Economic resilience presents a paradox for investors

03/06/2024 — There has been a remarkable shift in interest rate expectations within the last month as the Federal Reserve has indicated it’s in no hurry to cut rates. With economic data proving to be more resilient and the pace of disinflation appearing to be moderating, a more cautious tone has emerged from various Fed officials.

For example, Kansas City Fed President Jeff Schmid recently stated that “the best course of action is to be patient, continue to watch how the economy responds to the policy tightening that has occurred, and wait for convincing evidence that the inflation fight has been won.” Overall, inflation will likely move closer to the Fed’s 2% inflation target over time. However, recent evidence of a potential recovery in cyclical data might challenge the disinflation narrative.

For instance, both the ISM Manufacturing Index and Markit Purchasing Managers’ Index (PMI) are beginning to show signs of an early recovery, albeit modest. Furthermore, when reviewing various regional manufacturing surveys conducted by the Federal Reserve, specifically the “New Orders Index” subcomponent for each survey (see accompanying chart), a reacceleration in growth might complicate the disinflation narrative.

The potential inflection of manufacturing data has several implications for investors. First, the backdrop of a cyclical recovery might keep upward pressure on bond yields and increase market volatility related to expectations for a continuation of tighter Fed policy. Second, for equities, the undercurrent of a cyclical recovery should be positive for earnings, balanced against the need for equity valuations to adjust to the potential for a more hawkish Federal Reserve. Third, upcoming economic reports bear watching should data remain resilient or begin to reaccelerate. The Fed has never cut interest rates with an accelerating PMI backdrop.