Talk about conflicting signals! This week the Federal Reserve (Fed) raised its benchmark interest rate by the second consecutive aggressive amount of 0.75%, to a range of 2.25% – 2.5%. Their statement indicates they are committed to doing so to fight stubborn inflation by cooling demand for goods and services.
Just a day later the first look at the second quarter Gross Domestic Product (GDP) came in … at a negative 0.9%, indicating an economy already in slowdown mode. Following a similar down reading of -1.6% for the first quarter, analysts are noting that two-quarters of negative GDP typically signals an economic recession is underway. Hardly the textbook time for a central bank to be aggressively raising rates to slow down an economy! What in the world is going on?
In a word (or three) – very unusual circumstances. The onset of the Covid-19 pandemic in early 2020 upended the workings of traditional economic and interest rate cycles. From a healthy position, global businesses and society came to a screeching, self-inflicted halt as the pandemic spread. Governments then enacted extraordinary stimulus and support measures, generating record amounts of debt on their balance sheets, while bolstering the balance sheets of many citizens through cash and other support means.
Now, as the worst effects of the pandemic wane and some normalcy returns, the lingering distortions mean that a traditional cycle is just not in the cards. James Pierson recently called this a “Full-Employment Recession” in a Wall Street opinion piece. We are not in Kansas anymore Toto.
Consider just a few of the seemingly contradictory data points:
- Inflation has been driven by a near-perfect storm of post-Covid recovering demand met by supply shortages and logistical jams along with excess consumer savings (some $2.5 trillion) from government stimulus, all turbocharged by Russia’s war on Ukraine and the shock to already tight energy markets.
- Unemployment remains at an exceptionally low level of 3.6%. Companies large and small report difficulties in filling openings.
- June’s durable goods orders jumped 1.9%, far above estimates, indicating buyers of long-lasting items are still strong, and June consumer spending increased a healthy 1.1% in June.
- Exports from the U.S. are rising at an annual rate of 18% as the world reopens.
- Yet consumer confidence in the U.S. and around the world is falling as higher prices and global instability drag down sentiment. Indeed, the IMF just lowered its projections for world growth in 2022 to 3.2% and 2.9% in 2023.
- Demand is also shifting. During the pandemic it was all about goods – hunker down and order in – while now the advent of “revenge travel” and reopening economies is leading to strong services needs. Many retailers are now stuck with excess inventory due to the changing demand. The slowdown in inventory subtracted nearly 2% from GDP in the second quarter.
- In the U.S., pending home sales have dropped 20% year-over-year as higher mortgage rates have put affordability out of reach for many.
- Skyrocketing gasoline prices are beginning to slow driving demand, and shortages of natural gas loom large in Europe as a result of the Ukraine war with fall and winter just months away.
- M2, the broad measure of money supply, has plummeted following a Covid spike. This indicates a shrinking pool of disposable income. Historically inflation and M2 track closely, meaning we may already have seen the worst of inflation.
So where does this leave us?
In a unique place where contradiction is the reality. What seems likely is that many of the items noted above have already initiated a self-correcting slowdown. The risk now is a Fed that overshoots and keeps raising rates beyond a level necessary to just cool inflation, to the point where the U.S. plunges into a deep recession. It is well documented that there is a lag between Fed policy implementation and the actual policy impact, and most leading indicators point to slowing growth and inflation already underway. Part of the Fed’s job is to “talk tough” when needed, and they are certainly doing so today. Let’s hope they read the tea leaves correctly and timely and ease off as appropriate. The futures markets believe they will – in fact following this week’s meeting futures now point to interest rate cuts as early as year-end. Pandemic impacts certainly remain, both economically and societally, but we are both learning to live with Covid as well as seeing traditional economic and market relationships begin to normalize.
From a portfolio perspective, as we have noted before, this year has been one of the rare times stocks and bonds have moved in close relationship – both falling hard. Bonds have since reversed course, but stocks remain under pressure. But the silver lining for both bonds and stocks is that core high-quality bonds now offer yields of 3% – 4%, making them an attractive part of balanced portfolios. And stocks are now near long-term average valuations, suggesting better future returns. In other words, the near-term pain has washed out many excesses, returned interest rates to a more historic level, and set the stage for better days ahead.
JFS portfolios, while unique to each client, have in general benefited relative to benchmarks by focusing on value-oriented equities, maintaining a global allocation, and keeping bonds of high quality and intermediate duration. In other words, in a difficult market, the portfolios have done their job – minimizing the downside and preserving capital to stay at work for your benefit. If you have questions, reach out to your JFS advisor. We work every day to take the complexity out of investing so that you can focus on things that matter most to you and your family.