Dominos falling

Bottom Line

Russia’s atrocities in Ukraine have unleashed a domino effect throughout the global economy. Volatile energy prices have spiked, exacerbating the worst inflation in 40 years. In response, the Federal Reserve has begun to aggressively tighten monetary policy by ending their bond-buying taper, hiking interest rates sharply and laying the groundwork to shrink its bloated $9 trillion balance sheet by a third. 

Investors naturally are concerned about stagflation and the risk of a potential policy error. Business and consumer confidence softened during the first quarter, as manufacturing, retail sales and housing all weakened in recent months. The labor market remains strong, but higher wages are contributing to soaring inflation. Inventory restocking continues to improve as supply chain bottlenecks ease, but the auto market is still struggling. 

As a result, benchmark 10-year Treasury yields have leapt from 1.50% to 2.83%, After a head-scratching, counter-trend rally of more than 12% after the start of the Russian invasion Feb. 24, the S&P 500 corrected by about 5% over the past fortnight. We expect this trend to continue in coming months, as both economic and corporate profit growth slow.

Energy volatility Russia’s unprovoked invasion of Ukraine sent the price of crude oil soaring 45%, from $90 to $130 (a 14-year high), due to rampant fears of supply disruptions as Russia is one of the world’s three largest energy producers (about 10 million barrels per day). After that painful spike, however, prices have dropped nearly 20% to $107 today. Lagging gasoline prices initially leapt 20% to a record $4.33 per gallon, but they’ve since eased by about 6% to $4.07.

Inflation still soaring The nominal wholesale Producer Price Index (PPI) hit a record high of 11.2% year-over-year (y/y) in March, while core inflation also hit a record 7% y/y. The nominal retail Consumer Price Index (CPI) hit a 40-year high of 8.5% y/y in March 2022, while core CPI , which excludes energy and food prices, also rose to a 40-year high of 6.5%. The core Personal Consumption Expenditure (PCE) index (the Fed’s preferred measure of inflation) hit a 39-year high of 5.4% y/y in February, on its way to 6% in coming months, which would triple the Fed’s 2% target. 

Some investors believe that inflation is peaking right here, but that enthusiasm may be a few months premature. Regardless, the more important question, in our view, is how long before inflation recedes to normal levels, a process that we believe will be measured in years (possibly two-three), not months. 

Fed’s hawkish twist After completing their bond-buying taper last month, the central bank hiked rates by a quarter point for the first time in four years. We expect half-point hikes (for the first time in 22 years) at the next three Federal Open Market Committee meetings, with quarter-point hikes over the balance of this year and perhaps four more times next year. That could take the fed funds rate up to about 3.50% by the end of 2023. The Fed likely will begin shrink its balance sheet by a third over the next three years. 

Stagflation worries grow The combination of soaring energy prices and the worst inflation in 40 years, which prompted the hawkish turn in Fed policy, has contributed to stagflation concerns, the combination of rising inflation and slower economic growth. Our base case is that the Fed will manage to stick a soft landing, but this uncertain outcome won’t become apparent until next year at the earliest. 

Lowering our GDP estimates, raising our inflation forecast The equity, fixed-income and liquidity investment professionals who comprise Federated Hermes’s macroeconomic policy committee met yesterday and made the following changes to our forecasts: 

• The Commerce Department revised fourth quarter 2021 GDP down a tick to a final gain of 6.9%, versus 2.3% in the third quarter. The full year was unchanged at 5.7%.
• Soaring energy prices and the highest inflation in 40 years could result in slower growth in the first quarter, which will be flashed on April 28. So we reduced our GDP growth estimate from 2.3% to 1.6%. The Blue Chip consensus halved its estimate from 1.8% to 0.9% (within a range of -0.2% to 2%). The Atlanta Fed’s GDPNow model is at 1.1%. 
• Although we expect a solid rebound in “Mapril” spending, we also expect the Fed to raise interest rates by a half point in each of their May and June meetings. So we reduced our estimate from 3.6% to 2.9% in the second quarter. The Blue Chip consensus lowered its estimate from 4% to 3.1% (in a range of 1.6% to 4.8%).
• As the Fed tightens, growth could slow in the second half of 2022. We reduced our estimate from 3% to 2.4% in the third quarter of 2022. The Blue Chip consensus reduced its estimate from 3.2% to 2.7% (in a range of 1.3% to 3.9%). 
• Christmas spending could be much softer than last year’s strong season, so we trimmed our growth estimate in the fourth quarter of 2022 from 2.7% to 2.2%. The Blue Chip consensus reduced its estimate from 2.6% to 2.4% (in a range of 1.4% to 3.5%).
• We cut our full-year 2022 growth estimate from 3.8% to 3.4%. The Blue Chip lowered its forecast from 3.7% to 3.2% (within a range of 2.8% to 3.8%). 
• We increased our full-year 2022 forecast for core CPI from 5% to 5.4% (versus 6.5% in March 2022), and we also raised our full-year 2022 forecast for core PCE from 4.3% to 4.7% (versus 5.4% in February 2022).
• We reduced our full-year 2023 growth estimate from 2.4% to 2.1%. The Blue Chip consensus cut their estimate from 2.6% to 2.3% (within a range of 1.7% to 3.1%).
• We raised our full-year 2023 forecast for core CPI from 4% to 4.2% and for core PCE inflation from 3.5% to 3.6%.

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