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The “Three Steps Forward, Two Steps Back” Economy

The “Three Steps Forward, Two Steps Back” Economy

| September 19, 2023

Quick Skim Summary:

  • The financial world is a mixed and volatile bag right now with plenty of unknowns
  • Policy actions have helped to stabilize markets, but their effects may result in short-term investor pain at times
  • As stock market valuations turn higher, real estate is a major question mark at home and abroad
  • AI has boosted tech stocks this year, but it leaves many wondering if there’s too much hype
  • Overall, challenges exist, but the long-term outlook is promising when looking out toward 2024 and beyond

The consumer is strong, but credit card debt is up big. The housing market has crept higher but remains depressed in many parts of the country. The employment situation is healthy, but fewer jobs are being created each month.

Does this economy have you confused?

If so, you are right there with the smartest economists on Wall Street. It feels like, and the data backs this up, that one positive gauge of the broad economy is offset by another dismal figure. Indeed, the current economic climate is a mixed bag, but there are plenty of positives to focus on.

The government’s stimulus measures provided a much-needed demand jolt back in 2020 and 2021, and low interest rates fueled risk-taking. Now, though, we are working through a bit of a fiscal and monetary policy hangover. Challenges are many, including volatile swings in interest rates, inflation that remains uncomfortably high, and ebbs in the jobs situation.

Navigating by the Stars Under Cloudy Skies

It will take time to work off so many excesses caused by direct payments to families and businesses as well as a Federal Reserve that was late to the party in raising interest rates to rein in economic expansion. Aggressive fiscal and monetary policies also bolstered the stock market, and an emerging debate is coming to the fore: What are we going to do with all this debt? Investors and families alike may grow uneasy thinking about all the long-term consequences now that interest rates are at 16-year highs.

Bright Spot: Investments on the Mend

The good news? Your stock market holdings look a heck of a lot better today compared to a year ago. It was the fall of 2022 when the S&P 500 notched its low near 3500. Jump ahead to today, and we are a stone’s throw from all-time highs in some sectors. It’s a clear sign that the recovery is pressing ahead, albeit with near-term setbacks.

The Russian invasion of Ukraine and the Silicon Valley Bank debacle feel like ages ago. All the while, even with high inflation, economic growth has continued (though we did have two quarters of negative growth in the first half of 2022). Of course, anything can happen from here, and the financial picture is still evolving, with dings and touch-ups all the time.

Jobs, Inflation, and the Fed

A prevailing theme this year is that stocks have a peculiar way of interpreting news, especially when it comes to the jobs market and Fed actions. For instance, negative news about employment can paradoxically lead to hopes that Chair Powell and the rest of the Committee will refrain from raising interest rates. It all seems to hinge on the latest Consumer Price Index (CPI) report as to whether the central bank will hike rates again.

The bright side is that inflation has fallen hard from last year’s peak near 9%, yet it’s still up for debate regarding where CPI goes from here – higher energy prices today could throw a wrench in the sanguine trend down in the inflation rate. Ironically, as we write this, the market is up on bad labor market news!

Clipping Coupons: Last Year’s Pain, Future Investors’ Gain

As for the bond market, there are fits and starts to say the least. While the broad fixed-income space is about flat on the year, that’s much improved from the worst year since data began in 1976 that we all witnessed (and felt) in 2022. Yes, it was bad, but current bond yields look so much better today compared to two years ago. You can own high-quality bonds with rates in the 4.5% to 7% range – awesome news for those with balanced portfolios between equities and fixed income.

Piecing Together the Real Estate Puzzle

Real estate, meanwhile, is also under stress, but there are green shoots in this market as well. Residential housing is less fluid with so many homeowners “locked in” to their low-rate mortgages and first-time prospective buyers are between a rock and a hard place given the 7%-plus borrowing rates right now. Still, the Case-Shiller Home Price Index indicates that home values have been rising over the last handful of months.

