There is an art to felling a tree.

Of course, the most important requirement for felling a tree is having a really good reason for doing it. After all, in order to cut down a tree that has seen decades – or maybe even a century – of history pass underneath its branches, the cause to do so must be just. And it must also come with the promise to restore the environment to its previous state by planting one or more trees to replace the one removed. There are also economic reasons to consider. People like trees and removing a tree from your property could negatively impact its value.

Once the decision has been made, you can’t simply walk up to a tree and start hacking away chunks of wood. This could potentially lead to serious damage to other trees, nearby homes, or even yourself. You need to carefully plan out the ideal place for the tree to fall and then determine potential escape routes should your plan go awry.

Once you have a plan in place, the first cut is made: a triangular notch about a third of the way through the tree on the side of the tree in which you want it to fall. Next comes the back cut, a parallel cut starting from the back towards the notch until a thin “hinge” is all that’s left uncut. Finally, yell “Timber!” And get the heck out of there just in case your cuts aren’t as well placed as you thought.

No matter which way the tree is leaning, a well thought out plan and a well-placed notch and back cut – perhaps with the help of some wedges driven in to the back cut – can make the tree fall right where you want it.

Jerome Powell - 'Economic Lumberjack'

Over the past two years, the Federal Reserve (“the Fed”) and other policymakers have been navigating a similar, but vastly more complex, problem of pruning back the economy just enough to curtail inflation while both avoiding a recession and planting the seeds for new economic growth in the future. In the popular and financial press, this delicate balancing act is often referred to as the Fed’s attempt to engineer a “soft landing” for the economy.

Unfortunately, unlike an axe or a chainsaw, the tools of monetary and fiscal policy are blunt and prone to causing collateral damage. A case in point was the response to COVID. Due to the economic disruptions caused by government policies and massive voluntary shifts in consumer behavior, the Federal Reserve responded by lowering the overnight fed funds rate to effectively zero and purchased trillions of dollars of government bonds and mortgage-backed securities to push longer-term rates down. This was supplemented by trillions of dollars of fiscal stimulus in the form of deficit spending by the federal government. Actions of a similar type and magnitude were taken by central banks and governments around the world.

The end result was the avoidance of a prolonged recession, which almost assuredly would have occurred without these interventions. However, the collateral damage was a spike in inflation in the US and abroad as consumer behavior massively shifted again in the wake of the unexpectedly rapid development, manufacture, and distribution of an effective COVID vaccine. This shift, coinciding with the lagging effects of the monetary and fiscal stimulus already in place, led to demand for goods and services outstripping supply. In turn, this mismatch between supply and demand resulted in inflation, which peaked at 9.1% by the middle of 2022, as measured by the year-over-year change in the Consumer Price Index for All Urban Consumers. This caused the Fed to rapidly reverse course, raising overnight interest rates and ceasing the purchase of longer-dated bonds.

The challenge for policymakers, as outlined here, is that economic cycles never have a distinct beginning or end. There is always overlap between them and different sectors of the economy rarely align all at once. Yet, as to the question of whether or not the Fed will successfully engineer a soft landing for the economy during this particular cycle, they kind of . . . sort of . . . already did.

If a Tree Fall in the Forest...

Two years after inflation peaked, the overnight fed funds rate has risen from effectively zero to a midpoint of 5.375% and inflation (CPI-U) has fallen all the way back down to 3.3%. The Fed’s preferred measure of inflation, the so-called Core PCE, has fallen to 2.7%.

Figure 1: Two Measures of Inflation, CPI-U and Core PCE, Dec 2019 to Present

Source: Kovitz using data from Bloomberg Finance, L.P.

The Fed’s unofficial inflation target is 2% per year, so the economy is still running above that regardless of the metric chosen. Somewhat ironically, this last bit of above-target inflation is primarily concentrated in the housing components of the inflation equation, and inflation in housing is arguably being caused by the Fed’s attempt to bring inflation down more broadly. By raising interest rates, mortgage payments became much more expensive, and, with the vast majority of homeowners locked into mortgage rates below 4%, there is little incentive to sell their homes and forfeit those attractive rates. This has caused inventories of existing homes for sale to plummet; thus, prices have continued to rise despite the higher mortgage rates as muted demand for housing has still outstripped the much-diminished supply. This double-whammy of rising prices and higher mortgage rates has also helped rents stay elevated in much of the country (at least in those areas that aren’t absorbing an excess supply of new multi-family construction).

Turning back to broad inflation measures, disinflation, or the slowing of the rate of change, does not equal deflation, or a decline in general prices. Since the end of 2019, the cumulative impacts of inflation as measured by both the CPI-U and Core PCE have been 21% and 17%, respectively. This cumulative impact continues to cause sticker shock at the grocery store, but increases in wages, on average, have more than kept up with rising prices. Furthermore, those gains in real wages have disproportionately benefitted those at the lower end of the income spectrum.

