Engineering an Economic Slowdown
• Interest rate and FOMC headlines continue to rattle the markets, in turn driving investor returns towards Bear-Market territory
• Today’s economic environment is the result of FOMC activities during the pandemic two years ago to stabilize what might have developed into a much deeper recession
• While the news continues to highlight rising fuel and food prices, efforts by the central bank to tighten interest rates will ultimately reverse today’s inflationary pressures; but the question is whether it will be a “soft-landing”
• Market history indicates that following two difficult investment markets, the following one, three, and five years tend to deliver attractive equity returns
It comes as little surprise that this year’s economic slowdown has taken investors, consumers, and, apparently, the Federal Reserve off guard. Stepping back and reading the tea leaves, cautionary signals hinted at how this economic turn of events might play out.
Almost 26 months ago, the Federal Reserve quickly provided the necessary stopgap liquidity measures to offset a sudden pandemic-driven recession as governments and central banks juggled monetary policies, pandemic assistance programs, and ever-expanding deficits. Importantly, those policy decisions helped divert a potentially more significant economic (and market) recession or depression. They also helped fuel the liquidity-driven financial markets.
Unfortunately, however, those monetary and government-backed decisions weren’t without consequences. Today, they are the underpinning of recent market volatility, inflation fears, and recession concerns. And while the ongoing war between Ukraine and Russia was not part of collective policy decisions in early 2020, its impact has certainly added to current economic ills.
What today’s market headlines actually reflect, however, are impacts of the quick reversal of the post-COVID shutdown two years ago—government policies designed to keep the economy afloat while jump-starting consumer demand. The effect of too few goods drove prices upwards and supplies downward, and exacerbated inventory shortages (“just-in-time” and nonexistent), mothballed factories, and furloughed labor markets. Combine all the factors just mentioned, and inflation spiraled.
As a reference, just 13 months ago the Consumer Price Index (broad-based inflation measure/ CPI) showed a 5% annualized price level increase for May 2021, the fastest annualized price increase pace since August 2008. Excluding food and energy prices, core inflation had risen by 3.8%, the most in three years. This past December, CPI spiked higher at 7% with core inflation at an annualized 5.5%. By May, the CPI Index had risen by 8.6%, the largest one-year increase since December 1981. Again, not considering energy and food, the core increase was only 6%. June’s CPI Index spiked to an annualized 9.1%, with core inflation dipping slightly to 5.9% versus the prior month.
Most consumers, however, weren’t looking at the “lower” core inflation nuance, as energy inflation for June alone was up 7.5% and over the past 12 months was up 41.6%, while food inflation was up 11.7%. Gas lines and checkout lanes provided firsthand (and sometimes painful) experience to all of us about significant price increases. Add rising 30-year mortgage rates, up nearly 47% since January 1, and you have the consumer trifecta of headline inflation worries. It is little wonder that the Consumer Sentiment Index is in the doldrums and Google searches for “inflation” are surging. Again, reading the tea leaves, inflation is the new consumer pandemic.
The Disappearing Fed Backstop
Today, the task of reverse engineering monetary policies implemented by the Federal Reserve earlier in 2020 is not as easy as lowering the Fed Fund rates to zero. Hiking rates too quickly or too sharply runs the real risk of derailing the past two years’ economic growth. On the other hand, accelerating price levels, if left unchecked, eventually become inflationary economic hurdles.
With neither outcome optimum, the Fed is now navigating uncharted waters—accelerating rate hikes while keeping an eye on maintaining a healthy labor, business, and consumer market. This multitasking must be achieved while systematically reducing the approximate $4.6 trillion in incremental Treasury securities, agency debt, and agency mortgage-backed securities purchased by the Fed beginning in February 2020 to help stabilize the financial markets throughout the last two years.
How successful the Fed will be is still an open question. So far, the Fed has made three rate hikes—a 25-basis point increase this past March, another 50-basis point increase in May, and an additional 75-basis point hike in June. Although S&P 500 price levels have fallen approximately 12% since the first March 16 policy change through July 15, these hikes were planned and on the dockets for months. That helps explain the broad market sell-offs that began in early January and left most major indexes sitting in “bear-market territory” (losses in excess of -20%).
Over the next few months, the Fed and investors will continue the balancing act of managing through additional rate hikes. Investors will look to company guidance for perspectives on the rising rate impact to earnings while central banks tweak interest rates in their efforts to curtail inflation risks. Until there is evidence that inflation pressures have subsided, however, expect more aggressive rate hikes in the next Fed meetings: as of this writing, expect July’s increase to be a minimum of 75 basis points. The odds are even, however, that the Federal Open Markets Committee (FOMC) may further jump-start tightening efforts with a 100 basis point hike this next meeting. Let us hope that inflation data will have cooled off considerably by the FOMC meeting in September.
The Consumer’s Economic Role
Interest rates move markets, and consumers move economies. That statement may seem simplistic, but consumers focus on economic (and corporate) underpinnings, such as jobs, wages and living expenses, food, housing affordability, transportation, and retirement savings. When consumer health is at risk (jobs, income, spending), recession fears escalate on the belief that rising costs of living will dampen consumer spending levels. Because consumer activities comprised 68% of last quarter’s GDP, changes in consumer trends are being closely watched, given the ripple effect on the economy in general.
A few consumer issues cropped up this month that were concerning to both the Fed and market watchers, including the already mentioned sudden drop in the Consumer Sentiment Index. Escalating housing prices are one of today’s more visible cracks in the consumer financial picture. Based on data from realtor.com, June’s national median asking price for a newly listed home was $450,000, up 16.9% compared to last year and up 31.4% from two years ago. Despite an uptick in June housing inventory of 18.7% versus 12 months ago, higher mortgage rates and rapid price growth mean the pride of homeownership for many Americans is not around the corner.
