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The following is an excerpt from Kirr Marbach & Co.’s fourth-quarter client letter, available at kirrmar.com.
American author John Steinbeck wrote, “What good is the warmth of summer, without the cold of winter to give it sweetness?” Indeed, after enduring a brutally frigid “winter” in 2022 that saw the worst year for U.S. stocks since the depths of the Great Recession in 2008 (fourth worst for the S&P 500 since 1945) and worst year for bonds ever, investors enjoyed an unexpectedly warm and sweet “summer” in 2023.
The proximate cause of this good cheer has been the dramatic slowdown in the post-pandemic inflation. After fears that the Federal Reserve’s slamming on the monetary brakes to combat soaring inflation would crush economic activity, optimism abounds that the Fed has pulled off a miraculous “soft landing.” Investors have cheered the Fed’s signaling a “pivot” from its program of tightening credit via a series of 11 rapid-fire, jumbo interest-rate hikes that took its target for federal funds from 0% at the beginning of 2022 to 5.25%-5.50% in July 2023, a 22-year high.
With inflation stabilizing around 3%, down significantly from its post-pandemic peak of 9.1% in June 2022 (the largest increase since the early 1980s), interest rates have plunged as investors anticipate potential rate reductions in 2024-2025. Reflecting on the darkest days of the Great Recession, two of the biggest beneficiaries will be the housing market, which many feared would collapse, and the federal government, which might reduce credit-rating-agency concerns about surging borrowing costs in coming years.
The Fed’s dual mandate is keeping inflation low (2% target) while maintaining “full” employment (4% to 5% unemployment). Inflation currently stands at 3% and unemployment at 3.7%. With stable prices and employment, the Fed might be in a position to “pivot” and start lowering interest rates.
From the government’s perspective, the reduction in interest rates is a much-needed relief. The United States has $34 trillion in debt held by the public and has seen its net interest expense on this debt soar to an extraordinary $659 billion in 2023, nearly doubling in two years. For scale, our November interest expense of $72 billion (15.8% of tax revenue) eclipsed defense spending for the first time in over 20 years. This is particularly troublesome in a time of rising global conflicts.
Most federal debt was issued when interest rates were extremely low. As these debts mature and have to be refinanced at current rates, the Congressional Budget Office projects massive additional borrowing to fund deficits coupled with higher rates will cause net interest payments to reach $1.4 trillion by 2033, signaling a distressing trend where a growing portion of the federal budget is consumed by interest payments, restricting funding for other critical areas like health care, infrastructure and education.
The 2011 warning from former director of the Office of Management and Budget under President George W. Bush, former Indiana governor and former Purdue University President Mitch “The Blade” Daniels rings even louder today:
“In our nation, in our time, the friends of freedom have an assignment, as great as those of the 1860s, or the 1940s, or the long twilight of the Cold War. As in those days, the American project is menaced by a survival-level threat. We face an enemy, lethal to liberty, and even more implacable than those America has defeated before. We cannot deter it; there is no countervailing danger we can pose. We cannot negotiate with it, any more than with an iceberg or a Great White.
“I refer, of course, to the debts our nation has amassed for itself over decades of indulgence. It is the new Red Menace, this time consisting of ink. We can debate its origins endlessly and search for villains on ideological grounds, but the reality is pure arithmetic. No enterprise, small or large, public or private, can remain self-governing, let alone successful, so deeply in hock to others as we are about to be.”
The Fed’s decision to cut interest rates to 0% at the start of the pandemic caused many asset bubbles to inflate, including housing. Sub-3% mortgage rates led to greater affordability, leading to an increase in housing demand, even as inflation in construction costs drove up prices.
By 2023, however, the landscape of the housing market shifted, with mortgage rates reaching 8%. Despite significantly higher rates leading to plunging affordability, housing prices remained stubbornly elevated. In the third quarter of 2023, the median home sale price reached $431,000, a significant 30% increase from $318,400 in the third quarter of 2019, albeit slightly down from its peak of $479,500 in the second quarter of 2022. The resilience of home prices can be attributed to several factors, including a strong job market and ongoing inventory shortages, as homeowners with low-interest mortgages are reluctant to sell.
Mortgage rates have dropped below 7%. Falling rates could breathe new life into demand, reigniting prices. Fears about homeowners becoming “upside-down” (owing more than their property is worth) in a GFC-type housing crash would fade. However, there is a risk lower rates might prompt increased household borrowing and lead lawmakers to defer the difficult work of tackling our growing deficit.•
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Kim and Lee are chief operating/compliance officer and director of research, respectively, for Columbus-based investment adviser Kirr Marbach & Co. They can be reached at 812-376-9444 or mickey@kirrmar.com and roger@kirrmar.com.
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