Well, we’re not off to a good start this year and there’s been no place to hide. The first half of the year U.S. equities are off approximately 20%, foreign and international equities off 19%, bonds down 10% and even real estate is off 20% in the first half.
Financial markets posted worst return for the first six months of the year in over 50 years. And of course, this was due to turmoil, our theme from last quarter. We have military conflict, supply chain disruptions and shortages – they’re all leading to spiking inflation. And of course, the Fed is combating inflation by hiking interest rates.
So, our theme this quarter is the great slowdown. We have The Great Recession in 2008-2009. We have The Great Moderation from 2010 to 2019 with moderate growth during that period. Right now, we’re in the middle of a Great Resignation and of course we are now starting the great slowdown.
This great slowdown will more than likely morph into a short-lived, mild recession sooner than we anticipated perhaps end of this year or early next year. We’re at about a 50% chance of that happening and there are many economic variables that are suggesting a slowdown and perhaps a mild recession sooner than most had forecasted.
Inflation is front and center. Everyone is hearing about it every day and you’re seeing and feeling its impact. Our lives have gotten 8.6% more expensive from last year to this year. And that’s a really big number, about a 40-year high on inflation and it moved up very rapidly. It was the speed of which it accelerated that’s really called the Fed’s attention and got the Fed moving because the Fed’s target for all these inflation variables is down. They want inflation in aggregate to be somewhere in the 2% to 2-1/2% range. The Fed has to take action and try to do something about it and that’s the whirlwind we’re stuck in right now.
We’re all aware you filled up your tank and it cost you $110, and you went to the grocery store and it cost you an extra $100 last month. That gets consumers’ attention. Consumers are nervous about inflation and they’re aware of what’s happening, and inflation expectation has spiked.
Now the average consumer doesn’t expect inflation to be 6% or 7% or 8% but they do expect it to be higher than what they thought and well above 3% over the next few years. And when consumers get worried about that, they start to change their behavior. So, from a longer-term perspective, the markets are telling us that the inflation story is going to be okay. Shorter term, consumers are worried about it and The Fed is worried about it. Longer-term, it looks like it’s going to work itself out. So, there’s short-term bad news and maybe some longer-term good news in this whole story.
Energy cycle booms and busts
The Fed likes to look at core inflation which would be ex-volatile components like food and energy. And we know those cycles with those very volatile inflation variables are still intact.
So, we looked at West Texas Intermediate crude prices, the oil prices starting in 2006. What we know with energy it has the most consistent boom-bust cycle. And what’s difficult is it’s difficult to forecast the duration of each cycle. But these cycles have been intact for decades and we don’t believe that they’re about to change. Before The Great Recession in 2007, oil was at about $50 a barrel. By mid-2008 it spiked to $140 a barrel. Yet by the end of 2008 it was down to $40 a barrel. And these boom-bust cycles we’ve seen over and over again. Remember not so long ago they were paying us to store oil, right? Oil was priced at a negative number which is clearly an anomaly. But very quickly it went from virtually $0 to $125 a barrel. As of this month, we’re at $99 a barrel.
So, low and behold the cycles continue. We just don’t know the duration. But we do feel that because of destruction of demand as oil prices go up maybe we don’t take a long driving vacation or things like that and we use less energy. Then of course prices come down.
The Fed and interest rates
So, at this time we did talk a lot about how every economic cycle has some similarities. Every economic cycle has its own set of nuances. When it comes to interest rate, inflation and the Fed, clearly this cycle is going to be nuance. Typically, the Fed starts early, and inflation keeps moving as they move along and then they can start easing sooner too when they handle it that way. But this time it’s a lot different. You go back 75 years the last 13 cycles on average the Fed has started to increase rates when inflation simply got to 2-1/2%. If it got to 2-1/2 and it was on the way up, the Fed usually starts moving and they start much earlier.
The Fed told us for a while they were going to let it overshoot. It was an experiment. You call an experiment on these calls a bunch of times in the past. They definitely were running the experiment this time. They’re not – they decided they were not going to react at 2-1/2 like they used to. They were going to let it overshoot and let it overshoot for a while because it had been pretty low for a while. So, they’ve waited much, much longer this time and that kind of changes the dynamics of how this whole cycle is going to play out now. The next phase normally the Fed is cutting when inflation has – is still rising. It’s moved up from 2-1/2.
