Stocks managed to achieve a second week of gains despite a continued rise in interest rates. Investors took apparent advantage of the selling climax two weeks ago to scoop up bargains. Whether the sharp rally after an equally sharp decline constitutes an end to the market correction will depend on the economy’s course over coming months. This morning, the 10-year Treasury yield has crossed over the 2.5% line for the first time in three years. Perhaps as noteworthy, the 2-year yield touched 2.4%. The spread between the two narrowed to just 11 basis points, worrying some that a recessionary signal was likely soon, should the yield curve invert.
Economic studies have shown, rather convincingly, that it takes about a decade to heal from a true financial collapse. Since 1900, there have been three such events. The first two, the crash in 1909, rescued by J.P. Morgan, and the Great Depression, ultimately ended as wartime stimulated demand for both goods and services. The Great Recession of 2007-2009 that almost collapsed the banking system ended via a long period of excessive central bank liquidity. The 10-year window of healing came to an end just as the pandemic set off another economic shock, but both Congress and the Fed responded with a torrent of money that quickly erased the setback and put the economy back on a forward path.
If you look at the major world powers of the 20th Century (Germany, Japan and the United States), each is dominated by one economic indicator. Germany is fixated by price stability after its currency collapsed post-World War I. Japan, which lacks the physical resources to support its economy, must import vast amounts of goods. Its singular focus, therefore, is on the balance of trade. In the U.S., the signature scary moment was the Great Depression and the long bread lines and soup kitchens that ensued. Our focus for the last 90+ years has been on employment.
Over the past few years, as many suggested the Fed should slow its quantitative easing, the retort from Fed officials was that it would do so once full employment was reached. Many suggested that surveys showing two jobs available for every American unemployed proved that full employment was at hand, but the Fed looked at a different statistic, the labor force participation rate. That dropped sharply during the pandemic. The Fed presumed that the drop was temporary and that soon about 3 million Americans would quickly return to the workforce. While labor participation has increased, it didn’t return to pre-pandemic levels. Male participation has been in decline for decades. Female participation didn’t peak until the last decade. Why the peaks? In a word, demographics. The percentage of Americans living past the age of 65 has risen steadily. Peak participation occurs during ages 30-50. Beyond that, people retire, they get disabled, or they lose jobs and give up finding a new one.
The era of ultra-low interest rates added another factor. Workers approaching age 65 found out that their retirement nest eggs wouldn’t yield enough to support retirement, so they kept working. But a funny thing happened during the pandemic. All the money Congress and the Fed poured into the economy for over a decade served to lift the prices of assets. As a result, as the 2020s began amid a pandemic, home prices rose and 401k asset values soared. Suddenly millions had a nest egg sufficient to allow retirement. Over 2 million simply retired and aren’t going back to work.
The obvious result was inflation. Asset values have been inflating for over a decade. As some constraints on supply began to appear, prices shot up. Early after the Great Recession there was plenty of excess capacity. There was plenty of plant space to make stuff, there was plenty of cash to purchase stuff, and there was plenty of labor to make stuff. If one supplier’s prices were too high, there was another who could fill the order at a lower cost. The Internet made price shopping a breeze for all.
But too much of a good thing…… Eat too many cookies and you get a bellyache. Simply said, demand got stoked too much and now we have to slow that down. The Fed can’t do much about supply, but higher interest rates and the liquidation of assets off its balance sheet will slow demand. Whether it slows to just the right level to cool inflation while keeping the economy in a growth mode is an open question.
However, remember my earlier point that Americans are fixated on unemployment. Politically, the hardest thing to do in Washington is to decrease employment. Many in the Fed believe that the right combination of higher rates and balance sheet runoff will allow the economy to slow without causing unemployment rates to rise. Perhaps a reduction in supply chain snarls will solve the problem.
