Half Right But Not Yet Half Wrong
- Fed tightening always raises the prospect of a recession
- The U.S. economy has unusual resiliency providing time
- The forces that drove inflation are receding, but we need time for better outcomes
- With or without an intervening recession, the "K Expansion" lies ahead
By Jeff Korzenik, Chief Investment Strategist for Fifth Third Bank
To date, investors and participants in the U.S. Economy have been battered by a surge of inflation and the subsequent response of the Federal Reserve Bank. Our central bankers have embarked on a rapid pace of rate hikes in an effort to slow growth and tame inflation. Tightening cycles always raise the risk of recessions, but the rapidity and magnitude of these increases to the fed funds rate target are particularly unsettling. The central bank has made explicit their belief that they cannot relax their tightening until inflation breaks. Historically, this has often required a recession, but not always, begging the question, "Which will break first, the economy or inflation?"
Fifth Third’s Base Case
While we see room for a broad array of plausible outcomes, our base case remains that inflation will moderate before the U.S. economy enters a recession, allowing the Federal Reserve to move to monetary conditions that can support continued growth.Our case is based on two premises:
- The U.S. economy is structurally more resilient than in typical cycles, elongating the period between the Fed’s first rate hike and any prospective recession.
- Many of the conditions that fostered inflation are diminished or even reversed, although we note that there is a substantial amount of "throughput" – the initial surge of inflationary pressures is still working itself through the broader economy.
On balance, we believe that inflation will moderate before the tighter financial conditions induce a recession.
The Case for Economic Resiliency
We differ little from consensus expectations that the Federal Reserve will continue to increase interest rates, even at the risk of a recession. However, we believe that the actual risk of a recession is lower than past Fed tightening cycles. Typically, the Fed starts aggressively hiking at a later point in the business cycle, environments characterized by low remaining economic capacity (particularly in labor) and high indebtedness. Perhaps because the inflationary spike was driven more by changes in fiscal policy rather than monetary policy, the current Fed is tightening at an earlier stage of the business cycle. With roughly 6 million job seekers and 11 million job openings, each month we have witnessed hundreds of thousands of workers being added to the payrolls. Although some layoffs are coming, the historically unprecedented labor gap suggests payroll gains will continue to be positive, adding economic buoyancy despite the stress of Fed rate hikes.
Households and corporations are also far less vulnerable to higher interest rates, compared to previous tightening cycles. For example, relatively few households have adjustable rate mortgages, a sharp contrast to 2007. Although credit card debt has been rising, the total burden of debt payments as a percent of disposable income is near multi-decade lows. Financial institutions are in strong shape as are most corporate balance sheets. The Fed can tighten, but outside of interest-rate sensitive segments like housing, the sting of higher rates is muted.
The Case for Moderating Inflation
While it will take time (we estimate several more months) for a retreat of inflation to be evident, it is coming. Money supply growth has already fallen to pre-Pandemic levels, the federal relief programs that stoked excess demand have passed, supply chains have been healing, high mortgage rates and subsequent declines in affordability are arresting housing gains, many commodity prices are falling and even wage gains have shifted into a lower gear. An excess of inventories may well translate into actual price declines for many consumer goods.
While we see inflation eventually receding, the persistence of inflation carries its own risks. The Federal Reserve Bank has rightly emphasized the importance of managing inflation expectations. The longer inflation remains evident to consumers, the more we risk the sort of "inflationary psychology" that made the inflation of the 1970s so intractable; that environment ultimately required not one but two recessions to control price rises. To date, the Fed has been largely successful in controlling inflation expectations despite high actual inflation.
The K Expansion
We do recognize that stocks and risk asset markets will have a difficult time rallying until there is more evidence that inflation is receding (perhaps two consecutive months of declining core inflation). At some point there will be clarity, whether it comes in the form of a "soft landing" (slowdown without recession) as we anticipate, or a clear sign that the economy, including the labor market, is in retreat. Until then, we would expect a holding pattern of volatility, sector rotation and range bound trading.
Even if we are right and avoid a recession, the nature of the next phase of economic expansion will prove a challenge for investors. We believe that the structural damage of the Pandemic will at long last have a reckoning. Because of the flood of federal cash, the much-ballyhooed "K Recovery" (with distinct economic winners and losers, represented by the upward and downward pointing arms of the letter K) never occurred as gains were widely distributed if not universal. But the upheavals of recent years cannot be ignored. Work-from-home opportunities that spur the migration of workers from cities to suburbs as well as interstate moves, the partial abandonment of public transit and central business districts, the need for more localized and resilient supply chains, the accelerated departure of older workers from the labor force, and the resultant tilt of negotiating power toward workers all have widespread implications for investors, creating both winners and losers.
Such a K-expansion offers opportunities, but aggregate returns are likely to be more modest. In a similar vein, the shrinking of our workforce points to long-term annual economic growth potential below 2%. Adding to investor challenges, even if the Fed successfully contains today’s inflation, labor tightness and lessened supply chain efficiency will create an environment of higher embedded inflation and interest rates, limiting opportunities for multiple expansion/valuation improvement.
Assessing Our Economic View
We consider our forecast to be half right in the sense that the U.S. economy – in particular the labor markets – has proven exceptionally resilient in the face of higher interest rates. The addition of roughly 3 million employed workers to the economy in the six months since the beginning of the Fed tightening cycle is clear evidence of underlying momentum that should carry the economy forward for at least the remainder of the calendar year.
While we feel vindicated in our belief that a prospective recession is still in the distance, evidence for our forecast that inflation will turn a corner has yet to unfold. There are signs that some of the scenario we envisage is in play and not clear confirmation that we are wrong. Notably, back-to-back PPI reports have been promising even if CPI has shown no consistent improvement. Home price increases are slowing in aggregate with many markets in outright decline, but renters and the housing components of most inflation measures lag and will continue to rise. Transportation costs, another major driver of the CPI’s rise, are also moderating; new cars prices are still rising, but used vehicles are not, and fuel prices continue to fall.
The clearest challenge to our soft landing view is the tight labor market. Total compensation costs are still in an uptrend and too high, but the more frequently reported Average Hourly Earnings are decelerating. Particularly promising are signs that the supply of workers is growing through rising labor force participation. We believe that the U.S. economy is not at full employment, but tapping all our human capital resources requires new talent acquisition practices and investments, all of which take time, which the U.S. economy may or may not have.
Half right (economic resiliency) but not yet half wrong (inflation moderation) may offer little immediate comfort to investors, but reinforces the lessons learned over generations. The traditional formula for investor success is a disciplined, diversified approach to equities and patience.