Bottom Line Up Front
The combination of a historically accommodative Federal Reserve and a Federal Government with an incredible fiscal impulse has resulted in an economy that has proven immensely difficult to slow. At the beginning of this hiking cycle, few people – if any – thought the Federal Reserve would be able to push through 475 basis points of tightening in under a year and see little to no progress on slowing the economy. While we likely have not seen the full impact of tightening to date it’s becoming apparent that consumers used pandemic dislocations in policy to build up savings and become less interest rate sensitive while companies are clearly reticent to lay off employees that they could barely hire in the first place.
It’s important to remember that as recently as January 2022 – in an economy with 7.5% inflation – the Federal Funds rate was at 0% and the Federal Reserve was pumping $60 billion in liquidity into the economy every month. That could prove difficult for the Federal Reserve’s mandate as we proceed through the year, especially as the more challenging aspect of disinflation is still ahead of us. Getting inflation from 9% to 5% is a much easier task than from 5% to 2% – particularly when so much of the drop to date can be explained by a collapse in used car and energy prices.
Since the onset of this inflationary episode economist forecasts have always been for a quick and consistent path down to 2%. Inflation, however, is a psychological and largely unpredictable phenomenon that has defied most expectations up to this point. While we think it is unlikely that inflation ends 2023 at the 6.5% level it started with, we also believe there’s slim chance to see the glide path to 2% inflation markets expected at the start of the year.
Inflation has very likely peaked. We also think the Federal Reserve likely goes on Pause within 2 meetings and do not expect a Pivot in 2023. That said, there is still significant uncertainty around the ultimate direction of economies and markets and we anticipate volatility as market participants tangle between pricing in a soft, hard, or no landing scenario. We still think the most likely result is a mild U.S. recession in the back half of 2023 as households burn off their excess savings cushion progressively through the year.
Markets, the Banking System, and the Federal Reserve
Contrary to expectations at the tail end of 2022, the Federal Reserve continues to be the main driving force for market performance though the conversation has shifted from “How High?” to “How Long?” in regards to monetary policy. Having hit 5% for the target range after the March meeting, the Federal Reserve is likely within 50 basis points of finishing pausing its tightening cycle. We view this as broadly positive as it is one less aspect of uncertainty in what is still a very difficult environment to forecast.
The March turmoil in the banking sector adds some uncertainty to the outlook but we note that – at this juncture – events in the regional banking space appear to be unique to their depositor base, business model, or capital structure while the events of 2008 were the result of widespread fraud. We do not currently see signs of something systemic or structural in the banking system and note that all of the banking failures so far have been due to reasons specific to their individual bank combined with the ubiquity of mobile devices in hands of bank customers compared to past crises of confidence. In 2017 just 15% of households reported Mobile Banking as their primary method of bank account access – by 2021 the share of households primarily banking with their smartphone had nearly tripled. Smartphones have changed the banking industry just as they have reshaped how consumers shop – no one had to wait in line in order to withdraw cash from the bank. This wasn’t your grandfather’s bank run and the regulatory framework will need to be adjusted for that going forward.
Currently, expectations are for the first quarter to be the lowest point of the year in terms of earnings growth for the S&P 500 at a 7% decline with markets returning to profit growth in the back half of this year, boosted by the impact of a weaker dollar compared to 2022 when the Bloomberg Dollar Index hit its highest level since 2002. We ultimately see downside to earnings expectations this year – particularly if a material slowdown were to occur in the back half of the year. Earnings revisions so far have been pretty substantial but have largely been contained to the first 2 quarters of the year.
While at this juncture we do believe that the banking sector turmoil is more idiosyncratic than systemic we do broadly see risk in equities and we think patience will be of great virtue for investors in 2023. Half of the S&P 500’s returns in the first quarter were driven by just 3 companies while interest rates remain elevated, growth appears to be shifting more towards a slowdown, and the market is back to forecasting significant reductions to the Federal Funds Rate – now expecting cuts at every meeting between June and January. This outcome is highly unlikely to happen in our view as the Federal Reserve has never cut interest rates with inflation rates as high as they are today without a recession. A cut in the Federal Funds rate would signify a serious deterioration in the broader economy and imply significant risk for corporate profits, in our view.
For over a decade, global interest rates being at or near zero meant investing had been dominated by the mantra “There Is No Alternative” (TINA). With interest rates near 2006-2007 highs that theme is decisively different today. After 15 years of low interest rates, “Bonds Are Back Y’all” (BABY) and we broadly think fixed income now offers a meaningful alternative for investors. The yields offered by fixed income across the curve are a challenge for equities that are still commanding high multiples historically with a questionable earnings outlook and a backdrop of inflation that remains much too high for the Federal Reserve.
From a growth perspective, the economy continues to show strength but is beginning to display signs of moderation. After an exceptionally robust start to the year, data has started to become more mixed. Jobs numbers and overall economic growth have remained relatively strong compared to pre-pandemic levels but we have started to see the early signs of cracks in the form of increased layoff announcements, upticks in jobless claims, as well as slight softness in retail sales and other consumer spending. Bank of America has found that spending across its network of cards has moderated in recent months while Visa’s Spending Momentum Index also shows a slowdown.
The labor market, however, remains extremely tight and job additions continue to be substantially outside of 2019’s monthly average. Employment levels are at record highs, the U.S. unemployment rate is at 3.5%, and prime age labor force participation has recovered to the levels we saw pre-lockdown. We are beginning to see some cooling in the labor market but it is important to point out that the current softening is from substantially elevated levels. While the ratio of open positions to unemployed workers has moderated substantially from the highs of March last year, the US economy would need to shed nearly 2.8 million job openings just to get back to the average ratio of openings to unemployed workers we saw in 2019 – a level that was generally considered hot.
