We began 2022 with hopes that the omicron variant and the economic pressure it was causing would subside. At the time, we believed the pandemic-induced inflation would moderate. Then Russia invaded Ukraine. While this story is first and foremost about the humanitarian crisis it has caused, it has also had major financial implications. Increased geopolitical fears and the resulting commodity price spike amplified inflationary pressures. The S&P 500 (U.S. large-cap stocks) went on to post a 10 percent correction, the 25th time it has done so over the past 72 years. Investors were forced to contemplate a big unanswered question: How would the Federal Reserve react to these new inflationary pressures? In response, the market shifted quickly — from pricing in a meager 0.75 percent of cumulative rate hikes in 2022 to a more aggressive 2.25 percent.
Bond market reaction to the rate hike expectations was equally swift, as we’re likely churning back to more normal interest rate levels, especially given the heightened inflationary environment. The yield on two-year U.S. Treasurys rose from 0.73 percent at the start of the quarter to 2.33 percent by quarter’s end. Meanwhile the 10-year jumped from 1.51 percent to 2.34 percent. This interest rate spike negatively impacted overall equity market returns. However, much as we opined in our most recent Q4 commentary, the largest impact was felt by what we call hopes, dreams, themes and meme stocks, as well as growth stocks in general, which historically tend to have a higher negative correlation to rising rates. Indeed, large-cap value stocks finished the quarter nearly flat (down just 0.2 percent) relative to their growth counterparts (-8.6 percent), while U.S. mid- and small-cap value stocks handily bested their growth counterparts (-0.6 percent vs. -9.1 percent and -1.6 percent vs. -9.5 percent respectively). It’s also worth noting that Commodities, an asset class we have recommended due to its effectiveness as a hedge against unexpected inflation, returned 25.5 percent and has outpaced all other broad asset classes from the time COVID first reared its ugly head in mid-February 2020 through the end of March 2022.
Despite rising risks and a myriad of crosscurrents, we still believe we will see positive economic growth in the U.S. in 2022. Importantly, we believe that as consumer demand slows and shifts back toward services from goods sector spending, inflationary pressures will begin to ebb. While war-related commodity price spikes will likely lengthen the duration of this inflationary environment, we nonetheless think price increases will pull back toward (but not to) the Fed’s 2 percent long-term target. This should allow the Federal Reserve more breathing room to tighten policy, likely at a more muted pace than current market expectations.
Despite rising risks and a myriad of crosscurrents, we still believe we will see positive economic growth in the U.S. in 2022.
While yields will continue to rise, the pace will slow, and eventually the economy will lead the stock market toward new highs. Although the economic cycle is pushing toward the later innings, which would normally favor U.S. large-cap and quality stocks, we continue to believe that valuation discounts make U.S. small-cap and value stocks relatively attractive over an intermediate time frame. We would also note that while International Developed economies will feel a greater impact from the recent commodity spike due to their reliance on Russian energy, these markets are trading at extremely discounted levels to U.S. equity markets.
The Russia-Ukraine war shock
Gauging the likely impact of an economic shock, we believe, requires us to first assess the current economic backdrop. From a broad economic perspective, the Russia-Ukraine war has primarily caused a sharp spike in the price of commodities, especially for natural gas and oil. While this has implications for the U.S. and global economies, our research points to a U.S. consumer that has a spending “cushion” and is strong enough to withstand the resulting price increases.
The U.S. consumer entered 2022 with “excess savings” that have been rebuilt after the Great Recession of 2007-09. The debt to net worth (balance sheet) of the U.S. consumer resides at 12 percent. Contrast that with the record 24 percent during the Great Recession of 2007-09. Consumers’ monthly expenses relative to disposable personal income (income statement) are at 13.8 percent relative to its Great Recession peak of 18 percent. While rising food and energy prices will undoubtedly eat into this cushion, it would appear most consumers can absorb price increases. And consider this: Total consumer spending on food and energy is around 12 percent today versus nearly 25 percent back in the 1970s.
