The third quarter can best be described as a roller coaster ride — or a “tale of two halves.” The market spent the first half of the quarter in rally mode, surging nearly 14 percent from July 1 to August 16, only to spend the last half of the period giving up all those gains and more, falling nearly 17 percent. Similarly, the 10-year Treasury rose from 3 percent to start the quarter to a closing high of 3.95 percent by Sept. 27, while the two-year rose from 2.96 percent to a high of 4.34 percent on Sept. 26. The spike in yields correlated with a nearly identical loss in the S&P 500 (down 4.89 percent) and the Bloomberg Barclays Aggregate Bond index (which lost 4.75 percent of its value).
The primary cause of the weakness was the Federal Reserve’s decision to ratchet up tough talk on rate hikes in response to volatile but still too high inflation readings. Ironically, during the quarter, “all-in” measures of inflation fell significantly on a year-over-year basis. The Personal Consumption Expenditure price index (PCE) fell from 7 percent year-over-year at the end of June to August’s reading of 6.2 percent, while the Consumer Price Index (CPI) fell from June’s 9.1 percent reading to 8.3 percent in August. However, core measures, which exclude volatile food and gas prices, remained stubbornly high, with core PCE registering a 4.9 percent increase year over year in August compared to June’s reading of 5.0 percent. Likewise, core CPI came in at 6.3 percent in August, up from June’s level of 5.9 percent. These data points paint a picture of an economy that has a myriad of crosscurrents buffeting it, resulting in uneven outcomes. This reality has led to market volatility as investors try to interpret every new data point and parse each word uttered by Fed board members in their seemingly never-ending stream of public appearances.
We worry that the Federal Reserve pays the most attention to the backward-looking inflation number rather than paying heed to the broader, forward-looking economic data.
While backward-looking inflation measures paint a confusing picture, our research on forward-looking data continues to point to inflation moving lower in the coming quarters. The vast majority of economic reports released during the past several months have shown an unwinding of many of the elements that drove inflation higher in the aftermath of COVID. While we continue to believe these developments will result in price pressures receding in the coming year, we also acknowledge that the lag between improvements in the supply and demand equation and a retreat in the rate of inflation has been frustratingly slow.
This is where our primary worry lies: We worry that the Federal Reserve pays the most attention to the backward-looking inflation number rather than paying heed to the broader, forward-looking economic data. Case in point: The median expectation among Fed officials at the board’s June 15 meeting was that the Fed funds rate would be 3.4 percent at the end of 2022. Contrast that expectation with the meeting on September 21, when the end-of-year forecast called for rates of 4.4 percent. Now consider that one year ago, the Fed believed it would hike rates by a total of 25 basis points for the entirety of 2022. The implication is that the Fed is referring to lagging data to make reactionary decisions as opposed to paying attention to what forward-looking reports are showing. To paraphrase hocky great Wayne Gretzky, the Fed is skating to where the puck was.
We continue to believe that the Federal Reserve will see the fruits of its rate hike campaign begin to filter more broadly into the backward-looking inflation data, which will allow it to slow the pace of, or even stop, rate hikes in the coming months. The good news is that while economic growth has slowed dramatically and may already be at or tipping toward recessionary levels, the foundation of the U.S. economy — the consumer — remains in strong financial shape. As such, we believe the economy will be able to quickly regain steam once inflationary pressures and Fed rate hikes subside. Put simply, we don’t believe this bout of inflation is deeply rooted and, as such, believe current market volatility and economic disruption will eventually give way to better days in the coming quarters.
Too much money chasing too few goods
Monetary and fiscal policy over the past year have significantly moderated from the surge during the height of the COVID pandemic. Fiscal and monetary policy fueled a tsunami of liquidity (additional dollars) entering the U.S. economy. This, in turn, spurred spending, speculation and, ultimately, inflation. Evidence of the largess could be found in the dramatic increase of the U.S. money supply, which stoked the inflationary fire that is just now beginning to burn out as the growth of money supply slows.
Excess dollars ran head-on into the reality of too few goods as production ground to a halt during the early days of the pandemic.
