September 2024 | Quarterly Letter

We like to start our letters with an epigram, usually a quote from a person of some standing, that gives us an opening for discussion. This time we turn to Mick Jagger and The Rolling Stones from 1969.

You can’t always get what you want…
But if you try sometimes, well, you just might find
You get what you need

I have no idea what was in the mind of Mick Jagger when he wrote these words, but I am sure that the economy and investments were not the intended subjects. Nevertheless, we can adapt these words for our purposes as we contemplate the current environment.

We find ourselves at an inflection point in the economy. After more than two years of raising and holding the federal funds rate high, the Federal Reserve (Fed) recently reduced that interest rate by 50 basis points, a surprisingly large first step. This was a strong signal that the Fed wants very badly to achieve an economic soft landing. They have been attempting to cool down a strong economy that was experiencing high inflation without doing harm to the labor market. This is clearly a delicate balancing act that must account for the fact that the inflation goal of 2% has not yet been fully achieved, but at the same time several labor market indicators are flashing warning signs. They will also have to contend with the unknown factor of how long it takes for lower interest rates to become effective. Time will tell if the Fed in this instance will get what it wants. 

Why did the Fed move so aggressively? First, they are demonstrating improved confidence that inflation is moving sustainably toward 2%, and this gives them flexibility to shift their priority from fighting inflation to supporting the labor market. Their favorite inflation measure, the Personal Consumption Expenditure (PCE) price index, is now down to 2.2% year over year, not too far from the 2% target. The Core PCE price index is not as favorable at 2.7% year over year, but it is also trending in the right direction. Second, they are taking notice of the softening labor market conditions. Their aggressive rate cut is an effort to not let the softening labor conditions get out ahead of them.

The Fed keeps its eye on the bond market and notices that bond investors seem to be confirming their concerns over slowing conditions. During the quarter the 10-year Treasury yield declined from 4.46% to 3.81%, a significant move. While some of the decline in yields can be attributed to expectations of the Fed’s decision to lower rates, we assume it also means that bond investors are expressing some concerns about the direction of the economy. 

Let’s look at some of the warning signs from the labor markets. First, the unemployment rate has been slowly but steadily rising since last year. Its lowest point was 3.4%; currently it is 4.2%. This is not alarming, but the trend is not good. Second, wage growth, which reached a peak of some 8% annually at the height of the pandemic, has now receded to around 4%, near where it was just prior to the pandemic. Third, job openings, which rose sharply in the pandemic, have been declining steadily over the last two years and are now near the level of unemployed workers. When these two data points cross, unemployment usually begins to rise quickly. Of course, the significance of this is that our economy is driven by consumption, and when people either lose their job or worry about losing it, they begin to consume less, which can lead to a recession. 

“If you try sometimes, well, you just might find you get what you need.” No doubt about it: the Fed is trying. Will they try too hard, or maybe not hard enough? Again, time will tell, but unfortunately, history is not on their side. There have been a few instances when the economy has experienced something like a soft landing, but they are rare. Because almost all Fed tightenings have in the past led to recessions, we have been dubious of the economy’s ability to achieve a soft landing. However, in this cycle, we do find several reasons that suggest the economy may have a chance of landing softly. 

First, one mitigating factor is that unemployment has been rising because there has been an unusually large increase in the number of new entrants into the workforce. This is different from increases in layoffs, which have risen, but not dramatically. Second, the entire Covid cycle, starting in 2020 and still being felt in several ways, was so disruptive that it threw everything out of kilter. As these Covid economic effects wane, and with the help of Fed policy, it is possible that in this cycle the economy naturally settles back into normalcy. Finally, recessions usually occur after considerable distortions build up in the economy. This time, while there are issues, they are not deemed to be extreme. All of this considered, a full-scale recession may not be required to reestablish balance.

In terms of “getting what you need,” there could be another potential outcome: neither hard landing nor soft, but something in between. Because of the unique factors listed above, if we do in fact slip into a recession, it could turn out to be a mild one that is not too harmful in terms of unemployment but has the positive effect of finishing off the fight against inflation by reducing it to 2% or lower. Perhaps of more importance, it could place a lid on longer-term inflation expectations. In this case, the Fed has tried, and winds up getting what it needs, but without severe damage.

We do not know which of the three economic scenarios will develop, but we have always felt that it is best to be prepared for the worst and to be grateful if things work out well. Right now, all seems good for the economy and investors. Gross Domestic Product (GDP) continues to grow, averaging around 3% for the last two quarters, bond yields are dropping, and the stock market has been regularly hitting all-time highs. However, there was a reason the Fed moved aggressively. They obviously felt the risks to the economy were rising. If there are points of vulnerability in the economy, the implications for investment are clear. In fact, the stock market itself may be sending us a message regarding how to be invested at this time. Investor preferences have been changing within the market, and in the third quarter there was a broadening of interest among different sectors and a clear preference for high-quality stocks.  We applaud this development, for it has directly benefited the portfolio holdings. However, we also recognize that when investor interest moves sharply toward quality, it may indicate that we are getting what we need, that is, a place to be invested that is appropriate for an environment of increasing risk. 

The observation that quality emerges when risks are rising should not be taken to mean that our investment approach is appropriate only when trouble is on the horizon. The reality of investing is that over time, investors enjoy the benefits of bull markets in stocks, but they are also forced to endure the pain and disappointment of occasional bear markets. We want to be prepared for both. Our approach is designed to perform relatively well in all seasons, good and bad. We focus first on quality and include rising income from dividends as a key element in our approach. This has enabled us to participate on the upside in strong markets and protect capital in down markets. Realistically, it is virtually impossible to outperform in both up and down markets. In strong up markets we do not expect to fully capture the upside, but in very weak markets we have always protected capital by going down less than the market. It is this combination of upside participation and downside protection that helps add value for our investors over the long term. 

As investors, we accept the fact that we can’t always get what we want. Nevertheless, we are trying every day to create investment portfolios that are appropriate for long-term goals of preservation of capital, growing income, appreciation, and ultimately rewarding performance. We believe the portfolios are well prepared for the potential economic outcomes, and we know that when we embed quality as the dominant characteristic, we are likely to succeed over the longer term. 

Disclosures:

The opinions expressed are those of Crawford Investment Team. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Forward looking statements cannot be guaranteed.

Crawford is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about Crawford’s investment advisory services can be found in its Form ADV Part 2, which is available upon request.

Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed.

Crawford reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

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