Financial Markets & Economic Update -Fourth Quarter 2022
What a year 2022 has been! Thanksgiving is this week and we can all be thankful for our families and friends. May we all enter this holiday season joyously. We are closer to the end of inflation and employment is still strong, with job openings exceeding unemployed persons by several million. We’ve seen tremendous market declines in both stocks and bonds, volatility, and a Federal Reserve who is raising interest rates at a breathtaking pace. Short-term rates have risen from .25% to 4.00% so far and the Fed says they are not done yet. Housing markets have suffered, with mortgage rates climbing up to 7.00%. We are thankful that there has been some recovery in stocks and bonds over the past two weeks.
My biggest concern with the Fed is that they are continuing to pile on outsized rate hikes and are not spacing them out to consider the typical six- to nine-month lag in their policy moves. As Milton Friedman famously wrote: “Monetary policy affects the economy with long and variable lags.” Thus, the Fed needs to anticipate and assess the damaging effect of large rate hikes on the markets and on economic activity. I was rejoicing when I saw their latest FOMC statement from early November, which included wording about the pace of future hikes (they tell us there will be more): “The Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.” Maybe they will wait and assess the effect of the four big .75% hikes in June, July, September, and November; based on lags, we are not fully seeing their impact yet. As Philadelphia Fed President Harker said recently: “Inflation is known to shoot up like a rocket and then come down like a feather.”
The Fed is raising rates to reduce aggregate demand to fight off inflation, even though they themselves waited too long to raise rates and inflation began as a supply-chain-driven problem, when production of goods could not keep up with new demand. The downside to all of the rate hikes is that we face a high risk of recession in 2023. Consumer spending and business inventory financing will be hurt by higher interest expense and it will take a toll on savings and corporate margins, respectively.
Milton Friedman also wrote that “inflation is always and everywhere a monetary phenomenon.” Money supply, as measured by M2, was growing in 2020 by over 20% year-over-year and in 2021 by 12% to 20% due to the Fed injecting liquidity through its bond buying program of $100 billion per month and the federal government passing continued Covid-19 relief bills, placing trillions of dollars into the economy. It is no wonder that demand surged. And M2 growth started 2022 at 12%, with the Fed still buying its $100 billion of bonds through the month of March, even though they knew inflation was a serious issue. And now M2 growth is down to 1.3% in October, which is below the range we experienced during the prior 10-year recovery of 3% to 5%. The Fed has reduced their balance sheet by $900 billion so far in 2022; a decline of $1 trillion is the equivalent of 1.00% of tightening. Remember this “hidden tightening” as you see the rate hikes piling up.
Rates have risen since March 2022. The CPI peaked at +9.1% year-over-year in June and is now +7.7% in October, which is a good declining trend but still too elevated. The Fed’s preferred measure is the PCE deflator, which was +4.2% in the third quarter compared to +7.3% in the second quarter and +7.5% in the first quarter. The core PCE (excluding food and energy) has fallen to 4.5% in the third quarter from +5.6% in the first quarter. The CPI and PCE measures differ in the amount of housing and shelter used in the calculation; CPI has a weight of 42% for housing and 32% for shelter, which the PCE indices use 15% to 16%.
I mentioned earlier that the Fed was raising rates to reduce aggregate demand. They cannot control the supply side, which has been particularly hard hit for goods from China, as their Zero-Covid policy locks down entire cities. More analysts are pointing at energy policy as one of the main contributors to inflation, when government stopped drilling expansion of oil and natural gas and distribution networks such as the Keystone Pipeline to pursue a “green” agenda full of batteries, solar power, and wind. The problem is that we are not ready as an economy to turn on a dime away from fossil fuels and businesses are reluctant to make the necessary capital investments to drill for more oil. When Russia invaded Ukraine last February, the price of oil shot up to $110 per barrel in June but has since returned to pre-invasion levels at $77 per barrel. Transportation costs have increased leading to an increase in the price of just about everything, especially food, where prices are dependent on the cost of goods getting to their final destination. Food and energy prices have been damaging to family budgets.