Rising interest rates will also eat into consumers’ financial cushion, but we’d note that 65 percent of consumer debt is mortgages, and over the past 14 years most home loans have been issued with fixed rates. This is an important point since the housing market today is likely due for a price pause in the coming months, with 30-year fixed rate mortgage rates rising to nearly 4.9 percent (compared to the February 2021 low of 2.8 percent).
Some have compared today to the housing market in 2006 just prior to its collapse. We disagree. Today’s consumer is in a much better position. Additionally, in 2006 nearly 50 percent of the dollar value of mortgage debt was based on an adjustable rate vs. 14 percent today. In addition, banks are well capitalized today vs. over-leveraged in 2006.
Labor market strength & increasing participation
While the labor market is a lagging indicator, it remains strong. We have recovered nearly all of the jobs lost during COVID; the unemployment rate is now at 3.6 percent, just off its pre-COVID low of 3.5 percent. This strength is a double-edged sword. A higher employment rate is always better — but it raises questions about how many workers are available to fill the 11.2 million jobs that were open at the end of February. As of the end of March, there were only 6 million people looking for work. This is the worry we expressed in our Q4 market commentary. More workers will be needed to keep this economic cycle running.
Americans re-entered the workforce in the first quarter.
The good news is that we are adding around 550,000 employees to payrolls each month. To maintain that pace, workers who have fallen out of the labor market will need to continue to come off the sidelines (to be counted as unemployed, one has to be looking for a job). There is also good news here. The much-mentioned media headline over the past few months — the Great Resignation — was not greatly accurate. During the first quarter 2.115 million Americans re-entered the labor market looking for a job (the third fastest three-month pace in 75 years) and found employment. Much as we forecasted, the expiration of pandemic unemployment assistance in September marked the tipping point for the beginning of this trend, which has accelerated in recent months.
We continue to believe workers will be drawn back into the labor market, but the math is getting more tenuous and is likely indicative of an aging economic cycle. To get back to pre-COVID labor force participation levels, we need only an additional 2.6 million workers to rejoin. However, while the labor market was tight pre-COVID, we were still drawing workers back in, the pace was not slowing, and wage gains were relatively muted.
There is also another positive side to the labor coin, which is the recent productivity growth that is making existing workers more efficient. We have previously expressed our belief that business investment and technological enhancements driven by COVID realities would increase the productive capacity of our existing workforce. This story appears to be playing out, as productivity is currently rising at a three-year average pace of 2.4 percent versus less than 1 percent for much of the past decade. We expect this trend to continue, and that should help workers to meet future demand.
Employment is the key metric we will be watching to gauge how much staying power this economic cycle has. The good news, we believe, is that the U.S. Federal Reserve is going to err on the side of fostering continued economic expansion to bring more workers back into the labor market to further strengthen long-term U.S. economic growth.
The Federal Reserve and its primary goal
We repeat our view that the Fed’s overarching goal today is not to tighten the U.S. economy into a recession but to simply fine-tune policy today so the economy can keep pushing forward in the coming years while also drawing more Americans back into the labor market. Prior to COVID, this was the experiment the Fed was conducting, and we expect it to follow a similar script. The question: How low can the unemployment rate fall before we get real wage pressure?
We believe this Fed hiking cycle is likely to be bumpy relative to the past few cycles, and a “soft landing” is unlikely. Markets have become accustomed to a slow and gradual pace during the past two rate hike cycles. We expect fits and starts in the coming year and believe this cycle will look more akin to the mid- to late 1990s. Investors should prepare for volatility and the possibility of multiple .50 percent rate hikes, which hasn’t happened since the late 1990s. However, this does not have to spell impending doom. The most important question is whether the Fed errs on the side of hiking too much and risking recession or errs on the side of avoiding tightening, which results in continued inflation but a longer economic expansion. We continue to believe the latter is more likely, as a recession is more politically and societally unpalatable.
