Economic Update Fall 2022
The U.S. is in the late-cycle expansion phase with high recession risks. The economy is contracting. U.S. economic growth disappointed through the first half of the year, with the average of Q1/Q2 growth contracting by 1.1%. A tight labor market makes it difficult to make a recession call. The contraction has not been deep enough to cause unemployment to rise by a few percentage points. A significant rise in unemployment is the telltale indicator of every recession. There is hope that any recession will be a mild and short lived because unemployment may only rise from today’s extremely low rate of 3.5% to 4.5% rate and not reaching a 6% rate level characteristic of most recessions.
Conference Board’s Leading economic indicators have turned negative for the first time since the pandemic, pointing to a recession. Global PMI’s that measure manufacturing activity has contraction readings. Presently, Wall Street economists project real economic growth for 2023 at 1.1% according to Bloomberg. That is stall speed growth that could easily slip into a contraction.
For now, the U.S. economy is in its Late cycle phase characterized by Fed tightening financial conditions to curb inflation, tighter credit conditions, slowing sales and rising inventories, as well as downward earnings revisions. I would say at best the economy is experiencing Stagflation a term that means high inflation and low economic growth. Atlanta Fed’s GDP now model estimates real economic growth for the third quarter to be 2.8%.
The cost-of-living is running at its highest level in more than 40 years. It is too high for the Fed to stop hiking, and historically low unemployment provides the Fed cover to hike into year-end. The Fed believes there must be significant job layoffs to quelch inflation pressure. Wage growth is a contributor to inflation that must moderate for inflation to subside. Wage growth is beginning to moderate, 5.0% over the year ending September, however, it is still well above the average 3% rate associated with lower inflation expectations. Fed hikes aim to increase unemployment by at least one percent over next twelve months thereby lowering wage hike pressure on business.
The Fed has a dual mandate of maximum employment and prices stability. Inflation is so hot that the Fed only cares about price stability now. Hence, the fastest rate hiking cycle in decades. A lot of tightening has already taken place and has not had time to really impact the economy. Monetary policy takes about six to nine months to work its way through the economy. The Fed will not know how much damage it’s doing to the economy until it happens. In other words, the Fed is driving the car looking through a rear-view mirror. Many inflation indicators are lagging indicators. What economists do know is that the rapid pace of tightening raises the risks of a more significant downturn in the economy. Most times, fast tightening cycles have led to recessions.
Wall Street inflation expectations are heading downwards with each successive rate hike. Economists expect the consumer price index to decline in 2023 as layoffs mount, wage growth slows, and consumer demand eases. I expect the Fed Funds rate to pause at 4.5% and then the Fed will prudently assess economic conditions. The Fed does not want to create financial instability just price stability. Fed Funds rate at 4.6% is in line with historical average. Add on Q.T. and its effectively 5.1% based on CME’s projected terminal value for FFR! In the past, the Fed stops tightening when the 10-years Treasury yield matches the Fed Funds Rate (FFR). Monetary policy has become so restrictive that it should create financial conditions that bring about lower inflation and employment.
What should an investor do at this point given the economy slips into a recession? A garden variety recession last about 10 months on average since 1950 according to Capital Group. Recessions are minor economic events when compared to expansions. The average economic contraction in a recession is 2.5% compared to a 24.6% rise in GDP output in a typical expansion that last 69 months. Equity markets lead the economic cycle by about seven months. Bear market’s bottom before a recession or halfway into one. The highest returns in the stock market occur immediately following a market bottom. Investors must own the same number of stocks they had going into a Bear market going out of one to recover unrealized short-term losses. Stay the course at this stage. Every Bear market is followed by a Bull market which starts in a recession or after declines we have seen already. In fact, by mid-recession stocks are rising in value again.