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What We’re Watching Heading Into Q4 2022

We hope everyone enjoyed their summer and is preparing for the Autumn season. I know my kids are excited to start carving pumpkins and visiting apple orchards. They’ve even picked out their Halloween costumes already, which is nice for my wife and I as it’s one fewer thing to worry about on our ever-expanding list of to-dos!

With everything that has been happening in the markets the last few months, I felt it would be best to set the table for what we’re focusing on for the final quarter of 2022 and into 2023. While there’s no shortage of topics to narrow in on (I’ll apologize in advance for the length of this newsletter!), there are a few that stand above the rest as the most important drivers of economic momentum. Here’s what we’re watching:

The Federal Reserve and Inflation

 

Jerome Powell’s federal reserve has certainly taken our country on a roller coaster ride for the past few years. With hindsight being 20/20, I’m sure Powell would have begun withdrawing accommodation earlier in 2021, seeing how we’re still grappling with the worst inflationary environment in a generation. Unfortunately, we have yet to develop the elusive time machine to allow ourselves a remedy to our current issues and we’re forced to work through the hand we’re dealt today. The silver lining with our present situation is, and has been for the past few months, signs of disinflation working their way into our economy.

General Motors recently posted their third quarter earnings. In their report, they suggested supply chains and computer chip manufacturing has largely normalized as they’re seeing nearly three times the dealer inventory for cars when compared to Q3 2021. Shipping costs have come down dramatically, as have energy prices and a variety of other consumer goods. However, we’re still not out of the weeds yet as shelter, employment, and services costs continue to remain stubbornly high. Though the minor positive with shelter is this is a lagging data point, meaning the higher mortgage rates we’re seeing today won’t work their way through the data until 9 to 12 months from now. And, we know because of real-time data, the housing market has slowed significantly due to 30-year mortgage rates nearing 7%.

We’re also seeing some central banks begin to acknowledge their tighter monetary policies work their way into the system. In fact, the Royal Bank of Australia may be the first central bank to begin taking its foot off the rate hiking gas pedal when they only hiked 0.25% at their last meeting when the market expected 0.50%. The bond market is reacting favorably as we see yields fall from their recent highs in a sign the market may have identified the light at the end of the tunnel. However, it’s too early to wave the victory flag today as risks of a recession continue to loom on the horizon. Inflation will continue to play a critical role in the market’s directionality for some time.

The Labor Market

 

Welcome back to a world where bad news is good news when it comes to the labor market. One of the key drivers of inflation has been the cost of employment. As worker’s wages have risen, their ability to spend through price increases has developed into a scenario where higher prices become “sticky” as consumers are willing to “accept” these prices (i.e., pay the higher price for the good vs. buying a cheaper alternative or foregoing the purchase altogether).

We already have started to see signs of slack forming in the labor markets. Job openings have come down, participation rates have gone up in a sign that workers who were formally on the sidelines are reentering the job market, which in turn has caused the unemployment rate to tick up. Unfortunately, this is likely only the beginning as in order to quell inflation’s worst aggressors, the labor market needs to get knocked down a few pegs. We’re still running above trend on labor costs and job openings and below trend on unemployment and participation rate for working aged men. The Fed wants to see these numbers begin to move in the other direction. As we see the data unfold in the coming months, we’ll begin to understand the impact the Fed’s tightening policies have had (or haven’t had) on our country’s labor market.

Russia/Ukraine

 

As Russia’s sham referendums allow Putin to formally annex 15% of Ukraine, the stage is set for the conflict to move into new territory. On one hand, with Russia claiming territory and achieving success on paper (albeit limited within the scope of Putin’s initial military operations), this should allow Putin an off-ramp to limit further military action considering momentum is very much moving against him on a variety of fronts. Ukraine certainly won’t be happy about losing up to 15% of their country, but they may have no other choice as the rest of the world eagerly awaits a resolution.

The reason this remains a key point of focus globally not only has to do with energy prices, but also with geopolitical stability within the European Union that has been grappling with its own set of issues unrelated to the conflict. If the Russia/Ukraine war is taken off the table as an area of concern, the German and French governments can pivot towards reestablishing economic stability beyond a narrow focus around energy. A resolution should also have its obvious benefits to energy price stability, which would benefit most developed nations as energy is a generally fungible commodity.

For as many issues the market is facing right now, the silver lining remains the fact that inflation continues to move in the right direction, albeit at a snail’s pace, and the consumer remains in a relatively healthy position. Market volatility is likely to persist for a time until we see central banks pivot away from their aggressive tightening campaigns. As is often the case, uncertainty brings volatility, and solving a few of the aforementioned pieces of uncertainty would go a long way to placing support underneath this market. We continue to be optimistic about the longer-term outlook for the U.S. economy and remain positioned as such.

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