Please enjoy this edited transcript of the UMB Private Wealth Management Investment team’s third quarter economic webinar.
Fall 2022 economic analysis
The headlines continue to be littered with inflation news and talk about the Federal Reserve’s aggressive response to inflation, threatening to send interest rates materially higher and causing some economic pain.
You may recall since March; the Fed has been increasing rates and it has slowed economic growth. Last quarter’s theme “The Great Slowdown” remains intact; however, the increased risk of a recession has rattled financial markets in the past quarter.
Due to stubborn inflation taking its time to move lower, we think the Fed will be forced to move interest rates higher and perhaps keep them higher longer in order to cool economic growth and calm inflation.
So, our theme this quarter is “Longer and Higher.” The Great Slowdown will move more likely into a short lived, mild recession sometime early next year and we think the odds that continues to grow are greater today than 50%.
Inflation and interest rates
For a decade, the Fed could not create any inflation and then all of a sudden, we have the perfect storm. We had stimulus, shortages and pent-up demand all causing inflation.
The graph below describes how we spent the better part of the decade with inflation basically flat and the experts were telling us that inflation was dead. But of course, we get the recession, supply chain disruptions and a massive wall of stimulus like we’ve never seen before. Then the economy opens back up and demand comes back online. The Fed knew that was coming and they’re actually trying to create some of that.
On the right-hand side of the chart, we see the inflation spike was more dramatic than they expected. Overall, inflation is the top dark line that you see pressed at above 9%, has come back down now to that 8-1/2% range. The Fed follows more closely the other variables that are on here, the blue and green lines, which are the core numbers without food and energy in them. Core PCE, the green line, is above 5% and it has come down also with fits and starts. In the long-term, the Fed wants that green bar across the middle there along the bottom.
Early on, the Fed suggested that a lot of the inflation will be transitory and over time they may be right, but they changed their tune a little bit. So, will some of this inflation be transitory? Yes, some of it will be and the Fed tracks actually the broad inflation index. They break it into two different subgroups, the flexible group and the sticky group.
The flexible part is that transitory part that they’re talking about, and it includes things like food and energy. They always adjust for food and energy because we know that food and energy are very volatile.
There’s a lot of other things that they have in that basket that they call “flexible” as well, things that tend to go up and down fast like car prices, travel and leisure and apparel. About half of the index is what they call “flexible,” can go way up and come way back down and they expect it to move rapidly in both directions. The other half is the half that they call “sticky,” which moves very slowly and it’s hard to move in one direction. That’s the light blue line you see on the chart below.
As you can see, the flexible group has behaved the way you would have expected—it shot way up when demand spiked and now the growth rate of these flexible variables is coming down rapidly as well. That’s what’s helping the headline numbers start to come down. Those flexible variables are dropping very quickly in their contribution to inflation.
The problem is with that sticky basket, the light blue line. It doesn’t move very much over time and stays very, very steady and then when it starts to move it stays in long cycles. The cost of housing and rent dominate the sticky half.
Overall, inflation starts to move but it’s that sticky part that’s going the wrong way and it keeps inflation from moving as far as the Fed wants it to.
When it comes to oil and energy, we know that it has the most consistent boom-bust cycle out there over time. The other one that’s really popular at this time around because it’s one that caught us all off guard was the used cars and trucks which you see in the middle of the graph. We all know there’s a shortage in labor and huge shortages on parts.
So, all of a sudden about a year ago we had used cars and trucks going up 40%, which just doesn’t happen. Used car and truck prices go down, not up. As you can see on the left-hand side of the chart, they depreciate every year. They don’t appreciate like they did for the first time ever. We know that that’s a flexible variable. It shoots up like that and as soon as some of the supply chain starts to yield, that growth rate starts to come back down rapidly which is what you see.
Now, the prices appear to still be going up from some of the broad measures but at a much slower pace. There’s even some evidence that maybe even prices are finally starting to get down to zero. So, this chart you see here may actually get back down to zero or negative which is what would normally happen with used car and truck prices.