COVID-19’s arrival in early 2020 prodded policymakers to move quickly to flood the U.S. economy with liquidity to help cushion the blow for those most impacted by the shuttering of the global economy. At the beginning of 2020, pre-COVID, the money supply was growing at a rate of 6.6 percent year over year. Between March 2020 and early 2021, the money supply grew at an extreme pace as policymakers reacted swiftly; the result was a peak of 26.9 percent year-over-year money supply growth in February 2021, marking the fastest pace on record going back to 1960. However, since then, monetary and fiscal policy support have slowed drastically as government relief has tapered and the Federal Reserve has pulled back its accommodation. As of August 31, 2022, money supply growth is now running at a 4.1 percent year-over-year growth rate, which is below historical averages.
Perhaps the impact of money supply on inflation is best explained using Nobel Prize-winning economist Milton Friedman’s words: “Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” Put simply, inflation is produced when there is too much money chasing too few goods. As the COVID-induced spike in liquidity is quickly becoming a thing of the past and supply is now replenished, we believe inflation will retreat.
Supply is growing
Excess dollars ran head-on into the reality of too few goods as production ground to a halt during the early days of the pandemic. Consumers who were stuck at home dramatically shifted their spending from COVID-impacted services, such as vacations and eating at restaurants, toward goods, which were in short supply due to the lingering impact of low inventories and supply chain disruptions. Consider that between February 2020 (as the significance of COVID was just beginning to be recognized) and March 2021, overall goods spending increased at a real rate of 21 percent, with durable goods spending rising an astonishing 37 percent. Think about this in the context of a U.S. economy that normally grows at a 2 to 3 percent real rate. This large shift in demand in the face of diminished supply produced a rapid rise in prices for goods. Now, the reality is that consumers are shifting their consumption habits back toward services — all against a backdrop of goods inventories that have been largely rebuilt or, in some cases, overbuilt.
Rather than taking you through inventory levels, perhaps it’s best to place this in the context of comments from companies over the past few months. Target and Walmart are two high-profile retailers that were among the first to report a glut of goods inventory due to changing consumer demands. More recently, Amazon and shipping giant FedEx have warned of weakening demand, while athletic footwear and apparel maker Nike in late September noted its plans to discount prices in an effort to reduce excess inventories. Put simply, goods supply is no longer scarce, and demand is no longer elevated. The improved supply/demand dynamic reduces pricing power throughout the economy and should result in a marked softening of the rate of goods inflation. After hitting 10.6 percent year-over-year at the end of the second quarter, the August PCE showed overall goods prices up 8.6 percent year over year. We believe the data here point to a continued significant decline in the price of goods in the coming quarters.
Contemplate that according to Manheim Auctions, used car prices are up 0.6 percent year over year after being up 54.2 percent annualized in April 2021 and 46 percent year over year at the end of 2021. Consider that container costs (used to ship goods around the globe), as assessed by Drewry reports on a composite basis, are down from $10,377.19 on September 23, 2021, to $4,014.10 at the end of this quarter. Further evidence of easing congestion in the supply chain can be found in the September release of the Institute for Supply Management Manufacturing (ISM) Report on Business, which showed supplier delivery times falling to 52.4 (lower is faster) — the lowest level since December 2019 and off the peak of 78.8 in May 2021 and the December 2021 level of 64.9. (As an aside, 78.8 was the highest level in this index since 1973.)
Spending is shifting to services
Goods spending peaked in March 2021 as the U.S. economy began reopening. Since then, the pace of goods spending has fallen 5.2 percent through August 2022. Consumers have shifted to the service side of the economy, where spending has risen by 7.2 percent since March 2021 and is currently above pre-COVID highs. The result has been a shift of inflationary pressures toward the services side of the economy. A large component of service sector spending and inflation is the housing market, which was booming in the beginning of this year. However, the Federal Reserve’s rate hike campaign that began in March 2021 has had an almost immediate and outsized impact. Housing demand has fallen dramatically, with existing home sales down 26 percent from the pace set in January.
