• Current inflation is at levels not seen in almost two generations.
• The Fed will continue raising rates and tightening until it hurts … a recession will not deter their efforts.
• The Fed is determined to prevent the onset of an inflationary mindset among consumers.
• Weakening employment numbers, which are still too strong, are key to how far the Fed will go.
According to conventional wisdom, the U.S. economy is in a recession, having clocked two consecutive quarters of negative real GDP since the end of 2021. However, the ultimate arbiter of recessions and depressions — the National Bureau of Economic Research — has yet to make a call. There’s always a considerable time lag between the onset of a recession and the NBER’s declaration of one: reports on current conditions are always after the fact. And, in order to maintain credibility as the official arbiter of economic recessions, the NBER takes great care in its deliberations to avoid having to walk back hastily determined declarations. Sometime before the end of 2022, the NBER will likely make a recession announcement. Whenever and whatever their determination may be, we must confess that the last three months have not felt very recessionary. The two negative quarters of real GDP growth in the first half of the year (the third quarter GDP numbers won’t be available until November) have looked more like rounding errors than cliff drops. While it’s true that the stock market is down 20.5% since the end of 2021— technically a bear market — corporate earnings expectations have been notably upbeat: pre-announcements of weakness in third quarter earnings have been minimal and most indicators suggest a reasonable earnings reporting season for the current (third) quarter. And it’s hard to make an argument for a recession when the job market is as strong as it is: jobs are easy to find, unemployment is at a 3.7% rate, initial and continuing jobless claims are low, and hourly earnings increases remain high. If it weren’t for inflation, the good news might keep on coming and a positive path for the economy would be clear. But alas, such is not the case.
By every available measure, inflation is unacceptably high and at levels not seen in almost two generations. The causes behind this state of affairs are well known. For the most part, the current inflation springs from one global calamity: the Covid-19 pandemic. The international reaction to this disease — quarantines and lockdowns combined with massive stimulus checks for companies and out-of-work employees — effectively shut down the supply of goods and services while at the same time increasing the dollar demand for those same goods and services. The Russian invasion of Ukraine and the subsequent elimination of practically all exports of Russian oil and gas to the West only added to inflationary pressures. Given this combination of demand stimulus and supply contraction, it’s not difficult to understand the current 8.3% rate of inflation. In response, the Chairman of the Federal Reserve (Jerome Powell), believing that 1980s inflation requires a 1980s solution, has channeled his inner Paul Volcker and vowed to raise interest rates to whatever level necessary to bring inflation down to an acceptable level (generally regarded as 2%). And he’s been explicit about his willingness to plunge the economy into a recession in order to accomplish this goal. The Fed’s twin goals of full employment and price stability have been reduced to the single goal of price stability. As a consequence, even though the present may not feel particularly recessionary, the future looks decidedly more so.
We believe a recession (broadly defined as a significant, widespread, and prolonged downturn in economic activity) is likely to be declared before the end of the year. We would not be surprised if the NBER backdates the beginning of the recession to the first quarter of 2022. Like many prior recessions, this one is largely artificial and self-inflicted: the Federal Reserve is imposing its regimen of higher interest rates to slow the economy and discourage inflationary impulses. The primary goal is to prevent the occurrence of an inflationary mindset among consumers — a mentality that favors current purchases at high prices over future purchases at still higher prices and thereby feeding an inflationary spiral. Since job losses tend to focus consumers’ pocketbooks toward savings rather than consumption, the statistics on unemployment may well provide the key indicator as to how far the Fed needs to go in order to discourage this mentality. At this point, the employment numbers indicate that it may take some time to remove inflationary impulses from consumer discretionary spending: as of August, the Unemployment Rate was at a low 3.7%, Payroll Employment was still increasing, Average Hourly Earnings was still rising and, over the last six months, the economy had added an average of 380,000 new jobs per month (according to many economists, this is 330,000 more jobs per month than needed to keep unemployment from increasing).
We’ve mentioned before that the Fed’s record on fine-tuning the economy has not been good and true soft landings have been rare, if non-existent. Officials from the Fed suggest that they expect the Fed Funds rate, now at a range of 3% to 3.25%, to increase to between 4% to 4.5% by the end of 2022 and achieve a neutral rate of 4.6% sometime in 2023 (the neutral rate being the theoretical rate that maintains the economy at full employment while keeping inflation constant). These same officials also anticipate that the unemployment rate will rise to 4.4% in 2023. This scenario, essentially a soft landing, sounds optimistic to us. Other observers, perhaps less motivated by political considerations, argue that the Fed will have difficulty keeping the funds rate below 5% in 2023. We’ll have to wait and see. As a cautionary history, the last time CPI inflation rose to 8.2% (in September of 1978) from lower levels, Fed Funds were at 8.45% on the way to 19% (in July of 1981) and the unemployment rate was close to bottoming at 5.6% before climbing to a peak of 10.8% (in November of 1982). That was a different time — during the preceding ten years, inflation had become entrenched, rising and falling through three cycles with each cycle ratcheting upwards to ever higher rates — and we’re not suggesting that history will repeat itself. But it does provide some context to the putative soft landing suggested by Fed Chairman Powell.
The current instability of the economy — high inflation, an aggressive Fed, an impending recession — suggests a “risk off” stance for most investors. A bear market in stocks has been in place since the first of the year and, despite several hopeful, but ultimately futile rallies, seems likely to continue for a while longer. We should note that since 1929, the average bear market has lasted about a year and lost 37% of its value (the longest lasted two and a half years and lost about 50% of value); the current bear has been in place for about nine months and has lost 25%. In the fixed income markets, yields have increased (2yr. US Treasuries (USTs) at 4.28%, 5yr. USTs at 4.09%, 10yr. USTs at 3.83%) owing to inflation and the activities of the Fed, but are still negative in real terms (after inflation). When should investors assume a “risk on” stance and trade away from high yield stocks, short-term treasuries, cash, and other assets that have held up relatively well over the last nine months and trade towards growth stocks, longer-dated treasuries and just-barely-investment grade bonds that have suffered the most during this same period? Unfortunately, there are no credible soothsayers or bell ringers on Wall Street.
We are confident that the current miseries will end and that better investment times will return, once inflation peaks and disinflation emerges. However, that seems increasingly unlikely without a Fed-induced recession. It also seems unlikely that the Fed will accept a recession as “useful” without a notable worsening of the employment numbers. So far, that’s not happening. The Fed needs to see the job market worsening to the point that it alters consumer habits. Once this occurs, we should expect to see inflation falling and the beginning of the end of Fed tightening. And that might be the time to consider “risk on” investing. For now, investors should remain patient and remember their long-term investment objectives.
Not Investment Advice or an Offer
This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing. Argent Financial Group is the parent company of Argent Trust, Heritage Trust and AmeriTrust.