Figure 2: Change in Real Average Hourly Earnings, Dec 2019 to Present

Source: Kovitz using data from Bloomberg Finance, L.P.

Throughout this period of moderating inflation, the economy has remained near what is generally considered full employment. Although the unemployment rate has risen from near historical lows in 2023 amid much-publicized layoffs among primarily white-collar positions that experienced significant growth during the COVID expansion, it remains at 4.1% as of the last reading, which is still a level seen only a handful of times in the past 80 years.

There are some cracks underneath the surface. Despite reasonably strong wages and employment across all income spectrums, earnings reports from major retailers during the second quarter were chock full of references to consumers becoming more cautious with their discretionary spending. This trend was especially true for those same lower-income consumers who have seen outsized wage gains, perhaps indicating that inflation in areas such as housing, which comprises a bigger portion of lower-income household budgets than the average household, are biting those consumers harder than the headlines would indicate.

Then there’s the indefatigable stock market.[1] After ending the first quarter at an all-time high, the market proceeded to post eleven new all-time highs during this past quarter and ended the first half of the year up 15.5%. The strong year-to-date return is largely being driven by large Tech companies and anything that is even tangentially related to artificial intelligence (AI). This is especially true of GPU-maker Nvidia, which has returned around 150% on the year and has contributed roughly one-third of the return of the market.

That is not to say that AI is the only game in town. The S&P 500 Equal-Weighted Index, which reduces the influence of the large Tech stocks that have come to dominate the market-cap-weighted S&P 500, remains up 5% on the year. The divergence between the two indices is large by historical standards, but the Equal-Weight is still on track for a perfectly average year as far as equity returns go.

So, there you go. Inflation is fine. Not perfect, but fine. The economy is fine. Not perfect, but fine. The stock market is fine. Not perfect, but fine. Everything is just fine. Right?

Generally, that is what folks say about their own situation. The recently published Federal Reserve Survey of Household Economics and Decisionmaking (sic) showed 72% of those surveyed described their personal financial situation as “doing okay” or “living comfortably.” This is virtually unchanged since 2017 with the only meaningfully higher point in that timeframe coming during 2021 when stimulus funds were padding consumer wallets.

However, there is a massive disconnect between Americans’ views of their own financial situation and the state of the broader economy. It is not unusual for respondents to this survey to be more optimistic about their own situation than that of the local or national economy, but the gap has ballooned since 2019 to a level that can only be described as confusing. Less than a third of respondents who describe their own situation as “doing at least okay” also rate the national economy as “good” or “excellent.” There are many plausible explanations for this divergence in views, but it is hard to find a reasonable one.

Figure 3: Adult Assessment of Own Financial Well-Being, Local Economy, and National Economy (By Year)

One possible explanation is the Saturday Night Live effect. Ask anyone about Saturday Night Live and they will surely say that the show “used to be funny.” They will remember Christopher Walken imploring Will Ferrell to provide “more cowbell.” They remember Chris Farley as a motivational speaker “living in a van down by the river.” Some might even have fond memories of the “Bass-o-matic.” The problem is that this sentiment – that the past has always been superior to the present – has been the case at every point in the entire 50-year history of the show. At the current time, SNL spans nearly 50 seasons, 20 or so episodes a season, and a dozen or so sketches per show. Over time, the sketches that hit the mark stick in people’s memories, get rewatched more often, and create a sense of nostalgia. But people forget all the hot garbage that made up the rest of SNL’s body of work. That’s how it goes with the creative arts. They can’t all be classics! So memories fade, but the nostalgia remains, leading people to yearn for some halcyon period in the past that never really existed in the first place.

A Moment of Zen

The implication here is that we spend a lot of time and effort preparing our clients for the inevitable downturns in financial markets and this vigilance helps prevent the type of emotional overreactions that can turn temporary financial stress into a permanent impairment of capital. Whether we are at the beginning of the end of an economic expansion or at the end of the beginning of an economic contraction, or somewhere in between, will only be known in hindsight. This is the perpetual state of things.

Just the last six years have seen stock market drawdowns of 19% (2018), 34% (2020), and 24% (2022). There were a plethora of opportunities to tear up the long-term financial plan, sell everything, and sit in cash until it felt more comfortable, yet stocks have returned a somewhat astounding 14.2% per year over that same six-year period.

It can be psychologically challenging to stay the course in times of distress, which is why we must always be prepared for those situations. But let’s not add to those challenges by being unduly stressed when conditions are merely fine, even if not perfect.