So, they tend to start cutting rates when inflation is pretty high and sometimes even still moving up perhaps. This time it’s unlikely it’s going to play out just that way as well. And one of the things to keep in mind is they can move pretty quickly. If you go back into history, the median time between when they make their last increase to executing their first cut is typically only four months because they tend to move pretty aggressively. They get up there and they start to see the numbers change and within four months, they’ve started to take rates back the other way. We’ll see if it plays out this time.
Now, we’ll look at some economic data and see what signals we’re getting on the great slowdown and if we’ll see a looming recession at the end of the year or into 2023. First, we’ll discuss the financial conditions. And what’s interesting is this is an index of just the level of financial stress in markets which looks at credit, housing market, valuations, interest rates and more. When it’s a positive number, you can see up there the conditions are good and are favorable for business. And when they’re negative, the conditions are poor.
Given our reaction to the global pandemic, massive stimulus flooding the market with liquidity, we had virtually zero interest rates and virtually no inflation. That is very attractive financial conditions. Financial conditions have obviously come down, but it’s not a negative environment. When you look at the level we’re at today, it’s really consistent with the second half of the longest expansion we’ve seen in the U.S. from 2017 to 2019. Financial conditions were right at that level. So, even though it’ll probably come down some with our forecast if interest rates continue to rise and the Fed continue to try to fight inflation, we’re still at a decent level for financial conditions which is good for business.
We still have very low unemployment and decent job growth and job openings. So even though it’s coming down, you can see we’re still at a relatively decent level especially when you compare it to coming out of The Great Recession, we’re substantially higher than where we were. But remember one of the things that we like to do – and we talked about it numerous times – is when you forecast the economy and before you can see the picture it’s like a jigsaw puzzle. You got to put a few pieces together before you can truly see the picture at hand.
So, think about what’s happened over the past year. We have termination of stimulus programs and incomes and transfer payments were down. You’ve had spiking inflation not only at the gas pump where a lot of your income went, food prices, et cetera. So, if you’re asked the question about your household finances, you’re probably very concerned. But both these indexes are headed down. So, as you put the pieces in the puzzle together, it starts to suggest that you’re going to see the great slowdown. And as they continue to go down, it starts to suggest that you have a looming recession probably at the end of the year or into early 2023.
The labor market suggests we’re not in a recession. Typically, you see the unemployment rate go up months before a recession. And that should be intuitive as businesses are going to protect their margin. They see the slowdown. One of the things they can do, which is not fun, is lay off people. But you haven’t seen that in the broad numbers. We’re still at 3.6% and we’ve been kind of stuck there.
The other good news is there’s another unemployment indicator we look at called the U-6 which is the government code. U-6 is the underemployment rate where they’re marginally attached. Those are people that are overqualified for a job and they’re looking for a better job, but they can’t quite find it just yet, and that has come down to 6.7%. So, the unemployment rate says we’re not in a recession and the unemployment data says maybe we’re not in store for a recession this year. Another variable that supports that is payroll growth. Again, what happens is typically this number goes down prior to a recession, when it starts to get down to 1% payroll growth, we start to worry and that’s kind of a yellow flag indicating a potential recession.
We also like to look at our manufacturing data as we put the pieces of the puzzle together. Indexes above 50 tells you the economy is expanding and below 50 tells you it’s contracting. You can start to see when you study this chart prior to a recession the manufacturing data starts to weaken. And the red arrow in the far right on the top pane, you can see manufacturing slow down albeit we started coming out of the global pandemic we reached record highs. But we’re still at 53 as of the June reading.
But inside the manufacturing data you have multiple components. So, one of the components that we’ve identified as the most leading indicator is the New Order Index. On the right-hand side you can see my red arrow there, the middle pane, it unfortunately broke the 50 number. So, this indicator starts waving the yellow flag that it looks like we’re headed for a recession. That’s why our odds are at 50% for a recession towards the end of the year or into 2023.