But that all seems a bit naïve. A private enterprise response to less demand is less employment. If you run a restaurant feeding 100 people per evening and demand falls to 90, you need less help. You aren’t going to keep the same overhead to serve 90 as you did when you were feeding 100, are you? Labor is largely a variable cost that must be managed against demand. It happens with a lag. One doesn’t cut wait staff in anticipation of fewer diners; it responds after demand falls.
There are lots of reasons, an overwhelming list really, to suggest that there will be no recession this year. Major industries like housing and autos have been severely supply constrained and must catch up. Auto dealer lots are still sparse. Buyers await. In addition, Americans accumulated close to $2 trillion of excess savings during the pandemic. Money kept pouring in at the same time there were constraints on where to spend it. That excess will help to ease the bite of higher gasoline prices and airline tickets for a while, but not forever, and as the Fed keeps raising rates, your credit card bills will get larger. So will your mortgage rates. Necessities now take up a bigger portion of your paycheck. The shift is steady, insidious. But it takes several months to register.
Thus, 2022 will be fine. But what about 2023 and beyond? Aah, that depends on whether the Fed can walk that tightrope slowing demand without enacting recession. History doesn’t offer great odds, but it has happened. In recent years, markets had hissy fits in 2010 and 2011 during the European debt crisis, and in 2018 when the Fed raised rates four times in a year before reversing course. Many expect the Fed to follow a similar course this time, although with higher inflation it could take 8-12 increases over two years to tamp down inflation, allowing the Fed to reverse course in 2024.
Markets, however, can’t see that far ahead. Indeed, economic forecasts 12-months out are notoriously inaccurate. Clearly, uncertainty breeds market volatility. We also know from history that markets predict far more recessions than actually occur. That will require us to focus more and more on real-time data. There is little doubt that February and March inflation numbers will look bad. But after oil prices spiked to $130 per barrel soon after the start of the Ukraine war, they have stayed in a narrow range of $100-120. Gasoline prices that shot up for several weeks have started to level off. We have seen the same with other commodities. Inflation measures the rate of change, not actual prices. Thus, slowing upward momentum, should it continue, would be a positive sign.
Another key to watch, of course, is GDP growth. It was over 5% in the fourth quarter of last year, but a large part of that growth came about through the rebuilding of inventories. Final demand was closer to 3%. The Atlanta Fed tries to chart real-time GDP growth. Q1 has been hampered by the Omicron spike early in the quarter and sanctions related to the war in Ukraine during March. The forecast now is about 1%. That doesn’t factor in inventory changes or shifts in the balance of trade. Even if we assume the Omicron factor disappears in coming quarters (hopefully), it seems unlikely that real growth is going to return to 3%+ on a sustained basis. That’s actually good. Demographic growth plus productivity suggests it will be hard to maintain growth above 2% and keep inflation in check.
The first quarter has been a trying one for managements with the aforementioned Omicron spike and sanctions affecting many companies differently. The impact will show in earnings to be announced next month. We’ll see soon how well markets have or have not discounted those impacts. Beyond first quarter results, the hope is for a summertime return to normality for the first time in three years. Hopefully, some of the shortages we have been witnessing will start to resolve. Monetary policy works with a lag. This summer will be more impacted by the stimulus of the past year than the interest rate hikes just beginning. That’s the hard part of monetary policy, you won’t know for many months if what you are doing today will work. But in time, the stimulus of the past year will fade and the medicine now being applied will slow demand. Today, we can only guess at the outcome, but it will evolve over the next several months and markets will adjust. In the short run, uncertainty leads to volatility. The more important long-term outcome simply isn’t written yet.
What we do know is that a decade of massive stimulus is over. Once the Fed starts to retract that stimulus and remove money in circulation, it will put downward pressure on growth and asset prices, hopefully offset by some growth and higher earnings. That yin and yang will tell us how well stocks can perform in the coming year.
Gaga and Reba. Today Lady Gaga is 36. Reba McEntire turns 67.
James M. Meyer, CFA 610-260-2220