Those top two are great examples of what’s happening inside flexible. On the bottom is that hard part that we’re talking about that’s driving the sticky component, the other half. The Fed looks at this particular variable called owners’ equivalent rent. That’s what’s embedded in their inflation numbers and very similar number, up 6-1/4% and it appears to still be climbing. So that’s working the other way and is going to be one of the things at least in the short-term keeping inflation from behaving exactly the way the Fed wants it to.
The Fed would normally behave differently than they have this time. On the chart below you see the current cycle starting from the end of the pandemic coming up to where we are now, and the blue line is the Fed’s measure of inflation that we saw on the other chart. That’s core PCE that the Fed likes to follow.
The red line is their inflation target of 2% and on the left-hand side you can see March of last year. That’s when inflation crossed above their target and in all previous cycles that’s when the Fed would have started moving. They would have gotten on the move, and they would have started steadily raising rates to try to slow that inflation trend down a little bit.
They ran an experiment this time and wanted to create a little bit more inflation and they wanted to guarantee that they will pull us out of that recession that we were in. So, they didn’t move. When we were up to 4, the Fed still didn’t move. Then up to 4-1/2 and on to 5 all the way an entire year later with their measure of inflation above 5% before the Fed made their first move. They’ve never done anything like that ever in history—they’ve never waited that long. They did it deliberately and probably in the long-term they will say that was the first policy error. They just waited too long and so they created this inflation problem that we have now.
Now that’s why on the right-hand side of the chart with the Fed rates in the dark blue line they’re having to move so quickly. They know they waited too long, and inflation is hot and it’s kind of entrenched. They know they have a real battle on their hands. That’s why they’re being so aggressive right now.
We’ve seen rates go up quickly to squash inflation, but this is the fastest because during the experiment they waited which does create some complications for them to orchestrate a soft landing.
The Fed follows something called “inflation expectations” and they deconstruct the bond market. They say they look at all the things that are out there in the Treasury inflation securities market. They look at that relative to the regular Treasury market and they do the math and say what is the bond market telling us is going to happen to inflation over the next two years, five years and ten years. That’s why the 10-year is where it is and the Fed looks very closely at the five-year numbers which is what’s on the chart here, the five-year forward expectations for inflation that are embedded in the financial market.
If you look on the right-hand side, the financial market is telling them that five years from now the most rational expectation for inflation is 2.1%, right back to their target, right back to where they want it to be. So, when the Fed looks at the tealeaf and looks at what the bond market is trying to say, the bond market is telling us this is going to work. Inflation is going to come down. In the short-term, it’s going to be a spiky problem. Over the three to five-year period of time, it’s going to get back to our target. So, the bond market is telling them they’re probably going to succeed.
Here is one of our favorite recession indicators—the six months rated change of the Leading Economic Indicator (LEI) Index, which is a bucket of 10 leading indicators: The stock market, manufacturing new orders, some credit information in the bond market, all considered leading indicators.
The six-month rated change has a perfect track record of forecasting looming recessions. You can see this goes back to 1980 on the left-hand side. The dotted red line is our trigger that when this index gets below minus 3-1/2%, you can see my red indicator circles, lo and behold it says it’s waving a red flag “Hey, get ready because a recession is coming.” You can see on the right-hand side that in the last couple of months we were getting close. Two months ago, we broke through it. Then the following month it actually improved and then the most recent reading on the far right you can see crashing through our trigger of 3.5% and ending at minus 5.3, suggesting that, yes, sometime next year we’re going to see some type of recession. So, you can see why the odds are increasing with our forecast.
Labor market
The labor market is one of the variables that is not waving even a yellow flag and could even be considered a green flag. There’s no way we’re going to see a recession with the robust labor market.
Here on the graph, you see headline unemployment. In the shaded vertical areas, are periods of recession, and what you see is unemployment starts to head up prior to recessions. As things slow down, businesses see the slowdown. They want to protect their margins and unfortunately, they start to lay off people.
Now on the right-hand side the labor market has been so robust the last reading on headline unemployment went down to 3-1/2%. It was at 3.6% for a number of months, went up to 3.7% and then just last month down to 3.5%, not indicating that a recession is looming.