New-home builder sentiment has also soured as buyer traffic has dried up amid a jump in mortgage rates from 3 percent for much of 2021 to now above 6.5 percent. The National Association of Home Builders (NAHB) home builder sentiment index has fallen from its all-time record of 90 in November 2020 to a recessionary level of 46 (below 50 is contraction) as of the end of the third quarter. For further context, the reading was at 84 in December 2021.
This is beginning to have a significant impact on home prices, which are beginning to fall quickly. Indeed, the S&P CoreLogic Case Shiller Home price index fell during the month of July, with the year-over-year number posting the largest decline in the history of the data. Similarly, Black Night Data and Analytics reported that home prices not only fell by 1.05 percent in July but by another 0.98 percent in August.
We continue to believe that home prices are set to dramatically moderate. This will impact services sector inflation, which is what’s still driving inflation higher.
Overall spending is slowing
While spending is shifting from goods to services, overall spending has dramatically slowed over the past months. Total inflation-adjusted consumer spending is now up a modest 1.8 percent year over year compared to its pre-rate hike pace of more than 6 percent. Taking a broader view, real spending is essentially flat over the most recent three-month period for which data is available (June through August) and is up just .28 percent since April, when markets began dramatically reacting to the threat of aggressive Fed rate hikes. That pace translates to an annualized rate of just 0.88 percent.
The U.S. economy is slowing
Much as one might suspect, decreased spending and Fed rate hikes are beginning to weigh on overall U.S. economic output, as witnessed by two straight negative quarters of economic growth. Whether we are already in a recession is still up for debate, but the reality is that leading economic indicators point to one in the near future. During the third quarter the Conference Board’s Index of Leading Economic Indicators (LEI) continued its rapid descent, which began as the Fed rate-hiking cycle kicked off in March 2022. This decline has led the year-over-year number to post negative 1 percent “growth.” Based on history, the reading suggests a recession is already here or looming on the near horizon. Since 1960, every time this index has been at this level, the economy has either been in recession or has been on the verge of slipping into a contraction.
The one area that has yet to show meaningful improvement in the supply and demand imbalance is the labor market.
While a slowing economy is typically seen as “bad news,” it is likely to lead to further easing on price pressures and may accelerate the pace of declines in inflation readings. Furthermore, we believe that as long as the Fed pays heed to the slowdown and doesn’t continue pushing forward with unneeded rate hikes, any such recession would be brief and mild, thanks to the health of the consumer. The reality is that the U.S. consumer balance sheet in aggregate remains in the best shape it has been in 52 years (since 1970). The income statement is a similar story, with monthly debt expenses relative to disposable personal income near 40-year lows. Yes, higher interest rates will hurt consumers, but the reality is the impact will take place gradually given that 66 percent of consumer debt is held in mortgages and most homebuyers during the past 13 years have opted for fixed-rate loans.
The one area that has yet to show meaningful improvement in the supply and demand imbalance is the labor market. While job growth has slowed, demand for workers remains elevated. However, we believe that this lagging indicator is set to slow further as corporations react to the current weakening economic environment. During the month of August, job openings declined by more than 1 million positions. Given the market volatility of September and soft economic data, it’s not hard to imagine a further drop in open positions in the next report.
The demand for workers matters because wages rise when labor markets are tight, which in turn helps keep inflation elevated and sticky. We believe the labor market is evolving and note that workers in the U.S. are not expecting dramatic wage increases in the coming year. Both the University of Michigan Sentiment Survey and the Conference Board Consumer Confidence index show subdued wage expectations. For example, respondents to the Michigan survey note they expect their household income to increase a mere 1.7 percent over the next year. For historical perspective, back in the early 1980s this number was running between 5 and 6.5 percent. The modest expectation for pay increases shows that inflation not only is not as embedded as it was in the early 1980s but also is likely to lead to conservative spending habits in the face of higher costs.