How are the leading indicators doing? There is some good news for inflation but worse news for the economy. The index of leading economic indicators has continued to fall further, with October at -.8%, following September’s -.5%, and is now down for eight consecutive months. This indicator accounts for the lag in Fed policy and projects six to nine months in the future.
The FIBER leading inflation index also continues to fall, but this decline is good news for inflation. The index turned down in May 2022 and is now -8.0% in October, following -5.8% in September. This index also looks out six to nine months.
Stock markets have declined most of the year before stabilizing recently. The Dow Jones and S&P 500 averages are down -6% and -16% respectively. Nasdaq has been the worst performing, at -28% year-to-date. Stocks are a forward-looking mechanism, based on projections of corporate earnings. PE ratios 12 months forward are currently at 17.5 times for the S&P 500, which is slightly over the historical average of 16 times. Bond markets have also declined from the relentless Fed interest rate hikes, with the Treasury aggregate price index down -12.7% in 2022. The Fed said they will look for financial stress and may be getting their wish as we have witnessed crashes in Bitcoin and other “digital coins” and the sudden collapse of the FTX exchange.
Housing is leading the way lower as one of the most rate sensitive sectors of the economy. Mortgage rates soared to above 7%, up from 3.25% at the beginning of the year; the higher rates have backed down slightly in the past couple of weeks but are still contributing to a fall in affordability. New home sales surprised to the upside in October, but existing home sales keep falling. Inventories remain tight for existing homes and much higher for new homes. Commercial real estate is also under some pressure with projects proving uneconomical at higher borrowing rates.
Consumer savings rates are down to 3.1% in September as consumers dip into savings to afford higher priced goods. Consumer credit has continued to rise at a time when credit card and borrowing rates are all up dramatically. These signs, as well as personal income that has not kept up with inflation, are ominous for the consumer. Labor markets have held up well so far but we are starting to see cracks. Fed Ex, Amazon, and many technology companies who are dependent on consumer spending are cutting costs and laying off employees. And they are doing this right before the holidays. Employment is a lagging indicator and its weakness has been shown in fewer payroll jobs each month, with October at +261,000, but household employment declined by -328,000 jobs, pushing the unemployment rate up by .2% to 3.7%.
Finally, the Treasury yield curve is now inverted at both critical points. The 10 year to 2 year Treasury spread is -.76% today and the Fed’s favorite measure, the 10 year to 3 month spread is at -.57%. An inverted yield curve is a historically reliable indicator of future recession by six to 12 months on average, although it may be much longer. In 2023, we will be there. Long-term Treasuries will be seeing the recession first and typically will decline before short-term rates, which is happening now.
NBER will declare a recession when four conditions are met: falling production, falling real personal income, falling real business sales, and rising unemployment. The first three conditions are very weak.
The Fed has acknowledged cumulative effects of rate hikes and lags in policy, but increases of nearly 400 basis points in nine months in a 2% (at best) economy cannot be good. Recession probability is now very high for 2023 and will get higher if the Fed continues to increase rates. There are signs in leading indicators, business surveys such as ISM, S&P, and Philly Fed, and actual reports that inflation is declining. Unemployment should increase slowly from layoffs, hiring freezes, and cuts in job openings.
The yield curve is inverted in both important spread measures- the 10 year-2 year and the 10 year-3 month, and history tells us that recession follows inverted curves with a lag. Government debt remains high, at $31.3 trillion currently, or 120.5% of GDP. Remember, debt levels greater than 90% put pressure on GDP, leaving it at subpar levels. GDP is about even to up slightly for 2022, after negative first and second quarters and a surprising increase of 2.6% in the third quarter with another increase possible in the current quarter. I don’t expect better growth in 2023, and I don’t think the Fed does either, but they won’t say so.
“It is worth remembering that it is often the small steps, not the giant leaps, that bring about the most lasting change.” Queen Elizabeth II
Thanks for reading! D. Jaworski 11/23/22