Another factor to consider is the shift to remote work which has greatly devalued commercial real estate in cities. As part of the “two steps back” narrative, we expect to see more defaults in commercial real estate and a steady flow of negative headlines that could rattle stocks at times.

Good News, Bad News: A Market Paradox

That is a lot to digest. The market feels the same way! What does the future hold? Our crystal ball broke a long time ago, but there is no hiding the reality that valuations are on the high side as equities flirt with new highs again. Bear in mind that it has been a whopping 600 plus days since the last all-time peak, so there’s reason for investors to be cautiously optimistic. Think of it like this: These high valuations based on future expectations are like the markets way of conveying, “Of course we will eventually get through today’s hurdles as we always do, we need to look beyond current scary headlines if you want to make good long term returns.”

Pricey Stocks: A Double-Edged Sword

As we eye 2024 and beyond, expectations must be tempered. When the market has been doing well and valuations are lofty, we should not expect stellar returns in the short run. Rather, it’s the classic “three steps forward, two steps back” dance the market will likely jig. So, if you see a 5-7% dip following a 25% advance, don’t hit the panic button. It is not a red flag signaling a doomed market, but the usual do-si-do.

China Tensions & Reshoring: The New Normal?

A bit of malaise in bonds, real estate, and the occasional stock market retreat pale in comparison to what’s happening in China with their property woes. An extreme amount of housing supply and leverage has left the world’s second-largest economy teetering on a real estate meltdown.

Compounding the dour situation are tensions between the US government and China’s leader, Xi Jinping. In response, public and private investment at home feature a “re-shoring” theme to decrease dependence on foreign nations that don’t always seem to be acting in our best interests. This tactic is seen maybe most starkly in the semiconductor chip industry. While we don’t want to completely turn our back on China, the market will pay close attention to how testy relations unfold.

The AI Revolution: Game Changer or Just More Hype?

Fueling this year’s more than 35% Nasdaq gain is artificial intelligence (AI), though all diversified portfolios have returns far under that. Honestly, I love what AI is already delivering. It saves time by helping me complete various small tasks or questions more efficiently! The tools are quickly getting better as the tech arms race rushes to secure the top spots, lest they be made obsolete. I’m cautiously excited and optimistic for this technology to be more incorporated into our Microsoft and other tools in the coming months and years.

The hype may very well be overdone; only time will tell. That is an important investing principle to think about. Consider Apple. It’s a great company, arguably one of the best run in the world, and its products are the most beloved no matter where you go. But the future return on the stock does not depend on whether Apple is a sound company. It’s all about how its earnings per share grow relative to market expectations and what’s already priced in.

AI could be a massive productivity gain for the global economy. Goldman Sachs even asserts that global GDP could rise by 7% directly because of AI over the next decade. Talk about a game-changer!

In my experience, yes, there are echoes of the dotcom bubble some 25 years ago, but each time is different. Here’s what I conclude: Do earnings and financial ratios matter? Of course. So, don’t get too far ahead of your skis with AI and all the rosy projections out there. Still, we should happily take tech-stock gains as they come while ensuring we remain diversified across sectors, market caps and geographies. Simply holding the so-called “Magnificent Seven” stocks could prove problematic before long.

Playing the Long Game

Progressing through the financial landscape is often a journey of three steps forward, two steps back. Despite so many challenges and ongoing uncertainties, markets have proven to be resilient. It remains imperative, however, to recognize the risks that lie on the path ahead. Volatile interest rates, real estate weakness, and China’s stringent regulations are just a few of the unknowns.

You and I are in ideal shape. Do you know why? We get to play the long game. Unlike Wall Street economists and analysts, we do not (and should not) make decisions based on the latest economic report. The mosaic looking out many years is optimistic even with all the risks we have detailed.

Investors must keep a balanced perspective and not dwell on short-term setbacks as if they are financial catastrophes. A pullback is actually a healthy thing in markets, supportive of a solid financial ecosystem, which lays the groundwork for future gains.

Thanks for taking a look. Please reach out if you would like to connect and review your personal financial situation.

-Your ISC Financial Advisors Team