The Fed’s overarching goal today is not to tighten the U.S. economy into a recession but to simply fine-tune policy today so the economy can keep pushing forward in the coming years while also drawing more Americans back into the labor market.
The good news is that we expect downward pressure on inflation in the coming quarters as consumer spending slows and shifts back to the service sector from the post-COVID push toward goods. While overall real goods spending is 16 percent above its pre-COVID levels, service sector spending is still marginally lower. However, the trend is shifting as the economy continues reopening. Add in rising goods inventory levels, and we believe that the recent spike in goods inflation will begin to roll over and move substantially lower. Goods inflation in the latest PCE (Personal Consumption Expenditures Index) inflation report climbed 9.8 percent year over year. We expect this to moderate in 2022. Combine this with lower spending and higher historical comparisons, and we believe that as PCE inflation begins to move lower, the Federal Reserve will have more room to raise rates, meaning it may not need to hike as much as the markets currently have priced in.
Lastly, we shudder when we hear reports stating inflation is at the highest levels since the early 1980s. In February of 2021 PCE inflation was at 1.6 percent overall before it began its ascent higher in March. This is a one-year move, not multiple years of compounding increases like the late 1970s and early ’80s, when fiscal stimulus and money supply growth were a permanent feature of the economic landscape. We have certainly had a spike in money supply growth and fiscal stimulus since COVID, but it’s important to note that this is ending.
In the ’70s and ’80s, no one was convinced the Fed had inflation-fighting power. Paul Volcker changed that when he came into office and ratcheted policy so tightly that it threw the economy into recession and gave the Fed the inflation-fighting recipe and credibility it needed for the next 40 years. That credibility, despite the current narrative, remains. Inflation expectations today are still nowhere near where they were in the ’80s. Most measures of intermediate-term inflation expectations remain well anchored, with our preferred indicator the five-year, five-year forward breakeven rate ending the quarter at 2.37 percent, barely above the Fed’s average 2 percent inflation target.
Given the backdrop we just painted, it is not surprising that impending recession cries rose as the quarter wore on. As we ended the period, the recession commentary got louder as parts of the U.S. Treasury market/yield curve inverted. Put in simpler terms, historically when longer-term Treasury bonds yield less than shorter-term ones, a recession more often than not has followed. However, we believe there are nuances here.
First, there are many yield curves. For example, the 10-year Treasury less the 2-year Treasury inverted as we pushed to the end of the quarter. But the 10-year minus the 3-month Treasury resided at a positive 1.84 percent. The 2-year Treasury is an indicator of where the market believes the Federal Funds rate will be in two years, while the 3-month Treasury bill is where it is today. Given that, we believe the market is “voicing the opinion” that if the Fed hikes as much as what is priced into the 2-year Treasury, a recession is a growing possibility. However, there may be additional factors distorting the yield curves.
This gets us to our second point. Over the past years, the Federal Reserve and other central banks around the globe have embarked on Quantitative Easing (QE). Think of it this way: After the Great Recession, the Fed had lowered the short-term Federal Funds rate to 0 percent but was not getting enough “oomph” from that action. Not wanting to embark upon an experiment of negative interest rates, the Fed decided to pursue QE with the goal of pushing intermediate- to long-term bonds lower. Simply put, given this large, price-insensitive buyer (the Fed), we believe the 10-year Treasury today may not reflect an accurate price.
Finally, we note that yield curve inversions have had false positives, and often the lag between the inversion and the recession can be anywhere from a few months to up to three years in the future. Furthermore, from a market perspective it is far from a perfect indicator. Often the market rises sharply after an inversion, and when a recession arrives, stocks don’t always move below the level they were at when the inversion first occurred.
The best illustration of this commentary is the time period preceding the 1990 recession. On Dec. 14, 1988, the 10-year, two-year spread inverted with the S&P 500 Index at 275. The 10-year, three-month spread joined the inversion on March 28, 1989, with the index at 291. Eighteen months after the initial inversion, a recession began (7/90) with the index at 359 (up 37 percent and 28 percent from the respective inversions). The recession that ensued was mild, and the S&P fell to only 295 on Oct. 11, 1990, before the contraction ended in April of 1991.