On this slide you see the dark blue line is headline unemployment that we just covered. Then we overlay in light blue payroll growth, which is really good, solid number. In the indicator circles you can see that payroll growth, the light blue line, starts to come down prior to a recession and our trigger is 1%.
When payroll growth gets down to 1% and typically unemployment is on the rise, all indicator circles before the shaded areas, suggests we’re going to go in a recession.
In the far right in green, headline unemployment at 3.5% and payroll growth is still at 4%. So, you can see why the labor market is not suggesting a recession at all.
Consumer confidence
One of our last variables we look at is consumer confidence, which is important as it represents almost 70% of economic activity.
You can see starting on the left-hand side when we went through The Great Recession, confidence fell off dramatically. Look how long it took for confidence to get back to pre-crisis levels, nearly six years to get back to that level. On the right-hand side you can see prior to the pandemic, confidence was pretty good and we didn’t have much inflation. Interest rates were low, people were happy and all of a sudden COVID hit, and confidence dropped, but it never got as negative as The Great Recession. The good news is in the last month confidence picked up. One of the reasons could be because of the rally in the stock market. Now the stock market is selling off again, retesting or making new lows. We could see it had lowered, but it was interesting that last month consumers felt better about things.
Stocks lead the economy
The stock market is a leading indicator and it’s part of the LEI data. What’s interesting is when you look at the stock market down 25% year-to-date, if you just look at that leading indicator, it suggests a very high probability of a recession, much higher than 50%, if you let it stand on its own.
If you look at historical market decline around a recession, the market goes down 24%. So, when we say the market is pricing in a recession, that’s the data that verifies it. It’s important that, stock followers would argue that the stock market is the leading indicator, not a leading indicator, and this data that we graphed here supports this.
We graphed several different time periods, what the market did, which is the solid blue line, versus the economy, the dash line. What you can see is in every time period, the market bottoms prior to the economy bottoming. When you break that down from a statistical standpoint over history, typically the market bottoms four to six months prior to the economy bottoming.
So, the key takeaway is that even though the news can get very bad over the next several months, the market likely has discounted the majority of that.
Bull markets build on the back of bears
What we have graphed is bull versus bear market returns. You can see there’s some very extreme returns over the past years, some of the worst bull and some of the worst bear markets that were down 50%, with some of the best bull markets up over 400%.
Now those are extreme examples and that’s not our forecast, but this volatility for prudent investors creates opportunity. Historically, even if a recession does happen next year, the market will start discounting that already and create great opportunities.
Equity outlook
If you look at 2023, unfortunately, we think right now given the economic data that we presented here today it’s mixed. We don’t want to call for the recessionary environment of minus 15% earnings decline because there are some indicators that say we’re turning positive. So, our forecast for earnings is 0% right now for 2023.
On the first line you can see real GDP, inflation-adjusted GDP, going back to 2020 and you can clearly see our theme from last quarter that remains intact, The Great Slowdown. This year we think 1.5% GDP number and next year less than 1%.
Now you may recall that the National Bureau of Economic Research, the official dater of recessions, changed their definition of a recession. It’s no longer two consecutive quarters of negative GDP. Otherwise, we would have had it in the first half of this year. It’s rather a general broad slowdown of economic activity that lasts longer than a few months. So, you could have a recession given their definition next year and still have close to 1% GDP number for the year.
Unemployment we think right around where we are at 3.7% where we’ll end the year, starting to move up and then next year as the economy slows down perhaps enters into a recession as we talked about unemployment will creep higher to 4.2%.
2022-2023 Forecast
Fundamentals of the U.S. Economy:
| 2020 | 2021 | 2022 | 2023 | |
| Real GDP | -3.5% | 5.7% | 1.5% | 0.9% |
| Unemployment | 6.7% | 3.9% | 3.7% | 4.2% |
| Fed Funds | 0.25% | 0.25% | 4.5% | 4.75% |
| 10-Year Treasury | 1.00% | 1.51% | 4.25% | 4.00% |
| S&P 500 | 18.4% | 28.7% | (16%) – (10%) | 7%-10% |
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