A Slowing Economy Begins to Tame Inflation

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.

If the first quarter was defined by a sell-off in the most expensive and speculative parts of the financial markets (think “hopes, dreams, themes and memes” stocks), the second quarter was marked by widespread selling pressures as fear and uncertainty caused investors to head for the exits. The catalyst for those concerns was a narrative of continued rising inflationary pressures that could force the Federal Reserve policymakers down a path of increasingly hawkish monetary policy. During the quarter, markets experienced the first 50-basis-point rate hike since 2000, followed by the first 75-basis-point hike since 1994. This led market participants to push the terminal Fed funds rate up from 2.25 percent at the beginning of the quarter to nearly 4 percent by mid-June. Also fueling the heightened rate expectations were a hot Consumer Price Index (CPI) reading and a University of Michigan sentiment survey that showed consumers’ intermediate-term inflation expectations were ticking higher and could become unanchored. Indeed, notable economists (including Larry Summers) began sounding dire warnings that we were in for a return of rampant inflation that plagued the 1970s.  

However, the last half of June saw the narrative change as recession fears grew and many inflationary indicators began to roll over. For example, the price of shipping containers fell dramatically and is now off 32 percent from the September 2021 peak; the Baltic Dry shipping Index, which measures the cost of moving raw materials by sea, is off 62 percent from its highs. Oil fell 14 percent, and overall commodity prices tumbled 17 percent from their early-June highs. Supply constraints continued to ease in the manufacturing sector, and in financial markets both the 2-year and 10-year Treasurys retreated by roughly 48 basis points from early-June levels as rate hike expectations began to wane.  

We don’t believe today is reminiscent of the 1970s and instead trust the inflation narrative is beginning its downward descent.

This seemingly never-ending swirl of confusing crosscurrents has left investors dazed as the market gyrates between inflationary and recession fears. Similarly, for the first time in years our commentary began to feel a bit counterintuitive, as we were discussing weakening economic growth as a positive, not a negative. However, the reality is that we need economic growth to slow in order for inflation to wane. Inflation is today’s pressing economic problem and is what is in most need of “fixing.” We believe the big fear plaguing the markets is that economic growth slows but inflation remains sticky, much like during the 1970s. The thinking goes that this would force the Fed to keep tightening rates even as economic growth weakens, ultimately resulting in a deep recession and additional equity market repricing.  

We don’t believe today is reminiscent of the 1970s and instead trust the inflation narrative is beginning its downward descent. While volatility will likely remain the norm throughout 2022 and into 2023, we believe that equity markets have upside from current levels and are encouraged that once again bonds are acting as a counterweight to an equity portfolio. We continue to favor cheaper parts of the market and believe valuations offer a margin of safety against potentially falling earnings expectations.  

Inflation is set to slow 

While many continue to point to the CPI when making their case of excessive inflation, remember that the Personal Consumption Expenditures Price Index (PCE) is the Fed’s preferred inflation indicator. Despite the fears of spiraling inflation, we note that this index peaked in February and continued its descent during the quarter. Core PCE has fallen from its peak of 5.3 percent in February to 4.7 percent as of May — a .6 percent decline in the past three months. We further note that the month-over-month change has notched a .3 percent increase in each of the past four months, which, if continued, would result in a much lower year-over-year rate in the coming 12 months. We believe these numbers show that recent inflationary trends are improving. Overall inflation has pushed down from 6.6 percent in March to 6.3 percent in May, and we would note that the recent drop in commodity and oil prices should accelerate improvements. We continue to believe that inflation is set to drop, perhaps quickly, for three reasons.  

1. U.S. consumers are continuing a “post-COVID” spending shift away from goods and back toward the service sector. Real goods (inflation-adjusted) spending is still 13 percent above its pre-COVID levels, while service-sector spending resides a mere .5 percent above its early 2020 levels, but that trend has clearly shifted. As a reminder, goods spending fell for one month during COVID and then recovered quickly and shot higher as stimulus payments prompted Americans stuck at home during the pandemic to spend on everything from furniture to appliances to exercise machines. This buying spree occurred against a backdrop of supply-constrained inventories, which led to historically unusual price spikes in many goods segments of the economy. This trend remained largely in place until goods spending peaked on a seasonally adjusted annualized basis in March 2021, right about the time the U.S. began to emerge from COVID lockdowns. Since that date, goods spending has been choppy and is down 5.7 percent, while service-sector spending has risen 6.4 percent. Evidence in the shift toward services spending can be found in reports from the Transportation Security Administration (TSA) noting that check-ins at airports hit post-COVID highs in late June, while OpenTable restaurant seatings finally climbed above their 2019 levels. We believe this spending shift will continue and expect to see outright price declines in goods, as inventory restocking has outstripped demand.  