When it comes to future housing availability, units under construction this past May were up only 0.4%, the weakest monthly growth since September 2020. And unfortunately, housing start levels are also at their lowest level since April 2021. Remedying the housing issue will require an acceleration in new construction, which could potentially lead to a stabilization in housing prices, although mortgage rates will be an issue as long as interest rates are on the rise.
With worries growing about current monetary policy tightening leading to a recession here in the U.S., the post-COVID job market recovery is also being called into question. Undoubtedly, the job market remains tight with unemployment levels remaining near record lows of 3.6%. Meanwhile, the Fed’s rate hikes are engineered to slow down demand (including employment levels); some forecasts have predicted that unemployment will rise back up to an expected 4.3% by the end of 2023. Inevitably, job growth and new labor postings will slow, and unemployment rates will reverse as the rising rate environment dampens corporate margins. Trimming expenses is the natural progression of a tightening economy, but what remains unique in this environment, as of now, is the steadfast growth of the labor markets.
As evidence, this June’s employment report once again posted another solid reading, with an incremental 372,000 new hires added to the job markets. And despite the succession of strong incremental job additions, there are still near-record highs of 11.25 million job openings versus the approximate 5.2 million job seekers. While job openings spiked following the pandemic recovery, the number of job seekers has remained constant. Although job losses and deleted postings are to be expected during this inflation-fighting phase, I certainly wouldn’t expect a significant reversal in what has otherwise been a phenomenal labor market recovery.
While labor markets have held up well through these heightened recession warnings, the business community is certainly tempering its outlook. A recent May Conference Board CEO Confidence survey indicated 60% of respondents expected the current rate tightening to lead to a recession. The good news, however, was that respondents expected a recession to be very brief and mild. This month polling results from the National Federation of Business (NFIB) also noted that Small Business Optimism Index had fallen to its lowest level since January 2013. Interestingly, the survey also showed that 50% of the owners were still struggling to find skilled and unskilled labor.
Balancing supply chain issues, labor shortages, and rising costs are today’s global business challenges. There is no doubt that sharp rate hikes could inevitably impact profit margins, potentially leading to company cost-cutting. Throughout the next few months, corporate earnings and future outlook discussions will provide investors a better perspective about the state of the markets. Even so, through last month, the broad business economic environment wasn’t that bad.
Although June’s ISM Manufacturing PMI data dropped to a two-year index low of 53, survey responses were relatively positive, citing an improvement in manufacturing and delivery schedules. The ISM Services Index told a similar story as still expansionary readings of 55.3 pointed to a moderating (not inflationary) growth environment. Meanwhile, through May, new orders for manufactured goods were on the rise for 12 out of the prior 13 months as durable goods orders improved seven of the prior eight months. Continuing with the good news, global shipping rates are beginning to stabilize, and overall North America rail volume is up slightly (+1.9%) versus a year ago. This data certainly does not suggest a worrisome environment with a lengthy recession risk ahead.
Reading the Tea Leaves
The markets have been unforgiving this year, compounded by decades’ high inflation and countered by an aggressive Fed-rate tightening regime. And while earlier pandemic-era monetary policies set the stage for this year’s Fed interest rate reversal, the Ukraine war, followed by surges in commodity prices, certainly exacerbated the situation. Meanwhile, the central bank has high hopes that current policies and risks won’t necessarily lead to a recession, but investors aren’t convinced. We already have one negative quarter on the record, as the first quarter’s GDP (final) estimate was an annualized -1.6%. Although we are still weeks away from an “official” second quarter GDP report, early estimates are trending negative. And IF the economy does slip into a recession this year, the current expansion will be one of the shortest since World War II, as noted by Ned Davis Research.
Yet, both the U.S. consumer household and corporate balance sheets are still healthy today because they have taken advantage of pandemic-era refinancing at lower interest rates, rising markets, and government assistance, where and if available. At the end of the first quarter 2022, Federal Reserve data shows households had $18.5 trillion in cash in checking, savings, and money markets, up from $13.3 trillion pre-pandemic. But the market routs and inflation spiral have created a more nervous consumer and investor. Worried consumers beget falling retail sales, a phenomenon that investors are closely watching, and today’s investor is getting increasingly more bearish.
Checking in on the American Association of Individual Investors (AAII) Bullish Sentiment Survey, the current reading of 19.4 is at one of its lowest points since the survey’s 1988 launch. But, according to AAII data, when the survey records readings this low, the following year is great for investors.
In this backdrop, headwinds are indeed confronting policy makers trying to bring the economy into the often-mentioned “soft landing.” I can point to several of those headwinds, such as housing prices (no quick solution to bring down prices); oil and grain price levels (exacerbated by Ukraine war and Russian embargo); global monetary tightening (the U.S. is not alone in hiking rates); and a surging dollar (helps U.S. imports but harms exports).
A few positive considerations are worth noting as well, such as an improvement in domestic manufacturing and an upturn in imports, which in turn begins reducing last year’s inventory shortages, and premium pricing and inflation issues. From an investor perspective, today’s equity valuations are becoming exceedingly attractive.
Also positive: Looking back over time, these dramatic market declines (especially those seen this June) are followed by second-half rebounds. If we are still in the midst of a bear market, also take heart. According to Bespoke Research, if you bought into the S&P 500 at the beginning of a bear market, one year-total returns average 22%, three-year returns are 14.25% and five-year are 13.7%. Seeing beyond the daily noise is the hard part.
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