By Dr. Charles Lieberman, Co-founder & Chief Investment Officer
Expectations for a mild recession are seemingly embedded most everywhere, even as the risk of a downturn have been pushed a bit further into the future. A few more Fed rates hikes are highly likely, but it is widely expected that the Fed will soon pause to see whether inflation will revert close to the 2% objective. Even that outcome is hotly debated. Inflation is moderating, but insufficiently to bring the Fed close to its goal. So, some additional rate hikes seem likely in the coming months. With so much disagreement, markets are likely to remain volatile, but valuations are already attractive, so the downside should be limited. Interest rates should rise a bit further, but the worst is behind us on this front, too.
The inverted yield curve is a clear indicator that investors believe a recession is coming soon, but most likely, only a modest downturn. Statements by senior Fed officials, including in the most recent FOMC minutes, were purposefully intended to push back against this scenario. The Fed has tried repeatedly to signal to investors that it intends to raise interest rates a bit further and to keep them at a higher level to squeeze inflation out of the system, with its forecasts revealing that this lengthy process is expected to continue into 2024. Moreover, Fed statements are also intended to convey that reducing inflation is by far the dominant objective of policy for the visible future, even if it results in a recession. The Fed has been exceptionally transparent.
Investors seem to be misinterpreting recent reports on inflation and job growth, including to the more moderate jobs report released on Friday. Investors desperately want to see evidence of “peak” inflation and somewhat weaker growth to build a case that a mild recession is nigh or already underway to justify forecasts of lower interest rates. We agree that inflation has peaked. But its composition suggests that inflation is far from vanquished. Goods inflation, which was highly susceptible to supply disruptions and the surge in demand due to the Covid lockdown, is declining quickly. In fact, many goods prices are now falling. But just as the surge wasn’t sustainable, neither is the current decline. But as some goods prices go negative, they will push down inflation below its underlying trend. Moreover, service inflation is moderating rather little. And that shouldn’t really be surprising since service inflation is dominated by the cost of labor and the U.S. labor market remains very tight. Until the labor market loosens, there is little reason to expect wage inflation to moderate much, if at all.
The pace of job growth is the other measure that is misunderstood. The slowdown in hiring is taken as part of the swing from extremely rapid growth in employment to outright job losses and a harbinger of more moderate wage inflation. Indeed, Friday’s lower level of new hires was widely taken as an indication that the economy is downshifting to a noninflationary pace. This conclusion is premature. More likely, the slower pace of hiring reflects the low level of unemployed available to be hired. The unemployment rate is a mere 3.5% and only 5.7 million people are now unemployed. It becomes ever harder to hire as the number of unemployed declines. Because of the zero bound, we would have expected a slower pace of job growth even if the Fed hadn’t raised interest rates at all. Very simply, we are running out of unemployed people to hire. As firms try to employ more workers, despite the shrunken pool of unemployed, they maintain upward pressure on wage rates. And firms are still trying to bring on more workers, as is clear from the number of job openings that still exceed 10 million. The Fed understands this and has stated that hiring must slow to a more sustainable pace, i.e., something less than the growth of the labor force. But the trend in U.S. labor force growth is as little as 50,000 per month and as much as 75,000, so well below the prevailing pace of actual job growth, which is still running above 200,000 monthly.
In our judgment, the risk of a near term recession is fading fast for many reasons. The housing market has been extremely weak, which isn’t a surprise since it is the sector most responsive to changing interest rates. However, housing activity is likely to stabilize quite soon after declining so sharply in 2022. Another large decline in 2023 is unlikely, so housing will not provide much drag to the broader economy in 2023. Energy prices have already retreated recently, which is part of the outright decline in goods prices mentioned above. With inflation moderating, real household income is rebounding, which will translate into stronger consumer spending. Onshoring of manufacturing will promote more domestic investment, another tailwind to growth. Passage of the $1.7 trillion government budget will also add to demand. (Don’t be surprised if some supplemental spending is approved to provide more defense equipment and munitions to Ukraine.) Two large, key economic sectors are reviving, autos and aircraft. As chip supplies improve, auto assemblies are picking up and so are Boeing aircraft deliveries. With the sudden end to China’s Covid Zero policy, a reopening of China’s economy should become visible over the course of the next several weeks. Putting all this together suggests that the near-term risk of a recession is fading.
A legitimate debate already exists over whether the Fed has already done enough to contain inflation. By itself, this may be sufficient to induce policymakers to soon stop raising rates to give some time for incoming data to settle the conflicting views. Those at the Fed who want to slow down rate hikes will use Friday’s jobs report to justify their view. But the unemployment rate hit a cycle low and job growth remains unsustainably rapid. So, there are likely only a few Fed officials who fall in that camp. Others at the Fed may be more disturbed by the sharp rally in stock and bond prices relaxing credit market conditions and worry that the market’s reaction is premature and will counterproductively act to prevent the Fed from reaching its goal of inflation moderation.
So, it is our judgment that another 50 basis points remains more likely at the next meeting and possibly 25 at the following meeting before we expect the Fed to pause. Over time, the data will tell the Fed (and us) whether more rate hikes are needed. The Fed’s actual policy behavior will reflect the performance of the economy regardless of its current expectations. The Fed’s forecasts are just that, forecasts. The same idea applies to the markets, which must also forecast. Both will respond to incoming data. Given the underlying trends in the components of inflation and hiring trends, we think the Fed may return with some additional rate increases later in the year. That current, preliminary judgment will evolve along with incoming data.
The sizable decline in stock and bond prices in 2022 has established a lower, safer base for investment. If there is no recession in the near term, corporate profits may well surprise to the upside, at least for the first half of the year. But there are already so many stocks that trade at single digit price-to-earnings multiples that current valuations are already attractive. It is impossible to call the bottom of this stock slide, but valuations are so undemanding, we think investors should be putting money into equities. As investors, share purchases should work out well within a year or two. And as we saw on Friday, any hint that we might be close to the end of the rate hike cycle is sufficient to send markets sharply higher.
Bonds are a little trickier, since we don’t think rates have peaked, as yet. But the huge increase in interest rates seen in 2022 is highly unlikely to be repeated in 2023. Coupons are now considerably higher, too. And with the yield curve somewhat inverted, short maturities provide a nice safe haven even if the Fed has to tighten policy more later in 2023.
Geopolitical events could be wild cards this year, although they are an unknown risk every year, as Russia’s invasion of Ukraine demonstrated early in 2022. Iran’s nuclear ambitions are another wild card, as are the demonstrations within Iran that could yet topple that government. China could surprise everyone with some action against Taiwan, although we think this is fairly unlikely. Kim in North Korea is another wild card. And those are just some of the more obvious known unknowns. The list of potential surprises is truly almost endless. So, we will have plenty to monitor, as usual.
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