Yield curve inversions have had false positives, and often the lag between the inversion and the recession can be anywhere from a few months to up to three years in the future.
Yield curves are a piece of the puzzle and contain important information. However, they are only one piece of a larger picture. Yes, a recession is likely at some point in the future, possibly within the next two to three years. However, this is not guaranteed. If it does happen, it will most likely be mild given the state of the consumer, corporations and banks. And the market may not move lower than where it is today. Now is the time for prudence, not retreat.
The final word – unique but not different
Over the past several years we have consistently pointed out in pieces like this that we did not believe inflation was a relic of the past despite the consistent chorus that had announced its long-term demise. We believed that fiscal and monetary policymakers would not stop short of achieving their 2 percent inflation targets and would react sharply and forcefully with immense amounts of liquidity to any economic downturn given their experience with slow growth and low inflation after the Great Recession of 2007-09.
We expressed our belief that anti-globalization trends were rising as countries competed for their share of the decreased growth pie. This movement was solidified with trade wars, the global supply chain shocks as a result of COVID and now the Russia-Ukraine war. Economic theory posits that globalization benefits all society because of the gains from comparative advantage and trade. Simply put, production should occur in the countries that have the lowest marginal cost, allowing other countries to focus on their comparative advantage. However, we are increasingly finding out that this has real-life limitations, from supply chain logistics to the cruel reality that not all countries get along.
This backdrop has informed our investment decisions to include commodities and add Treasury Inflation Protection Securities (TIPs) in our asset allocation and has helped guide our decision to add to risk assets quickly after the initial COVID shock. In that same post-COVID commentary, we noted that the fiscal and monetary response to COVID would help solidify a return to an inflationary environment. These comments are the backdrop for the current state of economic affairs.
However, as this current commentary explains, we don’t yet believe these realities point to economic recession. We’ve written heavily about our belief that every economic cycle, while unique, is not different and follows the same script:
- The economy runs out of slack, which causes ...
- inflation to rise, which eventually compels ...
- the Federal Reserve to put the final nail in the economic cycle coffin to stomp out inflation when that rise becomes unpalatable.
We believed we were heading toward this reality in 2019, but then COVID forced us to hit a pause button. Now, as we continue to move back toward “normal,” it's time to revisit this formula:
- We believe there is hidden slack in the U.S. economy.
- We believe that inflation has risen but will begin to move lower in the nearer term as spending slows and shifts back toward services from goods.
- Last but not least, we believe that the Federal Reserve still values employment more than inflation and is going to try to stretch this cycle as long as it can.
Despite our belief that we still have room to run, the reality is that we are pushing toward the end of this economic cycle. Economic slack is waning; and while inflation is slowing, it’s likely to remain elevated, and the Fed doesn’t have unlimited patience. Yes, we just had a recession two years ago, but it was short. This is not 2011, which was two years after the great recession. We likely don’t have a runway of nine years of continued expansion like we did back then. Recessions are a reality of the business cycle, and it is likely — although certainly not guaranteed — that we will have a recession in the next few years.
Your plan and asset allocation are designed to help you ride out the tough times, like recessions, so that you can meet your financial goals in any economic season.
We remind that many recessions are mild and short. It seems like many of us have recency bias, believing that future recessions will follow the 2007-09 Great Recession script. That’s unlikely. The reality is that in the last 122 years — since 1900 — we have had 24 recessions, but only two have been associated with the word great: the aforementioned Great Recession and the Great Depression of the 1920s and ’30s.
This is where you get the real value from your advisor. Your plan and asset allocation are designed to help you ride out the tough times, like recessions, so that you can meet your financial goals in any economic season. The tough times are also where other pieces of the plan — permanent life insurance, annuities and other financial tools — can really shine. 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. Then, whenever the next recession hits, you’ll be better prepared and confident in your ability to stick to your financial plan.
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