Dear Clients,
Financial markets have encountered some turbulence as investors adjust to a new Federal Reserve chairman and a different approach to monetary policy. New Fed chairs are often “tested” by the markets soon after taking office, and this transition appears to be no exception.
The market reacted negatively after the Federal Reserve left short-term interest rates unchanged while firmly restating its commitment to returning inflation to 2%. Much of the criticism since then has focused on the chairman’s communication style and his decision to move away from the forward guidance investors had grown accustomed to receiving.
We view this as less of a policy failure and more like two new dancing partners trying to determine who is leading.
The chairman has deliberately reduced the Fed’s guidance about what it might do next. That makes the market’s job more difficult in the short run because investors can no longer rely as heavily on carefully choreographed signals from the Fed. Change is uncomfortable, particularly when the old system was familiar and relatively easy to interpret. But discomfort alone does not make the new approach unproductive. Its success will ultimately be judged by results—not by the initial reaction of market commentators.
Interest Rates and the Fed’s Next Move
The market currently expects the possibility of higher short-term rates in September. That does not necessarily mean mortgage, automobile, and other consumer borrowing rates must rise by the same amount.
The Fed directly controls a very short-term interest rate. Longer-term borrowing costs are also influenced by inflation expectations, economic growth, Treasury yields, and credit conditions. If the Fed convinces investors that inflation will continue to moderate, longer-term borrowing rates could eventually decline even if the Fed raises its short-term rate. That outcome is possible, but it is not automatic.
It is also possible that the Fed will leave its policy rate unchanged while adjusting its balance sheet or using other tools to influence financial conditions.
Fortunately, our job is to navigate policy—not to set it.
Doing that well requires us to consider both the decisions the Fed may make and the range of economic outcomes that could follow. One of the most important parts of that analysis today is productivity.
Productivity Changes the Inflation Equation
Productivity simply means producing more with the same amount of labor, time, and resources. When productivity rises, businesses can grow without creating the same degree of inflationary pressure that would normally accompany faster economic activity.
This distinction matters. If lower interest rates stimulate demand without increasing the economy’s productive capacity, inflation can return. But if economic growth is accompanied by stronger productivity, the economy may be able to expand while inflation continues to moderate.
Artificial intelligence could become a powerful driver of that productivity.
The Fed chairman has repeatedly discussed the relationship among business investment, artificial intelligence, productivity, growth, and inflation. We believe he is paying close attention to whether AI allows supply to grow alongside demand. If it does, the traditional assumption that strong growth and low unemployment must produce higher inflation may prove too simplistic.
There is still a risk that the Fed raises rates too aggressively. Tightening policy during a period of moderating inflation, low unemployment, and economic growth could unnecessarily weaken the economy and eventually increase unemployment. The Fed must balance that risk against its responsibility to restore price stability.
The Cost—and Promise—of Building AI
The enormous investment required to build AI infrastructure has created a short-term challenge for several of the market’s largest companies. Google, Microsoft, Meta, Amazon, and other “hyperscalers” are spending heavily on data centers, chips, energy, and computing capacity.
That spending has reduced free cash flow and, at times, weighed on investment performance. The market naturally wants evidence that these investments will produce an attractive return.
We believe this should be viewed as an investment cycle rather than simply an expense problem. The infrastructure must be built before its full economic benefits can emerge. There will undoubtedly be winners, losers, delays, and periods of disappointment. Nevertheless, we believe AI-related growth and productivity gains may ultimately exceed those produced by the early internet.
Bespoke Investment Group compared the Nasdaq’s performance following the November 2022 launch of ChatGPT with its performance following the December 1994 release of the Netscape web browser. The similarity during the early stages is striking.
No chart can tell us exactly what happens next, and correlation should never be mistaken for certainty. The comparison is valuable because it illustrates how markets can respond when a genuinely important technology begins changing the economy. It does not mean that AI must follow the internet’s exact path—including the internet bubble and its eventual collapse.
Are Market Highs a Reason to Wait?
Investing when the market is near an all-time high can feel uncomfortable. Investors naturally worry that they are buying at “the top” immediately before a decline.
History does not support that assumption.
Since 1989, the S&P 500’s average forward total return after reaching a new high has been slightly better than its return during all other periods. Its average one-year return following a new high was 13.6%, compared with 12.0% at other times. The same pattern appears over three- and five-year periods.
A market high is not, by itself, evidence that a decline is imminent. Markets reach new highs because businesses grow, earnings increase, and the economy expands. Over long periods, new highs are a normal feature of successful investing.
Time also changes the odds dramatically. Since 1928, the S&P 500 has produced a positive return during only 53% of individual trading days. Over one-year periods, that figure rises to 75%, and over ten-year periods it reaches 94%. The lesson is straightforward: investing is much less dependent on short-term market movements when investors give their capital sufficient time to work.
Earnings and Household Finances Remain Supportive
Stock prices have risen this year, but projected corporate earnings have grown even faster. That does not mean the market is inexpensive, nor does it guarantee that prices will continue higher. It does mean, however, that the advance has been supported by improving business fundamentals rather than price appreciation alone.
Over the long run, earnings remain the primary engine of stock prices.
Household finances also appear stronger than the popular narrative suggests. Americans carry more debt in absolute dollars than they did in previous decades, but that comparison ignores the growth of income and household assets.
Household liabilities are now approximately 10.8% of total assets—near levels last seen in the early 1960s and well below the approximately 20% reached around the financial crisis. Leverage is also below its historical peak across every income group.
This does not mean that every household is financially comfortable. Many families continue to face real pressure from housing, food, insurance, and borrowing costs. At the economy-wide level, however, household balance sheets do not presently resemble those that preceded the 2008 financial crisis. The consumer’s “financial battery” still appears to have a meaningful charge.
A Historically Favorable Stretch
The presidential market cycle provides one additional point of support. Since 1950, the fourth quarter of a president’s second year and the first two quarters of the third year have historically been the strongest three-quarter stretch of the cycle.
Several explanations have been offered for this pattern, including the resolution of uncertainty surrounding midterm elections and the political incentives to support economic activity as the next presidential campaign approaches.
History is useful context, but it is not a forecast. Elections, policy decisions, inflation, interest rates, geopolitical events, and corporate earnings can always cause a particular cycle to depart from the historical average.
Our View
We do not believe the recent volatility signals something fatal for the bull market. It looks more like a period of adjustment as the Fed and financial markets establish a new relationship.
The environment is not without risk. Inflation remains above the Fed’s goal, AI investment is consuming enormous amounts of capital, valuations in parts of the market are elevated, and the Fed could make a policy mistake.
At the same time, several important foundations remain constructive:
- Corporate earnings are growing faster than stock prices.
- Household leverage is low relative to assets and historical levels.
- Artificial intelligence is supporting a major investment and productivity cycle.
- Market highs have historically been followed by attractive long-term returns.
- The strongest portion of the historical presidential market cycle lies directly ahead.
None of these factors guarantees a smooth advance. Bull markets include pullbacks, corrections, and uncomfortable headlines. Volatility is the price investors pay for the superior long-term return potential of stocks.
Our responsibility is not to predict every market fluctuation or react to every press conference. It is to weigh the evidence, manage risk, and keep client portfolios positioned for the opportunities we believe lie ahead.
We remain watchful, but we also remain constructive.
Sincerely,
Kessler Investment Group, LLC
The S&P 500 and Nasdaq Composite are unmanaged indexes and cannot be invested in directly. Past performance does not guarantee future results. The views expressed reflect Kessler Investment Group’s assessment at the time of publication and may change as economic and market conditions evolve.