about six to nine months while economic stats reflect the past.

Retail sales increased for four straight months through April, though they took a step back in May. Likewise, industrial production has risen for four straight months. The Purchasing Managers Index reflects activity in the manufacturing and service sectors, and remains strong in both the U.S. and Europe, although it is down slightly from recent months. Yet, confidence surveys of consumers and small businesses are in the tank.

The S&P 500 barely avoided a 20% drawdown, the recognized threshold for entering into a bear market. After a recent bounce, it is currently down 15% on the year. The more volatile NASDAQ 100 is down 23%. Despite this year’s weakness, both indices remain well above their pre-pandemic highs, even in real terms adjusted for significant inflation. Bulls can take heart that the stock market has made good progress despite the unimaginable stress and uncertainty of the past three years, while bears may believe that stocks still have plenty of room to fall back to reality.

Who is right? Have we seen the bottom or not? The only reliable answer is maybe. FactSet’s John Butters notes that based on estimated forward earnings, the S&P’s P/E ratio is below 18 for the first time since the pandemic started. From a pure valuation perspective, we have come full circle. That said, stocks tend to carry lower P/E’s when interest rates are higher and also when economic conditions are softening, both of which are currently true relative to pre-pandemic levels. On the other hand, inflation tends to push stocks higher, and expectations for a new normal of somewhat higher inflation rates would support higher stock valuations.

After taking extraordinary measures to counter the impact of the pandemic, the Fed can reasonably claim “mission accomplished” as it relates to the full employment component of its dual mandate. The March report showed employers added 431,000 jobs while the unemployment rate dipped to 3.6% from 3.8% the prior month. This was only slightly higher than 3.5% registered in February 2020, representing a 50-year low. Job gains were also revised higher for the first two months of this year. Employment has rebounded sharply, with the economy now possessing just 1.2 million fewer jobs than in February 2020, a far cry from 21.6 million fewer jobs at the trough two years ago.

Labor force participation continues to run below pre-pandemic levels but is recovering. In March it inched up to 62.4% versus a recent low of 60.2% in April 2020. There are multiple drivers leading individuals to rejoin the workforce including declining household savings, as well as lower Covid cases, allowing workers who were home with children during school or caring for sick family members to return to the workforce. It would be helpful if this trend continues given there are currently more job openings than unemployed workers. Also reflective of the tight labor market, workers are quitting their jobs at near record rates, often for better opportunities. Fed Chair Powell has even expressed concern that the job market may be overheating, feeding higher inflation. Average hourly earnings grew 5.6% in March from the prior year, though this remains below most measures of inflation.

Vladimir Putin’s attack on Ukraine jarred global financial markets. Western democracies have responded with financial sanctions against Russia and its citizens, causing the ruble to suddenly lose roughly one-third of its value relative to major foreign currencies. Global investors are rushing to divest their Russian assets, but their efforts are frustrated by a lack of natural buyers and by the fact that the Russian stock market has been closed since February 25th. Nobody knows what Russian financial assets are currently worth.

Commodity prices and defense stocks jumped after the invasion. In the midst of a broad stock market selloff, Merrill Lynch sardonically proposed a new list of FAANG assets replacing the old investor favorites of Facebook, Amazon, Apple, Netflix, Google. The new FAANG according to Merrill? Fuels, Aerospace, Agriculture, Nuclear, Gold.