Economic Outlook

War, Inflation, and Market Turbulence

• Inflation continues at historic highs
• Supply side logjams not yet resolved
• Markets have discounted a lot of bad news
• Fed rate increases anticipated through year-end
• Recession probabilities rising

Written by Philip Rich, Chief Investment Officer

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Real GDP was lower than expected, contracting 1.4% in the first quarter, according to the early estimate. This follows a strong GDP expansion of 6.9% in the fourth quarter of 2021, according to the same Department of Commerce report.  The headline numbers in both of these reports are somewhat misleading, absent some attention to the details. If it weren’t for the very strong inventory build in the fourth quarter of last year, Q1 growth would have been closer to a moderate 2%. In the first quarter of this year, imports and shrinking inventories subtracted a full 4% from GDP growth. Personal Consumption Expenditures (PCE), a key driver of economic activity, actually expanded from 2.5% in the fourth quarter to 2.7% in the first quarter of 2022. Without applying any spin to the numbers, we can conclude that the last quarter of 2021 was not quite as strong as the headline number, and, subsequently, the first quarter of the current year is not as weak.

Business investment, healthcare, housing, and other services all made positive contributions to growth in the first quarter, as did durable and non-durable goods. Business spending expanded 9.2%, reflecting increased outlays for equipment and development. Government spending declined. The US economy is proving quite resilient, but it also continues to be buffeted by supply chain issues, labor shortages, and inflation.

The US consumer continues to provide lift to the US economy, thanks in part to the fact that household savings emerged from the pandemic much stronger than they were prior to its onset. However, sharply increasing prices are now forcing consumers to dip into savings in order to sustain their current pace of spending, a circumstance that cannot continue indefinitely. 

Viewing the past two quarters together, we see a US economy that continues to expand at a moderate pace. However, rising inflation, rising interest rates, and labor and supply shortages are all threats to future growth. Investors and decision-makers should take note that it will be difficult for the Federal Reserve to raise interest rates high enough to stem the current elevated rate of inflation without tipping the US economy into recession. 

  Source: U.S. Bureau of Economic Analysis, fred.stlouisfed.org 

Payrolls rose a solid 431,000 in March–lower than in recent months, but still solid. Participation in the job market increased, and the unemployment rate fell to a new low of 3.6%. Progress on jobs is healthy–jobs are abundant, unemployment is falling, and rising wages are luring idled workers back into the workforce. However, labor conditions also remain very tight, and many employers report difficulties filling open positions with qualified employees. The tight conditions are impacting costs. Hourly earnings were up 5.6% YOY in March, and higher labor costs can prove to be a stubborn component of inflation.  Overall employment is now only 1% below its pre-COVID level. However, that still translates to about 1.6 million jobs.

  Source: U.S. Bureau of Labor Statistics, fred.stlouisfed.org

Resurgent inflation and its many consequences may be the most significant feature in the current economic landscape. It can be found in higher wages, gas prices, and groceries. It is impacting rent as well as building expenses. It is motivating the Federal Reserve to move interest rates higher, a development already priced into significantly higher bond yields and mortgage rates. It is sapping consumers of their purchasing power. Higher prices and higher borrowing costs can eventually quell demand, raising the probability of a recession over the next six to eighteen months. 

The Consumer Price Index was up 1.2% in March alone, the largest increase since 2005. The annual inflation rate was 8.5%. Energy was the main culprit. Gasoline prices rose 18.3% in March, and energy is a component in the cost of most other goods and services. Groceries were up 1.5% for the month.  “Core” inflation (less food and energy) was still up 0.3% in March for an annual rate of 6.5%.

The war in Ukraine is contributing to inflation. Ukraine is an important producer of wheat and many of the key components in fertilizer. Russia is an important exporter of gas and other commodities. For the first time in decades, the possibility exists for the development of food crises in multiple parts of the world.   

Some analysts believe that inflation has now peaked and that price increases will decline from here.  There is reason to believe that some portion of the current high rate of inflation is attributable to factors that may not continue at current levels, such as supply chain logjams. However, many of the factors that have contributed to low prices over the past several decades–globalization, an expanding global workforce, low rates, and low energy costs–are now reversing. So, while inflation may come down quickly from current levels, it could still persist at a rate sufficiently elevated to warrant sustained Fed action. 
  
