The Flood Will Recede
It would be an understatement to suggest that 2022 proved a difficult year for investors. With the Fed on a rampage and recession fears simmering, virtually every major asset class dropped in value, most by double-digits. Even bonds — whose typical role in a portfolio is to offset risk and protect capital — experienced meaningful declines. Consequently, at its nadir last fall, a quintessential “balanced” portfolio (60% equities / 40% fixed income) had experienced a loss of more than 20%.
Too much money, too few goods
The pandemic unleashed a number of forces that contributed to broad-based, sticky price pressures. Excessive demand driven by expansive fiscal and monetary policies collided with business closures, supply-chain disruptions, and labor shortages. Prices for many goods and services have surged.
As the economy recovered in 2021, consumer inflation accelerated, rising 3.4% in the first half then stepping up to a 6.0% clip in the back six. Initially, goods fueled this trend, their availability jarred by COVID shutdowns. At the time, most observers dismissed this phenomenon as a temporary anomaly. However, like a river overwhelming its banks, price pressures spread to the services side of the economy. Inflation not only broadened, it also became more severe. Over the first six months of 2022, headline inflation rose 8.3%, hitting a peak rate of 9.1% that June.
Last March, the Federal Reserve finally began to recognize the non-transitory nature of this threat. And the bank has been forced to move swiftly to make up for its miscalculation. Over eight months, policymakers hiked the fed funds rate by 4-1/4 percentage points, the fastest pace of tightening since 1980. In doing so, Chairman Powell effectively called time on the era of ultra-low interest rates and super-cheap money born after the 2008 financial crisis.
Road to 2%
The speed and magnitude of this about-face has roiled stock and bond markets and explains much of the turmoil in 2022. Security prices continue to bob and weave with each inflation print as investors attempt to divine future Fed moves and the implications for the economy
At his press conference following last month’s committee meeting (and seventh rate hike), Powell indicated that monetary policy would need to remain tight “for some time” to restore price stability. With inflation this cycle running at the quickest pace in four decades, the central bank’s credibility is at stake. As the monetary tightening runs its course, inflation will indeed subside. However, it will take time to return to the Fed’s 2% target.
Beyond the easing of supply bottlenecks, inflation will abate when higher borrowing costs and lower asset prices slow economic growth by reducing the demand for labor as well as spending and investment. The question for investors: How much economic pain will households and businesses have to endure as the Fed attempts to corral the horses and return them to their stalls? Paul Volcker, the last chairman to wrestle with sky-high inflation, had to engineer a severe recession to subdue the beast. Volcker’s Fed increased the policy rate to 20% in 1980, leading to 11% unemployment by 1982.
False equivalence
Fortunately, the situation in the early 1980s is not really analogous to today’s environment. By the time Volcker assumed the helm, inflation had been spiraling for years, perpetuated in part by ineffective monetary policy; it had become ingrained in society’s collective psyche. Most anticipated that inflation would average 10% annually over the remainder of the decade. Volcker had to take drastic steps to extinguish that inflationary psychology because such expectations are self-fulfilling. A sharp recession proved the necessary and sufficient antidote.
In contrast, Jerome Powell will not need the aid of a deep recession to return inflation to palatable levels. He inherited an entirely different situation; for today, while inflation surged on his watch, expectations are still well-anchored. Recent surveys indicate that consumers only anticipate 3% inflation over the next 5-10 years, in line with their views over the last two decades. In addition, bond market measures are pricing in an outlook for 2% annual inflation over the next 30 years.
Another important distinction from the 1980s: Despite multiple rounds of rate hikes, the U.S. labor market remains resilient with demand exceeding supply. Unemployment stands at 3.5% while 1.7 job openings exist per unemployed worker. This positive “jobs-workers” gap will help mitigate the impact of a slowdown as some job losers discover more options to rejoin the workforce.
Rolling over
Meanwhile, although untenably high, inflation has begun to roll over. After peaking last June, the CPI had moved down to a 6.5% annual rate by December. With supply chains healing, goods price inflation has decelerated. On the services side, price increases have become more constrained over the last several months, outside of shelter and transportation.
And wage increases — often the tinder for an inflation spiral – have also slowed. For instance, average hourly earnings surged at a 7.3% annual rate in January 2022 but by December were rising 5%. Importantly, unit labor costs (which adjust compensation for productivity) were only increasing at a 2.6% annualized rate by the third quarter, down from the first quarter’s 8.6% clip.
Whatever it takes
Nevertheless, the central bank has made clear it stands committed to fully tame prices, even at the expense of higher unemployment and recession. Complicating the situation — monetary policy shifts work with a lag, the ultimate impact on the economy not apparent for many months. But interest-rate sensitive sectors, such as housing, have clearly begun to slow as a result of the new regime.
A majority of economists and other pundits believe that the Fed will fail to anticipate when enough is enough and overtighten, sending the economy into recession. In our view, any such contraction would be relatively shallow. Over the post-World War II era, severe recessions have coincided with an outsized shock or major imbalance (e.g., oil crisis, bursting tech and housing bubbles, COVID).
Today, although pandemic effects linger, no such imbalances are evident. And the job market is strong, consumers have excess savings plus low debt-service burdens, corporate balance sheets are fairly solid, the banking sector is well-capitalized. In other words, though higher interest rates will certainly bite and recession may be looming, the stage is set for a milder downturn.
Stocks are forward looking
This year, financial markets will be less obsessed with the Fed and inflation, instead focused on threats to both economic growth and corporate profits. Yet while the consensus outlook for the economy is rather pessimistic, analysts have been slow to anticipate much of a drop-off in corporate earnings.
The earnings outlook will obviously be a key factor for equity market performance in 2023. Earnings estimates have been revised down. But according to FactSet Research, S&P 500 profits are still forecast to increase 4.4% in 2023 after rising 5.5% in 2022. In recent quarters, while many companies have reported healthy sales growth, risings costs have pinched margins and hit profits. A slowing economy should also begin pressuring revenues, suggesting that earnings forecasts may need to come down further.
If an economic recession does ensue, what is the implication for stocks? History indicates that equity markets tend to bottom well before GDP and corporate profits do. Since 1950, the median recession has lasted ten months; on average, stocks reached a trough four months before it ended. Stocks actually performed worse in the year prior to a recession beginning than during the recession itself.
The Fed should soon pause to observe the cumulative impact of the rate hikes that are slowly flooding the economy. Inflation has peaked but a leg down from 8% to 4% will be much easier than a drop from 4% to 2%. Stocks will find a durable bottom once there is more clarity on the economy’s path.
Christopher J. Singleton, CFA, Managing Director
January 18, 2023