Gavin W. Stephens
Chief Investment Officer
Chief Investment Officer
As this difficult year for investors moves ahead, a peculiar logic is taking hold over the markets: what is good is bad, and what is bad is good. In other words, news that in a normal environment would lead investors to bid up stock prices, for example, is considered bad, driving prices further downward. Conversely, investors consider bad news as good, greeting signs of a slowing economy with increased willingness to take risk, driving markets higher.1
On first glance, this peculiar logic would seem to be yet another rebuttal to the argument that investors are rational. What could be more irrational than celebrating bad economic news by buying stocks? Peculiar as it may seem, this logic is indeed logical.
What’s behind this peculiar logic? The answer is easily observable and widely felt: inflation—and not modest inflation, but rather inflation at levels unseen since the 1980s. Only one year ago, increased inflation was largely considered “transitory,” or an effect of supply and demand imbalances that followed pandemic-related economic lockdowns. Beginning this spring, however, it became clear that inflation was more fully entrenched.
In fact, the latest U.S. Consumer Price Index (CPI) report affirmed that inflation is proceeding at an intolerably high level across an increasing spectrum of the U.S. economy. The so-called “core” components of the consumer-price index—which exclude categories with volatile price behavior, such as food and energy—increased 0.6% from July to August and 6.3% over the same period one year ago. As the chart below shows, these core components of consumer spending have increased rapidly over the past year and are well above the Federal Reserve’s long-term inflation target of 2%.
Additional measures of consumer prices, such as the Cleveland Federal Reserve’s “trimmed mean CPI” and the Atlanta Federal Reserve’s “Sticky Core CPI” highlight the same phenomena, namely that prices of essential consumer goods and services are increasing at unacceptably high rates.2
From an investor’s perspective, the perniciousness of inflation lies primarily with its cure. That is, to bring inflation under control, central banks around the world must slow economic growth by bringing consumer demand into better balance with supply. In the process, price increases should slow, easing inflation to more tolerable levels.
In the U.S., the Federal Reserve has embarked on an aggressive program of monetary tightening to achieve these ends. As a result, investors have contended with the most rapid interest rate increases in over 40 years,3 increases that have weighed heavily on asset prices and that are just now beginning to effect various sectors of the economy.
Federal Reserve officials have warned investors not to expect a quick end to its efforts to cool inflation. As chair Jerome Powell has noted, officials require “clear and convincing evidence” that inflation is moving lower before officials will consider slowing the pace of monetary tightening.4 But when such a pivot by the Federal Reserve comes into view, stock and bond investors will view it favorably. And because this pivot will occur at a time of slowing economic growth, investors are looking assiduously for encouraging bad news that puts an end to monetary tightening into sight, while showing a peculiar disdain for positive economic news.
The Federal Reserve’s primary method of slowing economic growth is to increase interest rates. Therefore, it makes sense to look for the first signs of a slowing in the economy’s most interest-rate sensitive sectors. The housing sector is a prime example. As expected, the housing market has proven itself to be a leading indicator of slowing economic growth.
As chart 2 indicates, monetary tightening has already left a mark on the housing market. Both new and existing homes are taking much longer to sell, with months of supply nearly doubling in both markets. Home prices, in turn, are increasing at a much lower rate than only a year ago (8% vs. 14%) as home sellers are forced to reduce prices to meet slower demand. Signs of encouraging bad news are readily visible in the housing market.
The labor market, on the other hand, has shown minimal signs of encouraging bad news. Through August of this year, for example, the U.S. economy has produced an average of 438,000 jobs per month, which is a 20% decline from 2021’s average of 562,000 jobs created per month. However, during the five years that preceded the COVID-19 pandemic, the economy produced a monthly average of 196,000 jobs. Thus, while the job market is showing initial signs of slowing, by historical standards it is still robust.5
In other words, job seekers continue to find a favorable market with plentiful job openings and growing wages. As chart 3 shows, the labor market is imbalanced with nearly two job openings available for every person looking for a job. Historically, the U.S. economy has had fewer job openings than unemployed workers.
The Federal Reserve is attuned to these imbalances and the degree to which an overheated labor market will continue to feed inflation. The Federal Reserve will apply increased pressure on the economy until the labor market cools—evidence of which will emerge from either fewer job openings or more unemployed workers. Both outcomes would push this important ratio closer to historical norms and ease pressures on prices.
As 2022’s market returns to date have shown, monetary tightening is generally unkind to asset prices. Increased interest rates immediately result in lower bond prices; higher rates also put indirect, though no less significant pressure, on the prices of stocks, real estate, and other risky assets. This has proven true during the first three quarters of the year, with traditional investor portfolios—such as a portfolio of 60% U.S. stocks and 40% U.S. bonds—producing deeply negative returns.6
As we enter the last quarter of 2022 and look ahead into 2023, investors will eagerly search for an end to the Federal Reserve’s program to cool the economy via increased interest rates. The end to that program—and a more favorable outlook for portfolio returns—will come into sight only when “clear and convincing evidence” exists that this program has produced its intended results.
1 The May 2022 payrolls report serves as a good example of this logic. Preceding the release of the May payrolls report, consensus expectations were for an increase of 301,000 jobs. On June 3, the Bureau of Labor Statistics announced an increase of 390,000 jobs during the month of May, beating expectations by 30%. In reaction, the S&P 500 declined by 1.6% the same day.
2 Federal Reserve Bank of Cleveland 16% Trimmed-Mean CPI Year-over-Year Change and Atlanta Fed Core Sticky CPUI Year-over-Year Change, as of August 31, 2022.
3 Entering 2022, the upper bound of the Federal Funds Target Rate was 0.25%. The Federal Reserve has increased this target by 3% through the first three quarters of the year. The most recent example of such rapid increases in the Federal Funds Target Rate dates to 1980, when the Federal Reserve increased its target from June 30 through December 31 from 9.5% to 18%.
4 Jeanna Smialek. “Powell says the Fed is Watching For ‘Clear and Convincing’ Signs of Inflation Fading”. The New York Times, May 17, 2022.
5 Bureau of Labor Statistics, US Employees on Nonfarm Payrolls Total Month-Over-Month Net Change, Seasonally Adjusted.
6 Through September 23, 2022, the Bloomberg US EQ:FI 60:40 Index, which replicates a portfolio comprising 60% U.S. large-capitalization stocks and 40% US bonds, produced a return of -19%.
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