What a difference a year can make.
This time last year, the Federal Reserve kicked off a tightening cycle that became one of the steepest on record. Recession fears abounded. Equities plunged. This year, by contrast, Q2 saw the first pause in that tightening cycle, indicating we are nearing the peak in interest rates. And hopes crept up that the US might escape a recession.
The widely hoped-for soft landing for the US economy, which looked far-fetched a year ago, is now more firmly in the cards. That doesn’t mean that investors can relax. Prices are still rising considerably faster than the Fed’s 2% target for price stability. On the positive side, there were more convincing signs in Q2 that underlying inflation is decelerating, while still above the headline rate. But the Fed, along with other major central banks, likely has further to go in the tightening cycle. In Q2, the Fed consensus view of the funds-rate peak went up to 5.6%, implying two more hikes of 25 basis points. Two further increases would dampen spending in the second half of this year. Cautious banks were already curbing business lending; further rate rises will exacerbate that trend.
The bottom line? A US recession is still possible. But developments in Q2 raised the odds that the US can escape without one. For institutional investors, a diversified portfolio has been the best way to navigate the last year of switchback turns and data revisions. It continues to be the strongest defense in times of uncertainty. Changing macro conditions have provided more interesting opportunities in fixed income than have been evident over the last decade of “low for longer” interest rates. More broadly, investment opportunities outside of traditional public equities and fixed income were plentiful in Q2.
Three themes to watch in Q3:
Peaking interest rates: The post-pandemic tightening cycle that began in 2022 is almost over. The third quarter will likely see the last rate hike from the Fed, either in July or September. Will markets cheer, or have the equities gains already been booked? That could depend on whether rates are set to stay high for longer.
Inflation, inflation, inflation: Opinion is divided about whether the global monetary tightening that has already happened will be enough to cool demand and inflation. If underlying price increases stay in the 4 % range, policy will stay tight until something gives. With luck, the Q2 disinflation trend will continue.
The landing — hard or soft: Europe likely slipped into recession over the end of 2022/23. Can the US avoid it? Will regional bank problems resurface, curbing credit?
Read the full RockCreek Q2 2023 Commentary Letter
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