2. The rapid rise in interest rates, decline in equity market prices, erosion of consumer confidence and overall tightening of financial conditions is likely to continue to slow economic demand as consumers and businesses pull back spending. The continuous rise in mortgage rates, from just more than 3 percent at the start of the year to more than 6 percent in mid-June, has undoubtedly dampened housing demand and should slow future price gains for homes. Overall consumer spending fell in Q1 to a post-COVID low of 1.8 percent quarter-over-quarter, and Q2 economic growth estimates are currently flat or slightly negative. In a sign of inflation’s impact, during the quarter, consumers’ views on buying conditions for autos and large household durables fell to the lowest level ever in the University of Michigan Consumer Confidence Survey — yes, even well below the dreaded 1970s to early 1980s period. The upshot is that this shows that consumers are likely willing to wait for better deals, as they don’t believe inflation is a permanent feature of the U.S. economy.  

3. While our first two points are related to supply and demand, our third reason is grounded in economic theory, which suggests that consumers and business expectations of future inflationary levels play an important role in embedding rising prices in an economy. Put differently, if consumers believe inflation is permanent, their behavior in response to that belief will lead to rising prices over the long haul. Fortunately, despite inflation expectations ticking higher, the data do not show that high inflation is in the U.S. economy. Indeed, the reason the Federal Reserve became increasingly aggressive during the quarter was because of emerging evidence this narrative was beginning to shift. Central Bankers believe that the longer heightened inflation expectations are left unchecked, the more aggressive the Fed will need to be to battle rising prices. The good news is that as we exited the quarter, the market estimates of future inflation declined markedly. For example, the Fed’s favorite market indicator of intermediate-term inflation expectations, the 5-year, 5-year forward inflation breakeven rate, tumbled precipitously late in the quarter and ended at 2.04 percent — nearly identical to the Fed’s 2 percent target.  

For those who still worry that we are in for a repeat of the 1970s, we believe there are many key differences between now and then. Today’s inflation expectations recently rose to 3.1 percent as measured by the University of Michigan’s 5- to 10-year inflation outlook. This pales in comparison to the high of 9.7 percent in early 1980. Furthermore, back then a wage/price spiral developed. For the entirety of the 1970s and early 1980s wage gains of non-supervisory and production workers averaged nearly 7.3 percent annualized and were in a range of 5.5 percent to 9.4 percent annually. Today this measure stands at 6.4 percent, but we believe this is likely to subside in the coming quarters. Returning to the University of Michigan survey, respondents expect a median 1.1 percent change in their household income over the next year.  

A potential “buyers strike” recession 

Do the above points suggest a recession? Perhaps. We acknowledged in January that one was likely in the coming years given that the economy was later in an economic cycle. Unfortunately, the fear of runaway inflation and dramatic rate hikes have pulled forward recessionary fears. However, we believe a contraction would be driven by consumers pausing their spending as they wait for inflation to ease — essentially a buyers strike. As a result, we remain convinced that whether the economy slips into recession, segments that benefited from COVID tailwinds will experience a contraction, while areas that faced headwinds due to COVID will advance.  

Recessions, while never pleasant, are a natural feature of the business cycle, and no two are alike.

The good news, in our view, is that any such recession should be mild given the overall strength of U.S. consumers and corporations. Yes, consumers are feeling the pinch of rising costs, but we believe lower prices are on the way. And while consumers are saving less and credit card debt has recently passed its pre-COVID high, flow-of-funds data from the Federal Reserve shows that as of March 31 aggregate consumer liabilities to assets are at lows last seen in 1970. Furthermore, the cost of consumer liabilities remains near 40-year lows relative to disposable personal income. Finally, a deeper look into household assets shows that consumers had in aggregate $4.5 trillion in checkable deposits compared to steady pre-COVID levels of around $1 trillion. Likewise, corporations have ample cash and are generating free-cash flows. While these data points may change in the coming quarters, it is important to note that we entered this difficult time period with a significant cushion.  

