The Reality of a ‘Soft Landing’

Market Commentary | Q3 2023 

For the past several years, investors and media pundits have been debating the likelihood of an economic recession in the United States. Phrases like ‘soft landing’ and ‘hard landing’ have been bandied about, and economists have trotted out various data points as they evaluate and critique current Fed policy. Through all of this, US consumers have remained quietly resilient and helped the domestic economy stave off a recession.  

While recent Fed policy has effectively slowed the economy without derailing it, this progress has brought its own set of consequences. Investors are now concerned that a soft landing will mean that higher interest rates will extend into next year – and possibly beyond. As we head into Q4, Federal Reserve policy expectations will continue to be the key driver of short-term market returns. 

A soft landing is generally understood to be a successful tightening cycle where the Fed raises rates to the point that the economy slows just enough to cool inflation without slowing it so much that it causes a recession. This phrasing first entered the economic lexicon in the early 1970s, shortly after America’s successful moon landing in 1969.[1] Setting a spaceship gently on the lunar surface was difficult, and yet it safely touched down. 

Even if the Fed pulls off a soft landing, in reality, there will be no “aha!” moment. Unlike the moon landing, there won’t be a visible moment of triumph. Rather, it will feel like an ongoing process. The nature of slowing the economy with imperfect tools means that the Fed is always at risk of pushing too far.  

We expect that this will translate into market swings like we’ve seen so far this year. Stocks will rise when investors are optimistic that the Fed is striking the right balance; then recession concerns will re-emerge, swiftly knocking prices down a peg or two. While markets have historically rewarded long-term investors, the experience can be stressful during short-term swings. 

The first half of 2023 saw portfolio values recover after last year’s declines, with US and international stocks providing meaningful growth as inflation slowed and investors predicted an end to Fed rate hikes. In the third quarter, that growth trend reversed, although most diversified portfolios remain in positive territory since January. 

Three primary culprits for these price declines were higher interest rates, higher oil prices, and a stronger US dollar. The Federal Reserve has raised rates four times this year and is signaling a potential fifth interest rate hike, putting downward pressure on global bond prices. Higher rates have also boosted the US dollar, which benefits American consumers, but dampens the value of earnings from international stocks. Lastly, when we add the fact that oil prices surged nearly 40% between mid-June and late September, we can see why markets experienced a broad-based selloff during the past quarter. 

The S&P 500 declined by -3.3% during the quarter, but the index has still grown by +13.1% since January.[2] That return has been buoyed by a few large AI-driven stocks, with Nvidia and Meta (Facebook) each accounting for an outsized portion of the growth. Despite the index’s positive overall return, more than half the underlying companies in the S&P 500 have negative returns since the beginning of the year.[3]  

Outside of large-cap US stocks, signs of deteriorating investor confidence were more apparent. US small-cap stocks declined by -4.9% during the third quarter, as these companies saw an outsized impact from higher interest rates. International stocks, as measured by the EAFE index, fell by -4.1% during the quarter. The Barclays US Bond Index declined by -3.2% during the quarter as longer-term rates rose rapidly, dipping into slightly negative territory since January. Lastly, the US real estate index declined by -8.0% during the quarter, reversing its gains from the first half of the year. The next chapter of growth for equity markets will depend on whether the Fed can engineer a soft landing that allows the central bank to pause – or even reverse – its path of rate hikes.

Some of the growth we saw early in the year was based on market expectations that the economy would stumble and the Federal Reserve would pivot to lowering rates – thus boosting asset prices. Instead, ‘higher for longer’ has become the newest catchphrase on Wall Street. With the economy remaining stronger than expected and the Fed signaling one more rate hike in 2023, investors are being forced to recalibrate their expectations for both stock and bond valuations.  

When interest rates rise, it becomes more expensive for companies to borrow money to fund new projects or expand their business. This can result in earnings growing at a slower rate than investors had anticipated. Higher interest rates and inflation also mean that future earnings are worth less. A tangible example can be seen in the housing market, where mortgage rates have surged to 7.3%, the highest level since 2000.[4] This has caused housing affordability to plummet and caused a slowdown in various industries that benefit from new home sales.

It is important to note that interest rate expectations have shifted dramatically since the beginning of the year, and they could easily shift again if inflation comes down faster than expected or if we see material signs of a recession. While recent market declines have taken some of the shine off the stock recovery this year, the reality is that the current economic and market cycles are historically normal.  

We take comfort in the fact that the global economy has navigated these issues – inflation, high-interest rates, and a resilient job market – during past cycles and has emerged into new chapters of growth and innovation. It is with this lens that we build and steward client portfolios, knowing that our clients’ wealth and well-being are meant to support them far beyond any short-term interest rate cycle and whether or not the Fed is able to perfectly stick the ‘soft landing.’ 

Resources

[1] ON LANGUAGE; Happy Soft Landings. Published 12/24/1989. NY Times  

[2] Returns as of 9/30/2023  

[3] S&P 500 Component Year-to-Date Returns Slickcharts.com 

[4] Primary Mortgage Market Survey: U.S. weekly averages as of 09/28/2023 Freddie Mac