[1] As represented by the S&P 500 Total Return Index

DISCLOSURES

Fees: Gross-of-fees returns shown incorporate the effects of all realized and unrealized gains and losses and the receipt, though not necessarily the direct investment of, all dividends and income. Net-of-fees returns shown are supplemental to the Core Equity Wrap Composite shown above. They are calculated by deducting the transaction cost of 0.10% and a portion of the total wrap fee designated as Kovitz’ management fee, which is 0.35% of assets per annum, from the gross return. The total wrap fee applicable to a particular client is dependent on the fees charged by the client’s financial advisor under the RBC wrap program. Composite Net-of-fees returns are calculated by deducting the highest, generally applicable wrap fee, which includes all charges for trading costs, investment management, administration, and custody, of 2.0% of assets per annum, less the portion previously designated for trading expenses, from the gross return. The total wrap fee applicable to a particular client is dependent on the fees charged by the client’s financial advisor and the applicable wrap sponsor. Such fees are negotiable and do not represent the experience of any Kovitz client. Gross-of-fees returns are presented before the deduction of management fees, but after the deduction of the portion of the wrap fee designated for trading expenses. Current wrap fees can theoretically range from 1.0% to 3.0% of assets per annum.

Prior to January 1, 2010, the Composite included the performance of assets that had been “carved out” of multiple asset class portfolios. When calculating performance, a hypothetical cash balance for each month was allocated to the carve-out on a pro-rata basis relative to the portion of each portfolio’s assets that comprised the carved out asset class. Beginning January 1, 2010, changes in the GIPS standards caused the Composite to be redefined and all carve-outs to be removed from the Composite. Carve-outs formerly included in the Composite continue to be managed in the same manner as they were before being removed from the Composite.

Definition of The Firm: Kovitz Investment Group Partners, LLC (Kovitz) is an investment adviser registered with the Securities Exchange Commission under the Investment Advisers Act of 1940 that provides investment management services to individual and institutional clients. From October 1, 2003 to December 31, 2015, the Firm was defined as Kovitz Investment Group, LLC. Effective January 1, 2016, Kovitz Investment Group, LLC underwent an organizational change and all persons responsible for portfolio management became employees of Kovitz. From January 1, 1997 to September 30, 2003, all persons responsible for portfolio management comprised the Kovitz Group, an independent division of Rothschild Investment Corp (Rothschild).

Composite Definition: The Core Equity Wrap Composite includes all fee-paying, discretionary portfolios, including portfolios managed under a relationship with a wrap sponsor, managed to the Kovitz Core Equity strategy. The Kovitz Core Equity strategy utilizes a private owner mentality to purchase equity securities issued by companies with durable competitive advantages and strong balance sheets that are trading at a significant discount to their intrinsic value. The goal of this strategy is to maximize long-term total return. The inception date for this composite is January 1, 1997, and the Composite was created on June 1, 2014. The minimum portfolio size to be included in the Composite is $250,000 until December 31, 2021. Thereafter, the strategy minimum was raised to $1 million. The benchmark is the S&P 500 index.

The benchmark for the Composite is the S&P 500 Index. The S&P 500 Index is composed of 500 leading companies in the United States, covers approximately 75% of the market capitalization of U.S. equities, and serves as a proxy for the total market. The S&P 500 Index returns do not include the effect of transaction costs or fees and assume reinvestment of dividends into the index.

GIPS: Kovitz Investment Group Partners, LLC (Kovitz) claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report in compliance with the GIPS standards. Kovitz has been independently verified for the periods January 1, 1997 through December 31, 2022. The verification report is available upon request. A firm that claims compliance with the GIPS standards must establish policies and procedures for complying with all the applicable requirements of the GIPS standards. Verification provides assurance on whether the firm’s policies and procedures related to composite and pooled fund maintenance, as well as the calculation, presentation, and distribution of performance, have been designed in compliance with the GIPS standards and have been implemented on a firm-wide basis. Verification does not provide assurance on the accuracy of any specific performance report. GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein.

Valuations are computed and performance is reported in U.S. dollars. The measure of internal dispersion presented above is an asset-weighted standard deviation. The three year standard deviation presented above is calculated using monthly net-of-fees returns. The three year standard deviation is not presented when less than 36 months of returns are available. The risk measures, unless otherwise noted, are calculated gross of fees. A complete listing of composite descriptions and policies for valuing portfolios, calculating performance, and preparing GIPS reports are available on request. The composite includes accounts that do not pay trading fees.

The description of products, services, and performance results of Kovitz contained herein is not an offering or a solicitation of any kind. Past performance is not an indication of future results. Securities investments are subject to risk and may lose value.