Recessions, while never pleasant, are a natural feature of the business cycle, and no two are alike. We have had 24 recessions since 1900, and only two have been labeled “Great” — the Great Depression of 1929-1939 and the Great Recession/Financial Crisis that ran from December 2007 through June 2009. As investors fret about the impact of a potential recession, we believe recency bias is likely coloring the views of just how severe it may be. At the beginning of the Great Financial Crisis, consumers and banks were highly leveraged, and many had to spend years rebuilding their balance sheets — but this time both groups are in much better financial shape to face a potential downturn. For this reason, we believe that if inflation continues to moderate, consumers will resume spending, and a potential recession is likely to be mild.  

A washed-out market 

We have spent the past year pointing out the oddities that existed in both the economy and markets. Indeed, in our Q1 Quarterly Market Commentary we pointed to record negative real interest rates and extreme valuations in many segments of the U.S. equity markets that raised the likelihood of a pull-back in equities. We have discussed hopes, dreams, themes and memes (largely unprofitable companies) that were bid up on pure speculation as a result of this flood of liquidity unleashed by monetary and fiscal policy. The good news is that much of this excess has been purged from the markets, with some of the most speculative names in the market falling by 60-80 percent. This is a healthy sign that we are nearing, if not at, a market bottom.  

This market washout has taken a toll on investor sentiment. During the first six months of 2022, the Investor Sentiment Survey by the American Association of Individual Investors failed to register a single weekly reading of bullishness that exceeded the 45-year average of 37 percent. Instead, there were seven weekly responses when bullish sentiment was below 20 percent, with six of those occurring in Q2. There have been eight readings of bearish sentiment eclipsing 50 percent. The gap between bulls and bears hit its highest level since the day before the market completed its 57 percent sell-off during the Great Financial Crisis in early March 2009. Our research shows that this level of negative sentiment has historically given way to positive future market returns.  

As we previously mentioned, the current backdrop feels a bit like the late 1990s to early 2000s period, when some but not all parts of the market were trading at excessive valuations. Back then, it was internet stocks; now it is the hopes, dreams, themes, memes names as well as crypto. While this comment may alarm readers, we note that in the years following the bursting of the tech bubble, many parts of the market did well, as did active stock selection. Furthermore, during this market pull-back valuations have contracted much more quickly. 

In anticipation of potential downward revisions to expected earnings, we continue to believe investors should favor cheaper parts of the market, where there is a margin of safety against falling earnings growth.

Another similarity between now and then is the S&P 500 Index is once again concentrated in the top 10 securities. While it can be argued that the top performers of the index are where earnings growth has been the highest, much like during the tech bubble, the prices people have been willing to pay for these stocks are elevated. While many highlight that the markets remain expensive, it should be noted that, according to JPM research, the 10 largest names of the S&P 500 index trade at 23.6 times forward expected earnings, while the remaining 490 stocks trade at 13.9 times expected 12-month forward earnings. Although earnings forecasts may be revised downward, we do not believe these valuations are expensive. 

In anticipation of potential downward revisions to expected earnings, we continue to believe investors should favor cheaper parts of the market, where there is a margin of safety against falling earnings growth. Additionally, if Treasury markets remain calm, and their current yields of near 2.9 percent on the 10-year represent a near-term peak we believe a multiple of 17-18X earnings for stocks would represent reasonable value. While this may still sound expensive to some, the reality is that, with the exception of the period of the 1970s to early 1980s, these valuations have been the norm, not the exception. 

To be sure, we are not sounding the “all clear.” Heightened volatility is likely to remain in the coming months, and we expect that the major indices will not make new highs until well into next year. Much as we did last quarter, we want to emphasize that this is not 2011, when the economy was just two years removed from a recession and gearing up for a long run. Instead, we are facing an economy that is later in an economic cycle and may have less room for expansion. However, in our estimation it is also not like the period of the ’70s and early ’80s, when inflation and a slowing economy put significant stress on the markets. 

It has been a bumpy quarter and rough start to the year, but times like these are when your advisor can shine. Your plan and asset allocation are designed to help you ride out the tough times, whether caused by inflationary shocks or recessions, to help you meet your financial goals in any economic season. The tough times are also when other pieces of the plan — permanent life insurance, annuities and other financial tools — can play their roles. Anyone can grow wealth when the markets and economy are running hot. But downturns separate those who truly plan from those who scramble to react in challenging times. If you have concerns about the future, now is the time to talk to your advisor. Once you do, you’ll be better prepared and confident in your ability to stick to your financial plan. 

Commentary is written to give you an overview of recent market and economic conditions, but it is only our opinion at a point in time and shouldn’t be used as a source to make investment decisions or to try to predict future market performance. To learn more, click here. 

There are a number of risks with investing in the market; if you want to learn more about them and other investment-related terminology and disclosures, click here.