Avoiding reruns of that ’70s show
The Federal Reserve is haunted by the ghosts of the 1970s and ’80s and the mistakes it believes were made that caused inflation to persist for many years. To avoid repeating past errors, the Fed has increased its hawkish comments in the face of still elevated inflation. Fed Chairman Jerome Powell’s August speech in Jackson Hole, Wyoming, illustrates this point. The thrust of the nearly eight-minute speech was a review of the errors the Fed made in the 1970s and early ’80s, with the implication that the board of governors has learned from the past. The Fed doesn’t want to lose its hard-earned inflation-fighting credibility and believes a message of tough love is needed to affect consumer behavior. This is the reason when chairman Powell is asked why the board doesn’t simply make a dramatic hike of 100 basis points or more to quickly stamp out elevated inflation, he responds that the board of governors prefers to work through the expectations channel. In essence, the Fed is taking the same approach I do with my children — I threaten now with consequences later to get the behavior I want in hopes I’ll never need to follow through with my original threats. However, in the case of the Fed, it is talking tough on future rate hikes in hopes of cooling economic growth. If the threats are successful, the board won’t have to follow through on outsized hikes in the future.
On this front, there is also good news. Both the stock and the bond markets have heeded the Fed’s words, as witnessed by their sharp drops. Meanwhile, the bond market’s expectations of where inflation is headed signal confidence that the Fed will prevail in bringing price increases under control. Consumers also seem to be acknowledging the turning point in price pressures, as the final revisions to the latest University of Michigan Sentiment Survey show that forward inflation expectations (for five to 10 years into the future) fell to 2.7 percent. That figure is down from June’s reading of 3.1 percent but still modestly higher than the top of the range between 2016 and 2020, when economists and the Federal Reserve were concerned about the U.S. entering a deflationary (falling inflation) period. To add some context, during the late 1970s and early 1980s — a period many are drawing comparisons to today — inflation expectations hit 9.7 percent.
Overall, we believe that the forward-looking data point to a dramatically improving inflation picture.
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The Fed and the markets
The current tightening cycle is playing out in a slightly different way than those in the past in that the rate hikes have had an almost immediate impact on both the economy and markets. This distinction is important when contemplating how quickly the economy and markets could change course should the Fed slow or pause its rate-hiking march. In the past, it took time for movements in rates — either up or down — to make an impact on the economy. That no longer appears to be the case. This change to a near-immediate response from rate movements, along with the healthy financial position of consumers, should allow the economy to recover more quickly if we fall into recession than has been typical in past downturns. The recovery from the Great Recession of 2007-09 was slow because consumers, banks and companies needed time to rebuild their balance sheets. Today, the foundation of the U.S. economy appears to be in much better shape.
While there are myriad risks to worry about, including declining earnings for companies as the economy slows, many of these concerns are already priced into equites. It’s worth noting that despite the narrative that stocks are expensive, there are now swaths of the market that are cheap. We believe this may offer some level of downside protection against potential negative earnings surprises. For example, a basket of sector-neutral value stocks trade at eight times current earnings and an 11 percent free cash flow yield. International Developed stocks trade at 12 times current earnings, while U.S. quality small caps check in at a multiple of 13. Additionally, for the first time in years, bond yields offer the prospect of positive real returns going forward.
Unfortunately, this roller-coaster year has led many investors to sell amid heightened emotions. Unfortunately, as we’ve seen repeatedly, emotions are the enemy of successful investing. Reflecting this, individual investor sentiment as measured by the American Association of Individual Investor sentiment survey has plumbed new depths.
Through the end of the quarter, there have been no bullish readings that have eclipsed the long-term (1987 through today) average of 37 percent bullish. During the past three months, there have been four readings of 20 percent or below for bullish sentiment, bringing the year-to-date total of 20 percent or below readings to 11. For context, in the 34 years from 1987 through 2021, there were a total of 38 readings below 20 percent.
As our research shows, in 37 of the 38 instances, equities posted positive returns 12 months forward. Pessimism has become so extreme that bearish sentiment eclipsed 60 percent for each of the last two readings of the quarter. Prior to this period, there have been just four other times in the history of the survey when bearish readings have registered greater than 60 percent. Further highlighting just how pessimistic investors have become, in mid-September, the gap between those who were bullish versus bearish hit the highest level since March 5, 2009. Many investors will remember this as the Thursday before the market bottomed on the following Monday during the Great Financial Crisis of 2007-09.
