Another Fed meeting came and went with little to be surprised about, at least for readers of our commentary. The Fed has been crystal clear on their intention to get inflation under control. They continue to emphasize that this requires a rise in unemployment and a decline in wages. The labor market is too strong (backward looking) for inflation to get back to their stated goal of 2%. While inflation has clearly peaked, they are not letting a few months’ worth of data halt their interest rate increases. Higher for longer is a near unanimous consensus by voting Fed members. For now, there is not even a hint at slowing until inflation ratchets down to their 2% target, at least that is the main talking point today. The Fed may feel differently next year if GDP is negative and unemployment rises too quickly.
What was different? The proverbial dot plots hinted at a terminal rate of 5.1%, with a view that at least two more 25 basis point rate hikes are necessary to get the job done. This was fractionally higher than some economists’ models. The Fed’s Summary of Economic Projections (SEP) also raised 2023’s Core PCE inflation level to 3.5% from 3.1% and the Unemployment Rate to 4.6% from 4.4%. A rise in unemployment of this magnitude (from 3.5% in July to 4.6% next year) has always led to a recession. I repeat, there are zero instances where unemployment rose by that much without causing a recession. However, the SEP also predicted positive GDP for 2023 and inflation being higher than what was expected last meeting. This does not compute, which is par for the course for Fed prognostications.
Here are the last 9 recessions, which were preceded by rising unemployment (the red bars indicate recessionary periods):
One must consider how horrible the Fed’s projections have been, especially over the long term. At this point last year, their summary pointed to 4% GDP and 1% Fed Funds by the end of 2022. Suffice to say, they were way off. Yesterday’s 50 basis point increase put Fed Funds at a range of 4.25% – 4.50%. GDP for the year has been -1.6%, -0.9% and 2.9% through three quarters as well. Although we take these estimates with a grain of salt, it is still crystal clear that the Fed is not stopping this rate increase cycle just yet, in spite of leading indicators pointing to the notion that they have done plenty. With global money supply declining, central banks around the globe aggressively tightening, and a strikingly inverted yield curve, one must continue to prepare for rougher waters ahead. None of this should be considered new news!
Lastly, on Fed projections, they think rates will be cut in 2024 and 2025. However, they also believe inflation will be 2.5% in two years. Talking tough and actually executing on that plan are two different things. When Fed Chairman Powell states that they are focused on getting inflation back to 2%, recognize that his entire team does not believe that is going to be true. They also project cutting rates before getting inflation to 2%! They want inflation under control, but reverting to sub-2% inflation is not necessarily needed. There is a difference in what he says and what they will do. It is more likely that inflation turns negative next year than their projections will come true.
On to the market’s reaction; stocks took it on the chin yet again, with growth areas hardest hit even though interest rates declined on the long-end. The Nasdaq dropped 6% in the past few days. FANGMAN stocks were almost all down 4%+ yesterday alone. Every sector finished in the red on Thursday as well. REITs were one of the best performing sectors, dropping less than 1%. This stems from the sizable drop in interest rates. REITs are heavily indebted and consistently tap the credit markets for funding needs. When yields drop, it helps their cash flows.
Interest rates have been collapsing for weeks now, mainly in longer maturities where GDP, recession risks and lower expected inflation drive yields. Bonds are starting to point towards a more aggressive recession and hinting at Fed rate CUTS by the end of 2023, not 2024 where the Fed projects. Stocks, even with the 2-day drop, are still pricing in only a modest slowdown, with earnings coming down a little and P/E’s staying elevated. These two markets are expecting two wildly different outcomes. Bond investors think the recession will be a strong one, the Fed will have to reverse course quickly and stocks are priced too high right now. Stock investors believe in the soft landing, a mild recession, and that the economy can handle 5% interest rates without impacting earnings significantly. One of these markets is going to be terribly wrong. After seeing the retail sales report come in very weak for November, the bond group is feeling more confident.
On the positive side, this could wind up being one of the last few hawkish meetings. Inflation is clearly in a downtrend. Layoffs are piling up. Home prices are dropping and that will start to hit CPI early next year. Corporate executives are almost all expecting a recession, or believe we are already in one. This could prove to be a “rolling recession”, where different pockets of the economy are hit at different points. Home builders have seen orders outright collapse. This sector is one of the most important for the US economy and will impact jobs. Retailers have been laying off workers, even during the Holiday season where demand is robust. Next year, it could be the travel and service sectors that feel the pinch as travel plans come back to normal. Lower interest rates could put a floor on housing and retail sectors as consumers react to mortgage rates getting back to 5% instead of 7%. A rolling recession from sector to sector would be following the abnormal recovery path that has been anything but normal since Covid lockdowns.
Before the positives can come to fruition, we must stop the trend of lower highs and lower lows:
There is also history to deal with. No bear market has ever bottomed BEFORE a recession started. With executives expecting one early next year, it could become a self-fulfilling prophecy. A true recession is likely to put inflation to bed for good, so long as the Fed does not get overly aggressive in bringing rates back to zero and reigniting higher prices. Lessons have been learned; there must be a cost to borrowing. Here is hoping that the Fed agrees, but also can tame inflation without crushing the consumer yet again.
Lastly, today is quadruple witching, where stock index futures and options, individual stock options and single stock futures derivatives expire. There are trillions of contracts coming due. History points to elevated volatility and wild swings in both directions. Futures point to a solidly down opening at the moment.
Pennsylvania native and Breaking Bad actress, Krysten Ritter, turns 41 today.
James Vogt, 610-260-2214