  Source: U.S. Bureau of Labor Statistics, fred.stlouisfed.org

As expected, the Fed raised its target for short-term interest rates by 0.50% on May 4. The central bank has clearly entered a tightening cycle that will also include reducing its balance sheet by allowing some of its massive bond holdings to mature without replacement and perhaps also an outright selling of bonds. The reduction in its balance sheet would be a strong part of the tightening process–it would be a reversal of the strategy of “quantitative easing” that pumped trillions of dollars into the financial system during the COVID crisis. Quantitative easing involved an unprecedented expansion of the monetary base, a massive increase in the amount of money in the financial system through bond purchases. The selling of bonds could drain a substantial part of that money from the US economy. If quantitative easing helped support the economy through COVID, suppressed interest rates, and propped up the stock market, the anticipation of its reversal is part of what is causing rates to rise and stocks to fall.

The bond market is pricing in the anticipated rate increases. The yield on the 10yr Treasury note has risen from 1.63% at the beginning of this year to just over 2.93% at this writing. The 30-year mortgage has gone from 3.11% one year ago to 5.41% today. A policy program of steadily rising rates will make all debt and all financings more expensive. At some level, higher interest rates should dampen inflation.  They can also slow down economic growth in an economy that is still struggling with the after-effects of a COVID-induced recession. It remains to be seen whether inflation or the economy reacts first. In the past, Fed tightening has been a fairly reliable predictor of recessions. It has also been a key tool for combating inflation. In the present instance, some elements of inflation may not be as responsive to higher rates as they have been in the past. Higher interest rates will not impact supply shortages caused by logistical problems. They will not counter the indirect impact of Russian sanctions on Western economies. They will not, by themselves, loosen a tight labor market. And they will not cure a supply deficit in housing. The price of oil might not be impacted by higher rates unless overall demand is hit by a downturn in the economy. It will be a very tough balancing act by the Fed to control the current rate of inflation without plunging a fragile economy back into recession. That dilemma has been made worse by war in Ukraine and a resurgence of COVID in China.

  Source: Board of Governors of the Federal Reserve System (US), fred.stlouisfed.org

The stock market declined over 9% in the month of April and is now down over 13% year to date. If all security pricing is, at a basic level, an effort to value a future stream of earnings or income, then higher rates will produce lower valuations, all else equal. Lower rates produce a higher present value calculation, and higher rates push present values down. The price-earnings multiple of the S&P 500 is now 20.88, well down from a recent high above 39, but still above its long-term average of 16. Reported corporate earnings have been reasonably strong in the first quarter; 80% of companies have reported earnings above estimates, but the margin has been tight. On average, the earnings have beaten estimates by 3.4%; the five-year average is over 8%. Many CEOs are expressing a cautious outlook, given headwinds from rising costs and supply disruptions.

Bonds, which decline as rates rise, have also come under pressure. Broad bond indexes are down over 8% year-to-date at this writing, so balanced portfolios made up primarily of stocks and bonds are under greater pressure now than at any time in recent memory. It is very unusual for both asset classes to produce negative returns over a full calendar year.  

These are discouraging results for diversified investors; however, a lot of bad news may already be priced into these markets. Stocks have had to digest war in Europe, an ongoing pandemic, extraordinary energy and commodity prices, and a general inability to secure materials, even at elevated prices. The bond market has priced in seven or more rate increases between now and year-end. The two-year treasury is already above what the Fed has indicated is their “neutral rate”–neither stimulative nor constrictive. None of this is to suggest that stocks can’t go lower or rates can’t go higher. If inflation proves to be persistently high, the Fed may have to push rates substantially higher in order to quell demand. If doing so precipitates a recession, negative market conditions will be with us for a while.

So why stay in? It is impossible to accurately forecast something as complex and as dynamic as the global economy. Yet markets are forward-looking, so we cannot know when all the bad news has been priced in. What we do know is that stocks are cheaper than they were at the beginning of the year.  Market timing fails because it assumes we can know in advance the right times to buy and sell securities.  Planning works because it leverages time and discipline to tap into the long-term returns available to diversified portfolios. Longer-term, the odds favor the patient investor. It is part of a natural dynamic that economies and markets expand over time. They just don’t do it in a straight line. Problems get resolved, inventions come online, and new markets are developed. Human innovation does not stand still.

These markets are not easy. If we can be of assistance to you through these times, please reach out to us. Thank you.

  Source: S&P Dow Jones Indices LLC, fred.stlouisfed.org

As always, if we can be of assistance to you in navigating these challenges, please do not hesitate to contact us.