13 Aug A Deepening Recession?
“Inflation is the dragon that the Federal Reserve must slay. At what cost?” – The Lonely Realist
The anticipated recession has arrived. America has suffered two consecutive quarters of negative GDP growth, the classic definition of recession (as discussed here). If more evidence were needed, the yield curve on U.S. government debt inverted in June and hasn’t reversed – a yield curve inversion occurs when the interest rate on the 2-year US Treasury note exceeds the interest rate on the 10-year US Treasury bond. This most looked-at indicator has been at its most inverted since 2000. Since debt with a longer maturity normally carries a higher interest rate than debt with a shorter maturity, an inversion means that near-term risk is perceived as being greater than long-term risk. By this measure, America is in or soon will be in recession. That recession may get worse. Much worse. Jay Powell and company have decided to channel Paul Volker (and not Arthur Burns), committing themselves to raise interest rates until inflation cries Uncle. Unfortunately, squeezing inflation until it squeals also will squeeze America’s economy until it, too, squeals.
Inflation in America jumped 9.1% in June with July job growth exceeding 528,000 – the markets were expecting only 250,000 new jobs after an increase of 372,000 in June. Although inflation in July came in at 8.5%, lower than expected, America’s economy is running hot and the Fed has promised to raise rates again in September and thereafter to bring it down below 3%. The Fed is fearful that the Inflation Dragon of the 1970s has returned, having been resurrected by 13 years of Quantitative Easing (QE) and excessive government stimulus. America’s elected officials – both Congress and the President, believers in Modern Monetary Theory and their God-given right to be re-elected – are not interested in undertaking the task of Dragon-slaying. They’ve accordingly ceded the role of Saint George to the Fed. For good economic (and political) reasons, the Fed now has taken up the Quantitative Tightening (QT) sword and vouched to slay the Dragon … and the Fed accordingly will keep withdrawing liquidity, in part by raising interest rates, until the deed is done and the Dragon is dead. Lest anyone doubt the consequences, no economic expansion since WWII died a natural death. Each was slain by Federal Reserve interest rate hikes. Each time, the Fed’s motive was to save the economy from over-heating. Each time it succeeded …, and each time its actions brought down America’s economy.
How much damage will the Fed’s continuing QT campaign cause?
The world is in the early years of a new economic era, one radically different from its predecessor. Although there are similarities to a normal boom-and-bust cycle, this era has more critical players and more geopolitical, scientific and health uncertainties and risks.
The prior era began in the early 1990s after the fall of the Berlin Wall. America’s resulting global economic dominance embedded spreading wealth, democratization, globalization, low interest rates and persistently low inflation. Cheap international producers and the influx of cheap immigrant labor into the U.S. and Europe led to stagnant Western wages. Cheap goods from China and Southeast Asia kept a lid on prices. Living standards and GDP rose throughout the world. And cheap energy from fracking, together with Russian and Middle Eastern oil and gas production, powered the economies not only of America and Europe, but of developed and developing nations alike. It all worked wonderfully …, until it stopped, ushered in by a new era marked by nativism and protectionism with geopolitical fallout and interventionist Statism that has created volatility, economic stagnation and increasing inequality. Add to these the effects of the Ukraine War, COVID fallout and the abandonment of nuclear power in Europe and Japan (and America), and the result has been skyrocketing global food and energy prices and radically re-ordered international relationships, supply chains and labor markets. With birth rates dropping below replacement levels, reduced immigration and the withdrawal of Baby Boomers from the labor force, America’s demographic landscape also has markedly changed. The labor force participation rate among men, which used to be 88% a few short decades ago, is only 70% today. That means that there are perhaps ten million missing male workers, most of whom will not return to the labor market (many because of long COVID). That’s a key reason why the unemployment rate today is only 3.5%. The Heritage Foundation believes that “the U.S. faces massive worker shortages, particularly among young workers [that] will lead to even higher inflation … and a smaller economy that will hurt all Americans.” If correct, the consequence will be wage inflation as far as the eye can see …, leaving the Fed with little latitude.
Today’s inflationary pressures are not likely to quickly abate. As TLR noted in January, the real rate of inflation has been and remains underreported due to the understatement of the heavily-weighted Owners’ Equivalent Rent component. Year-over-year OER, which is 24% of CPI, was up 5.1% in May, 5.5% in June, and 5.7% in July. With ongoing increases in rental costs and housing prices, the OER component will continue rising. Combined with wage pressures, likely-to-increase energy costs, production shortages, deglobalization, supply chain issues, the Ukraine War, and increased China frictions, the challenges the Fed faces in stemming inflation are daunting.
Stocks nevertheless have rallied over the past 7+ weeks (the NASDAQ is up >20% from its 2022 low) with the market faithful trusting in the Fed to engineer a soft landing that will bring inflation under control and ensure that interest rates will come down by year-end. Although risks abound, there is a reasonable basis for belief in such a Goldilocks outcome (as TLR suggested here). Consumers, after all, have over $2 trillion in savings, the stock and real estate markets are sitting on a cushion of unrealized gains, most corporate balance sheets are healthy, the CPI could indeed have seen its apex in June, and the energy and other commodity markets have seen appreciable price depreciation. The excesses that were present during the dot-com and real estate bubbles of 2000 and 2008 have been largely banished, with leveraged positions and bank solvency protected by sizable levels of liquidity and capital. Moreover, the U.S. remains the center of global wealth, growth, consumption, manufacturing and industry. Finally, the Biden Administration has taken a step to address energy inflation (in addition to the recently-enacted Inflation Reduction Act) via a little-noticed policy change that will allow the government to replenish the Strategic Petroleum Reserve using forward pricing for future delivery, a much-needed step that should help to stabilize current prices and encourage domestic exploration and development.
Whether or not the Fed will succeed in fine-tuning America’s economy, a number of America’s leading investment professionals have urged a defensive investment approach in the current risk-filled environment (reminding readers that the opinions expressed in TLR are not to be treated as investment, legal or tax advice). There are way too many adverse unknowns and unknown unknowns that, should even one come to pass, could derail the most well-thought-out investment strategy. Unless the Fed already has largely tamed the Inflationary Dragon (as the markets presently believe), it will continue raising interest rates …, and the Fed never before raised rates into a yield curve inversion. It will stop only when the pain felt by labor markets, businesses, and the stock market force it to do so. Although the Fed could pause its QT campaign for political reasons prior to the November elections, that seems unlikely given inflation’s current trajectory. Moreover, even ending its current rate-raising campaign will not itself prevent stock, bond and real estate markets from weakening. With that as backdrop, keep in mind Sgt. Esterhaus’s warning to the Hill Street Blues: “Let’s be careful out there.”
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Finally (from a good friend)