Of course, this doesn’t guarantee markets produce positive returns in the coming 12 months — and the recent failure of other tried-and-true indicators, such as the 50 percent retracement theory (stating that a retracement of 50 percent of prior lows indicates the bottom has been established for that correction), has led to increased discussion that any such market rallies may simply be “bear market rallies” that ultimately fail and lead to new lows.
The key point for long-term investors to consider is that one of these bear market rallies will turn into the next bull market. The questions we encourage you to ask yourself are these: How will you know which rally will lead to new highs? And how long will it take for you to realize a new bull market has arrived? In that context, think about the impacts to your financial security of missing that subsequent rally. We ask that you not fall prey to the financial disruption that can be caused by trying to time the market.
A closing word on emotions
There’s plenty that’s uncertain today: inflation, Fed actions, geopolitical events (including the Russian-Ukraine conflict) and upcoming midterm election. As we’re currently approaching the midterms, we’d like to take a moment to touch on emotions around politics and investing. While it’s understandable to want to connect emotions around politics to investing decisions, data show the reasons that’s not a wise decision.
A review of the past midterm elections shows a pattern worth considering. As the chart in this article shows, equity markets are often rangebound before midterms, when emotions are running high. In the 18 midterm elections since 1950, six-month returns prior to the election have been positive only 56 percent of the time, with an average return of 0.2 percent. Post-election, the outcomes are different as emotions cool. In the six- and 12-month periods following each of the past 18 midterm contests since 1950, the markets have posted positive returns 100 percent of the time, with an average six-month return of 15.2 percent and an average 12-month increase of 17.1 percent. We are not implying that midterm elections guarantee positive returns one year forward, and certainly 18 observations is a small sample size. However, the reality is that to date, there has been a strong correlation.
With emotions around the election running high, it’s also not uncommon to be concerned about the impact the winner may have on your portfolio. Once again, the data suggest that markets are, on average, positive in all combinations of presidential and congressional party outcomes. The reality is that while politics are important, there are other (more) important variables to contemplate.
Go to the ballot box to cast your vote rather than betting your portfolio on any election outcome.
The U.S. economy is large and complex with a natural long-term rate of growth. Politics is important and a variable we consider in our investment decisions; however, it is hard for any administration or party to substantially alter that rate of growth. We acknowledge politicians can influence that natural rate of growth on the margins, but absent extreme events, they are unlikely to have a significant impact on the economy for the better or worse. Rather, our research reveals that one of the most important determinants of market outcome during a politician’s time in office is where the economy is in the business cycle at the time of election. Put differently, politicians who enter office later in a business cycle are more likely to experience a recession and lower market returns during their term, while those who enter office shortly after a pull-back in the economy should see an economic expansion during their tenure.
This is not to say that politicians can’t have an impact on sectors, industries and companies as a result of their agendas. However, even here the results aren’t always clear cut, as external forces and economic shocks can arise. Consider that during the Trump presidency, an administration that was viewed as friendly to oil and gas industry, the energy sector in the S&P 500 posted negative returns. In fact, it was the only sector that produced negative returns during his term in office. Contrast that with the current Biden administration, which has shown less deference to the oil and gas industry — yet energy stocks have been the strongest-performing group in the market. Certainly, there are other issues at play here, such as COVID, the Russian war on Ukraine, inflation and global growth, but these external forces at play underscore our original premise: Politics are just one factor among many that play a role in the economy. As such, it is hard for one party or candidate to have a lasting and significant impact on the markets.
We encourage investors to stay invested during elections. Go to the ballot box to cast your vote rather than betting your portfolio on any election outcome.
The year has been tough on investors, and emotions are fraying. 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, recessions or political uncertainty. Your plan is designed to help you meet your financial goals against any economic backdrop.
Challenging times are also when other pieces of your financial plan — permanent life insurance, annuities and other financial options — 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. 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.
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As the chief investment officer at Northwestern Mutual Wealth Management Company, I guide the investment philosophy for individual retail investors. In my more than 25 years of investment experience, I have navigated investors through booms and busts, from the tech bubble of the late 1990s to the financial crisis of 2008-2009. An innate sense of investigative curiosity coupled with a healthy dose of natural skepticism help guide my ability to maintain a steady hand in the short term while also preserving a focus on long-term investment plans and financial goals.