Now another positive indicator is the bottom pane. After we look at the manufacturing data, we also like to look at the non-manufacturing data or the service data. And if you think about it, because the global pandemic kind of clouded some of our data where services were shut down. The only thing we could do was buy goods from Amazon or whatever the case might be. We couldn’t go to the movies, baseball games or a cruise. But there is some evidence that we’re moving from goods to services as services open up.
People are doing revenge travel. They haven’t been on vacation with their family for two years and they’re willing to pay the prices of high airline ticket prices and hotels because of pent-up demand. But on the bottom pane on the right-hand side, yes, it continues to come down, but it remains at a very elevated level 55.3. So, it’s a little bit of mixed data. We’re watching that new orders very carefully, which is waving the yellow flag, but the other data point suggests that maybe the Fed will orchestrate that soft landing. Meaning they’ll increase rates, brush inflation and yet we’ll not send the economy into a recession.
Stocks lead the economy
It’s really no secret that the S&P 500 has just wrapped up one of the worst halves it’s had in the over 50 years and it finished down 20% through June. So, there’s an old expression that said, “The market gets the news first.” If you put another way, you can say that stocks tend to lead the economy.
To help explain what I mean, the charts on the screen show six of the last major business cycle downturns. What we’re charting during each of these cycles is the S&P 500 Index which is marked by the dark blue line. And then you have the U.S. GDP which is marked by the light blue dotted line. Now what you’re going to notice in every single time period is that a similar pattern has emerged. Equity markets decline first. The economy then worsens a few months later. Then finally equity market bottoms while the economy was still getting worse.
History doesn’t necessarily always repeat itself, but it certainly does appear that the same trend could be happening again today. We’ve got the S&P 500 already falling more than 20% year-to-date while the U.S. has only experienced one quarter so far of negative GDP growth.
So last quarter, there’s nowhere to hide. Everything from stocks and bonds, the copper and gold, it all holds off together. This everything sells off that we saw is incredibly rare. It’s only happened one other time in the last 50 years and that was actually back in 1981, which is one of the reasons that we keep coming back to this time period. The good news is we slightly already experienced a lot of losses. So, while most of the damage is already done, the sharp move higher it may not be imminent, but we do think what this chart does is it really helps show that there is opportunity knocking.
One of the concerns we hear out there is earnings. Of course, we just entered second quarter earnings season this week and we have a feeling that in all of these corporate conference calls CEOs are going to be talking about our theme, the great slowdown. One of the things that we’re watching is we still see positive earnings growth because when we talk to a lot of businesses, CEOs, business owners, we found that most companies had pricing power. They were able to increase prices. So as inputs go down in price, and there are some reductions in inflationary pressures, that should protect their margins.
We’ve already mentioned the boom-bust nature of the energy cycle earlier but a lot of these other commodities they’ve really shown similar patterns. Copper is a global indicator for manufacturing especially in places like China. You know, you’ve already seen it dropped 20% over the last couple of months. You can also look at natural gas. It’s plummeted near 40%. Lumber is also seeing similar moves where it’s down more than 50% from just a few months prior.
What does this mean in terms of equity is all of these do help show a potential relief in terms of inflationary concerns. So, these lower commodity prices they should really help ease the margin pressures. For example, margin compression, what we mean is profit margin contracting even when overall sales rise. It’s really a big threat right now to corporate earnings. It’s typically a very difficult thing to avoid during periods of intense inflation.
The good news is that as we’ve seen oil, as we’ve seen some of these other commodities that we list here continue to drop over the past weeks, it’s really helped ease some of these margin concerns and fears that the market has brought up.
It’s been a rough year, down 10% so far this year which has been awful for total return. Historically and virtually every cycle the ten-year peaks near the peak in the Fed funds rate in both level and oftentimes in timing. It peaks around or typically a little bit above the peak in the Fed funds rate. That’s important to tell us what we might expect this time. Even though rates have come down a little bit lately, we would say probably not past the peak in rates. We should expect the ten-year to probably start to move back up and peak a little bit later in that 3-1/2 to 3.75 range.
So, are we most of the way there? Yes. Is most of the damage behind us? Yes, but it’s probably too early to call the peak though.
2022-2023 economic forecast
Fundamentals of the U.S. Economy:
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