Layoff announcements have been pronounced of late, but we note that much of them are confined to technology and more representative of the massive expansion in headcount and focus on “growth at any cost” over the pandemic. For context, Amazon’s announcement of 27,000 layoffs represents just 3.3% of the 810,000 employees the company added between 2019 and 2021 – a period where the company more than doubled its headcount.
In total, the approximately 223,000 tech layoffs since the start of 2022 as tracked by Crunchbase is still below even the smallest number of monthly payroll additions over that same period. Even if every single layoff was announced and acted upon in the same month the U.S. economy would not have seen a single negative payrolls number. It’s a bad time to be a participant is San Francisco’s economy but much of the rest of the country remains strong.
Today’s consumer also appears less sensitive to interest rates than they have been in past cycles as many used pandemic-era fiscal and monetary regimes to reduce debt and strengthen balance sheets. Today, more than half of existing mortgages were originated in 2020 or later, 85% of which have a rate under 5%. The result is mortgage servicing costs as a share of disposable income are nearly half of what they were at their peak in 2007 and a housing market with a historically limited supply of existing homes available for sale.
A strong labor market and a historically strong consumer certainly makes the Federal Reserve’s job harder, but it lends credence to the idea that a recession – were one to materialize – would be mild in nature. Consumer balance sheets remain strong, debt servicing costs as a share of income are low and wage growth is elevated – particularly for those in the bottom quartile income bracket.
Outlook for Inflation
While robust consumer balance sheets are a positive from the perspective of consumer spending and economic growth, it is a substantial challenge for a Federal Reserve that is very clearly trying to engineer a slowdown. Nobody told the U.S. consumer “Don’t Fight the Fed” and consumers are still fairly flush with savings to a point that 475 basis points of tightening has done little to curtail spending or job additions thus far.
Ultimately, we do think inflation has convincingly peaked and we expect to see a rapid decline in year over year prints through June – largely the result of base effects from the supercharged inflationary period in the wake of Russia’s invasion of Ukraine when gasoline prices peaked at $5.01 nationally.
After June, we likely begin to see a deceleration in housing costs as the broader market catches up to private indicators of rent growth. CPI shelter costs have lagged private market indicators by approximately 12-18 months over the course of this episode, and new rent growth is now below the rate seen by all tenants according the Cleveland Federal Reserve. Estimates from the Federal Reserve Bank of Boston put shelter costs rising 5.9% year-over-year in September compared to the 7.9% rate we saw in January.
That said, there is a significant difference between peaking inflation and acceptable inflation, particularly from the point of view of the Federal Reserve. Supply chains can only heal once and the last several months of weak inflation have largely been explained by just a few categories and the Fed has seen limited progress on unemployment and “Core Services excluding Housing”. This is the Federal Reserve’s preferred indicator and is much more correlated to the health of the labor market and other areas that are less sensitive to interest rates.
While the combination of Fed action and supply chain recovery has made substantial progress on the price of goods, there is risk that a lift in market sentiment alongside Europe likely avoiding a recession and a reopening China could lead to situation where goods prices reaccelerate on top of a services segment that is still at worrying levels. As an example, Manheim data shows that used car prices have increased 3 months in a row and the CarGurus used vehicle index has returned to price growth. Combined with the recent OPEC+ cuts and a China recovery that may see record crude demand, there is a chance that there may be significant challenge to the disinflation narrative and we expect the path of inflation to remain volatile.
The fundamental problem in markets is that the economy is too strong and that is a substantial change from past periods of volatility. While we are hesitant to make a call on the ultimate direction of the U.S. economy in 2023 based on three months of highly volatile data, growth in the first part of the year has been strong. Looking forward, early data since the collapse of Silicon Valley Bank has shown muted impact on the broader economy or households. The Federal Reserve’s balance sheet has resumed its downward trend and banks have reduced their borrowings from two Federal Reserve backstop lending facilities for fourth straight weeks as liquidity constraints continue to ease. Time will tell when it comes to Silicon Valley’s impact on credit creation, but so far the aftermath has not matched the worry – the banking system resumed deposit growth in early April, and consumer sentiment has rebounded along with inflation expectations in what is a worry for the Fed.
We have seen some progress on inflation with the early signs of peaking shelter inflation but that comes alongside a worrying rise in pricing for oil, gasoline, and used cars and trucks. This could prove challenging for markets when the bond market is priced for cuts to the Fed Funds rate by July and the equity market continues to see a robust back half of the year for profits. It’s difficult for us to envision both outcomes happening and we think near term risks lean more towards interest rates going higher instead of lower given the robustness of the labor market. At the end of the day, the Federal Reserve likely does have to go higher for longer than markets expected at the start of the year, but the end result is that after 15 years investors finally have an interest rate – patience finally pays.
For our clients with Strategic Asset Management (SAM) accounts where we manage with full discretion. Depending on your individual situation, objectives and type of accounts, we may lean towards building slightly higher fixed income positions to take advantage to the current interest rate environment. Cash will be deployed as we evaluate both volatility and values in line with our current outlook. This will give us an opportunity to mitigate volatility and take advantage of opportunities around our generally positive outlook for the second half of the year.
For our clients who hold brokerage accounts, if you are interested in a similar fee-based strategy, please contact your advisor.
If you are not yet a client and are interested in learning more about our services, please contact our team at (833) 302-0520 to schedule an appointment.