Ukraine, energy, inflation and Fed driving markets.
Heightened geopolitical risks from Russia, China and Iran have significantly shrouded the economic and market landscapes. Chief is the energy shock inflicted on the U.S. economy caused by Russia’s unprovoked invasion of Ukraine.
Energy crisis The price of crude oil (West Texas Intermediate, or WTI) nearly tripled from $34 to $90 per barrel over the past 16 months, partly due to the Biden administration’s climate policies. But over the past fortnight, it has soared another 30% to a 14-year high of $117, due to rampant fears of supply disruptions from Russia, one of the world’s three largest energy producers at about 10 million barrels per day. Lagging gasoline prices in the U.S. have soared 82% from $2.11 per gallon in November 2020 to more than $4 now, a negative trend sure to worsen in coming weeks and months.
Inflation soaring Nominal retail inflation hit a 40-year high of 7.5% year-over-year (y/y) in January 2022, while the core Consumer Price Index (CPI) also rose to a 40-year high of 6%. The core Personal Consumption Expenditure (PCE) index (the Fed’s preferred measure of inflation) hit a 39-year high of 5.2% y/y in January (more than double the Fed’s 2% target), a level we expect will rise to 6% in coming months.
Fed getting hawkish Having finally thrown in the proverbial towel on “transitory” inflation, the Federal Reserve appears to be laser-focused on this worsening inflation problem. We expect it to complete its bond-buying taper at its upcoming March 16 FOMC meeting and launch a series of six quarter-point hikes of the fed funds target range in 2022. The first hike is complicated by the war in Ukraine, without which we believe the Fed might have seriously considered a half-point rate hike. It likely also will lay the groundwork for shrinking its nearly $9 trillion balance sheet later this year.
Stagflation worries The combination of soaring energy prices and inflation amid a more hawkish turn in Fed policy has contributed to growing fears of “stagflation,” the combination of rising inflation and slower economic growth. While our base case is that the Fed will manage to stick a soft landing as officials reverse their so-called “wealth effect,” the bond market clearly needs some convincing. Bond vigilantes have narrowed the spread between 2- and 10-year Treasury yields from 160 basis points a year ago to 100 six months ago to around 25 today. Historically, as this relationship narrows, and eventually inverts, bond vigilantes believe the risk of recession grows.
Labor market still solid Nonfarm payrolls are strong, rising an average of 583,000 jobs per month over the last six months. Initial weekly jobless claims have declined 25% in the past two months to only 215,000 claims last week, and the ADP private payroll survey has added a monthly average of more than 540,000 jobs over the past half year.
Manufacturing also strong It is seeing increased activity across the board, as supply-chain bottlenecks are starting to ease and as inventory restocking has improved sharply. But the service portion of the economy has shown signs of softening. The personal savings rate normalized from nearly 27% last March to an 8-year low of 6.4% in January 2022, in line with its 6.7% average over the past quarter century. And the University of Michigan’s Consumer Sentiment Index fell to an 11-year low of 62.8 in February 2022, largely due to inflation worries.
In the past three weeks, 10-year Treasury yields plunged from 2.05% to around 1.67% in a sharp flight-to-safety trade and VIX more than doubled to 38. The S&P 500 has fallen more than 10% to start this volatile year. We’re not done yet, so buckle your seatbelts.
Adjusting our GDP estimates The fixed-income, liquidity, and equity investment professionals who comprise Federated Hermes’ macroeconomic policy committee met last week to discuss the Russia/Ukraine war and its impact on energy prices, inflation and Fed policy:
- The Commerce Department revised fourth quarter 2021 GDP up a tick to 7%, versus 2.3% in the third quarter. The full year remained unchanged at 5.7%.
- The surge in the Covid omicron variant, brutal winter weather, soaring energy prices and the highest inflation in 40 years could result in slower economic growth in the first quarter of 2022. So, we reduced our GDP growth estimate from to 3.5% to 2.3%. Blue Chip consensus lowered its from 3.3% to 1.8% (within a range of 0.4% to 3.3%). The Atlanta Fed’s GDPNow model has fallen from 1.7% in mid-February to near zero.
- We expect a solid rebound in “Mapril” spending in spring as omicron fears fade and inflation and supply-chain problems peak. But we anticipate the Fed will raise interest rates in March, May and June, so we trimmed our estimate of 4% to 3.6% in the second quarter. Blue Chip consensus raised its from 3.9% to 4% (range of 2.7% to 5.6%).
- As the Fed hikes interest rates and begins to shrink its balance sheet, growth could slow in the second half of 2022. We did not change our projection of 3% for the third quarter. But Blue Chip consensus lowered its from 3.3% to 3.2% (range of 2.4% to 4.3%).
- That slowdown should continue into year-end, so we reduced our estimate for the fourth quarter from 3% to 2.7%. Blue Chip consensus lowered its from 2.7% to 2.6% (range of 1.8% to 3.7%).
- We kept our full-year 2022 growth forecast at 3.8%. Blue Chip decreased its from 3.9% to 3.7% (range of 3.1% to 4.2%).
- We increased our full-year forecast for core CPI from 4.4% to 5% and for core PCE inflation from 3.8% to 4.3%.
- We set our first full-year 2023 GDP growth estimate at 2.4%. Blue Chip consensus left its unchanged at 2.6% (range of 2% to 3.2%).
- Our initial full-year 2023 forecast is 4% for core CPI and 3.5% for core PCE.