Stagflation and recession risks growing.
The U.S. economy has clearly downshifted over the past few months, as the housing market and several of the regional Federal Reserve indexes have turned sharply lower, while the labor market is showing signs of peaking. The Michigan Consumer Sentiment Index hit an 11-year low, and the personal savings rate has declined to a 9-year low. Food and energy prices are soaring, so the brief inflation reprieve we enjoyed in April could reverse in May.
But the Fed is now aggressively tightening its monetary policy. It completed its bond-buying taper in March, has already hiked interest rates by a quarter-point in March and a half-point in May—with at least a pair of half-point hikes on tap in June and July—and will start to shrink its bloated $9 trillion balance sheet by a third next month. Investors are rightfully concerned about stagflation and a monetary policy error, potentially increasing the risk of recession.
Bond vigilantes arise After more than doubling from 1.5% at the beginning of the year to 3.15% on May 9, benchmark 10-year Treasury yields have declined sharply to 2.70% over the past three weeks, as the bond vigilantes are anticipating slower economic and corporate profit growth.
Dead-cat bounce The S&P 500 fell by more than 20% on an intraday basis from January 4 to May 20, declining for seven consecutive weeks through last Friday for the first time since the dot-com bubble burst in March 2001. This marks just the fourth such losing streak of seven or more consecutive weeks in the post-war history of the U.S. While stocks have enjoyed a predictable dead-cat bounce of nearly 7% from oversold levels over the past week, we are not convinced that we’re completely out of the woods just yet, with a variety of headwinds still in front of us in coming months.
As our equity CIO Steve Auth points out in a companion piece, Stay strong, but defensive, we could see a technical S&P 500 re-test of 3,800, or perhaps a move down to a new low of 3,500, between Memorial Day and Labor Day, at which point we envision getting more constructive on stocks.
Cracks in the labor market? While this has been a picture of strength, we have noticed some recent cracks. Initial weekly jobless claims (an important leading indicator) have risen nearly 27% over the past two months. April’s disappointing ADP report posted job gains roughly half of March levels and Challenger job cuts in April rose 6% from a year ago and nearly 14% from March. The household survey declined by more than one million jobs sequentially from March to April, and the participation rate declined to a disappointing 62.2%. The pace of leisure & hospitality hiring has fallen by half over the past four months, while the unemployment rate for low-wage-earning workers has risen from a 30-year low of 4.3% in February 2022 to 5.4% in April.
Food and energy volatility Corn, wheat and gasoline prices have more than doubled over the past 18 months, while crude oil and natural gas prices have more than tripled. We expect these negative trends to continue in coming months. It is unlikely, in our view, that we reached the definitive peak in inflation in March 2022, when the nominal retail Consumer Price Index (CPI) hit 8.5% y/y and core CPI rose to 6.5%, both 40-year highs. The more important question, in our view, is how long it takes for inflation to recede to more normal, pre-pandemic levels, a process we believe will be measured in two or three years, not months.
Focus on Jackson Hole We expect half-point hikes at the FOMC meetings on June 15 and July 27. The Fed hosts its annual monetary policy symposium at Jackson Hole, Wyo., in late August, during which we believe Chair Jerome Powell would love to take a victory lap for helping to engineer a summer peak in inflation. That would allow the Fed to announce a downshift to quarter-point hikes on September 21, November 2, and December 14, with perhaps four more data-dependent quarter-point hikes over the course of 2023.
In conjunction with the completion of a challenging second-quarter earnings reporting season from mid-July through mid-August and the prospect of midterm election results on November 8 that result in divided government, this period could represent a reasonable trough in equity valuations.
Lowering our GDP estimates again The liquidity, equity and fixed-income investment professionals who comprise Federated Hermes’ macroeconomic policy committee met this week to discuss the recent deceleration in several key economic metrics, in the wake of a more hawkish twist in Fed policy:
- Gross domestic product growth declined 1.5% in in the first quarter of 2022, versus an outsized gain of 6.9% in the fourth quarter of 2021. Private domestic final sales were strong in the first quarter with a gain of 3.9% due to positive contributions from personal consumption, corporate capex and housing. But a soaring net trade deficit gutted the quarter, along with a decline in the quarter-over-quarter pace of inventory restocking and a decline in federal government defense spending for the fifth consecutive quarter.
- Although “Mapril” spending was solid with a 7.8% year-over-year (y/y) gain, we expect the Fed to hike interest rates by an additional half point at each of their June and July meetings. So we reduced our GDP growth estimate from 2.9% to 2.3% in the second quarter of 2022. The Blue Chip consensus lowered its estimate from 3.1% to 2.8% (in a range of 1.3% to 4%). The Atlanta Fed’s GDPNow model is at 2.4%.
- The Fed’s aggressive rate hikes and shrinking of its bloated $9 trillion balance sheet by a third starting in June could negatively impact Back-to-School spending, and growth could slow further in the second half of 2022. So we reduced our estimate from 2.4% to 1.9% in the third quarter of 2022. The Blue Chip consensus ticked its estimate down from 2.7% to 2.6% (in a range of 1% to 3.9%).
- We expect the Fed to finish the year with three quarter-point rate hikes in September, November, and December, so Christmas spending could be much slower than last year’s strong season (with retail sales up 16% y/y). As a result, we cut our estimate in the fourth quarter of 2022 from 2.2% to 1.7%. The Blue Chip consensus tweaked its from 2.4% to 2.3% (in a range of 1.1% to 3.5%).
- We cut our full-year 2022 GDP estimate from 3.4% to 2.4%. The Blue Chip lowered its forecast from 3.2% to 2.6% (within a range of 1.8% to 3.3%).
- We left unchanged our full-year 2022 forecast for core CPI inflation at 5.4% (compared with an actual 6.2% in April 2022), and our full-year 2022 forecast for core PCE at 4.7% (compared with an actual 5.2% in March 2022).
- We reduced our full-year 2023 growth estimate from 2.1% to 1.5%. The Blue Chip consensus cut its from 2.3% to 2.1% (within a range of 1.3% to 2.9%).
- Given our forecast that the fed funds rate will be sharply higher going into next year, we cut our full-year 2023 forecast for core CPI inflation from 4.2% to 3.8% and for core PCE inflation from 3.6% to 3.2%.