Committed
Fed Chair Powell made crystal clear with his Jackson Hole speech and the Fed’s latest policy statement that the Fed is fully committed to squeezing inflation back towards 2%, even if it requires a recession. Notably, all of the Fed’s doves are on board. So, a mild recession is now likely in 2023. Investors are belatedly catching up. Stocks have already sold off quite sharply, close to the average decline seen in past recessions. Bonds are down about as much as stocks. If the recession is mild, as we suspect, the bottom for this cycle may not be too far off, even if the markets remain volatile.
Readers are well aware that we have been critical of the Fed’s unwillingness to recognize the surge in inflation as highly worrisome and that they incorrectly mischaracterized it as “transitory”. No more. Returning inflation to the Fed’s 2% goal is now the entire focal point of policy. They now clearly get it. Powell has publicly expressed a tolerance for a recession, if that’s what it will take to bring inflation back to the Fed’s policy objective. In fact, the Fed’s economic projections imply a recession in 2023 with rising unemployment. Even so, the Fed’s projections remain somewhat optimistic.
The Fed is now forecasting that unemployment will rise to 4.4% in both 2023 and 2024 and that inflation will slow to 2.8% in 2023 and 2.3% in 2024. These forecasts are more realistic than the prior set released three months ago, but it is highly doubtful that such a moderate rise in unemployment will be sufficient to reduce inflation as much as expected. Job growth will slow, if only because the nation is fast running out of unemployed people to hire. But with more than 11 million job openings, it is doubtful that wage inflation will slow quickly. Firms are still scrambling to hire. According to the Federal Reserve Bank of Atlanta, those paid hourly who quit their jobs to switch to another earned a median pay increase of 8.4% for the three months ending August. It may simply take more time for tighter monetary policy in the form of higher interest rates to restrain employment and to curtail inflation.
There are several reasons to think the looming recession will be mild. First, while housing is currently quite weak, which is hardly surprising since it is the sector most sensitive to interest rates, it also suffers from an exceptional shortage of housing units. As soon as rates begin to anticipate that inflation is coming down, long-term rates may start to decline, reducing mortgage rates, which would open the door to a housing rebound. Unlike the last two recessions, which were extraordinary, this one is the result of Fed rate hikes to contain inflation, a classic recession followed by a classic rebound.
Second, this expansion was badly harmed by rising energy costs, at least partially due to the Russian invasion of Ukraine. The rise in energy prices cut sharply into household spending power. While there is no resolution in sight yet for this conflict, when the situation resolves, Russian energy supplies will come back to the market. In the meantime, the likelihood of a recession and the rundown of our Strategic Petroleum Reserve has caused prices to recede, which will limit the damage to household spending, especially since job growth is still solid and wages are still rising.
Third, China will come out of lockdown at some point, improving supply chains and restoring a meaningful source of demand. That will also happen in Europe when the Russian invasion of Ukraine is resolved. Europe will need a Marshall Plan for rebuilding Ukraine. Perhaps most importantly of all, the U.S. economy lacks the severe imbalances that caused the last two major downturns. Banks have bulked up on capital, credit quality is very good, and most everyone had locked up cheap financing when rates were ridiculously low. While a recession is very likely because the Fed needs one to reduce inflation pressures, a deep one seems unlikely.
In a very long article in the weekend Wall Street Journal, former Fed Vice Chair Alan Blinder makes a case that a soft landing is quite plausible, even likely. We don’t share that view. In order to increase unemployment to constrain wage inflation, actual growth must decline below the natural growth rate of the economy, which is itself quite low, around 1.5% to 1.75%. A decline in growth to 1.0% would result in only a small steady rise in unemployment and that would take some time to rein in wage inflation. That’s not impossible, but akin to landing a plane on an aircraft carrier during a storm. Though feasible, the Fed simply lacks the precision with monetary policy to fine tune the outcome, even if that is its wish. Raising interest rates with long and variable lags is simply too blunt an instrument for such precision.
Markets are, however, increasingly prepared for a recession. The average decline in stocks during a recession is about 20% and we’re already there. Earnings estimates haven’t receded much as of yet, but if we use a bearish number like $200 for the S&P 500 for 2023, the market is now trading at 18.5 times depressed profits. It has traded at much higher multiples at the trough of prior recessions. If the recession is mild, one could arguably suggest we are close to the cycle lows. Of course, forecasting such an outcome is also difficult and we lack the ability to see the future so precisely. Still, with so many good values in the stock market, it is our judgment that it is way too late to sell, even if it might be a little early to buy. But since we can’t anticipate the bottom, and we don’t want to miss out on the excellent values, we’d rather be early than late. Either way, markets are likely to be volatile for a while.
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