Since last March, the Fed has raised rates more aggressively than at any point in the past forty years. The latest economic data shows that the economy is slowing materially without causing rising unemployment—an impressive feat and begging the question, has the Fed done enough?
Financial markets think we are near peak rates and expect rates to fall in late spring—and if all goes right, perhaps the Fed can achieve a “soft landing” whereby inflation continues to fall without a big rise in unemployment. In contrast, the Fed says that it thinks rates need to stay higher for longer, creating a disconnect with markets.
Who is right? Will rates start to fall by summer? And can the economy really achieve a soft landing? Those are the big questions for financial markets as we enter the new year. The answers aren’t as simple as financial headlines might have you believe.
Economic reports in November and December brought encouraging news, and financial markets rebounded with an optimistic “yes!” to those questions. After such an aggressive increase in rates, it’s clear that higher rates are having an impact.
Headline inflation peaked at over 9% in June and is now 6.5%. While companies are still hiring, the labor market is cooling, with important indicators like wage growth slowing to 4.6%. Broader economic activity is slowing, too, with sectors like housing, construction, and transportation arguably touching recession already. Banks have also tightened their lending conditions significantly, showing caution about the future.
In relief, the S&P 500 stock index is up about 10% off its October lows, and bond prices have rebounded as well (driving yields lower as prices rise). Investors are encouraged that the Fed should be able to slow the pace of rate increases (we agree) and even perhaps begin to LOWER rates starting late spring or summer as the economy slows further (we are more skeptical that they can).
A Clear Disconnect
There’s a clear disconnect between expectations of financial markets and the Fed’s public guidance. The Fed keeps saying that they do not expect to lower rates this year. Why? In short, as we articulate it, inflation risk is still embedded in the economic system.
The risk of inflation still lingers when you consider three things:
- Prices are still rising faster than what people earn. Consider services inflation (services drive a major part of our economy) which is around 7% (closer to 6% excluding rents and housing) vs. wage inflation of 4.6%. The difference between the two is falling but it has not closed yet. When prices are rising faster than earning power, inflation usually persists.
- The real fed funds rate is still negative. “Real rates” are adjusted for inflation, so if CPI is 6.5% and the fed funds rate is 4.3%, the rate net of inflation’s impact is -2.2%. That means price inflation is still imbedded in economic activity. There’s little incentive to save because your dollar won’t keep up with future price increases. Historically, the Fed has not stopped raising rates while real rates are negative.
- Financial conditions are actually easing. A rising stock and bond market, combined with positive hiring trends, among other factors, are generally supportive of economic activity, which works against the Fed’s policy to slow the economy.
For these reasons, we think the Fed will have to convince the public that it is committed to “higher rates for longer” than current financial markets hope. In a sense, the IMPRESSION of commitment is more important than a change in policy itself. Markets must believe the Fed is committed to taming inflation for the policy to work. If the Fed stops too early, the risk that inflation surges again (a lesson during the 1970s) is significant, in our view.
Overshooting the Goal
History teaches us that the Fed usually overshoots—i.e., it raises rates higher than necessary in hindsight and drives the economy into recession. We wrote about this here. The key reason for this outcome is due to the lag effect of higher rates. It takes time for higher rates to pass deeply into economic activity. Stopping too soon risks not solving the problem of inflation.
As we saw last summer, financial markets began pricing in a higher probability of recession this year. The yield curve of bond markets continues to invert, and other leading economic indicators have been slowing since last spring. These have been good indicators of recession historically, occurring generally within a year.
Our research shows that in periods when rates and inflation are low but start to rise, stocks and bonds tend to do poorly. Stocks broadly don’t become more attractive until the Fed stops raising rates, in our view. Accordingly, over 12 months ago, we started adding more defensive allocations to equity exposure in client portfolios, where appropriate.
Our own market outlook continues to be:
- Mild recession most likely late this year or early next. A soft landing means to us that the Fed quit too early, unfortunately.
- Core inflation will moderate to around 3.5% to 4.5% by year end. This is well above the Fed’s target rate of 2%, but we do not think the Fed has to hit that target for initial success.
- Unemployment will be around 5% late this year. The participation rate is a key variable here. Participation in the labor market remains below pre-pandemic levels for a host of reasons, which is helping to make the unemployment rate appear as low as it is.
The bottom line to us as we begin the new year is that higher rates are beginning to take effect, but we are not out of the woods yet. During 2022, we de-risked equity allocations as appropriate and continue to expect financial markets to remain volatile, which we will look to exploit opportunistically.