The Fed shifts to “pause”
Growth slows with inflation
Consumers and jobs continue to power subdued growth
Money supply is in contraction
Written by Philip Rich, Chief Investment Officer, on May 30, 2023.
Leading economic indicators, an inverted yield curve, and a contracting money supply all indicate that a recession is coming. And yet consumer spending remains strong, hiring continues, and unemployment is at historically low levels. The Conference Board’s Leading Economic Index was down 0.6% in April and is now down almost 9% since its peak in late 2022. This type of downturn in the leading index has proven to be a reliable indicator of an impending recession. At this writing, the 10-year Treasury yield is over 50 basis points below the two-year yield, an inversion that has proven both deep and persistent. Inverted yield curves are a classic precursor to recessions. The money supply, measured by M2, has contracted over 3% so far this year and is down over 4.5% over the past twelve months. This is the first sustained contraction in the money supply in US history, so it is difficult to predict the extent and timing of its impact, but if expansions in the money supply can stimulate growth, contractions should operate to tamp down demand, growth, and inflation. Annual growth in the money supply peaked at 27% in February of 2021, driven by the COVID stimulus payments. Contraction in the money supply may prove to be a powerful antidote to inflation, but since we have limited experience with it, its precise effects and time lags are unknown.
Personal consumption (PCE) expanded 2.52% in the first quarter; however, much of that was concentrated in January. Corporate profits were down 5.1%, continuing a trend from the prior two quarters. Corporate profits are now down year-over-year.
At the same time, retail sales were up 0.4% (MOM) in April, payrolls rose by 253,000, and unemployment remained at the historically low level of 3.4%. Real GDP increased 1.3% in the first quarter of 2023, according to the second estimate, but that does represent a deceleration from the pace achieved in the back half of 2022. Sales were “up” 1.6% YOY in April but would be negative 3.2% if adjusted for inflation.
If it seems like every bit of economic data contradicts the prior read, it is because, like crosscurrents at slack tide, economic indicators are often mixed at turning points. However, taken together, the most reliable indicators show that the economy is gradually slowing down. The prudent course for investors and decision-makers would be to prepare for a recession, although the hoped-for soft landing remains a possible outcome.
Payrolls rose 253,000 in April, and unemployment held steady at 3.4%. The addition to payrolls was solidly positive and consistent with results seen since the beginning of the year. Hourly earnings were up 4.4% YOY. The tight labor market and wage inflation have been focal points for the Fed. Although these numbers have come down from their peaks, the labor market remains a source of strength in the economy and, therefore, a contributor to inflationary pressures. There has been some evidence of softening in the labor markets, in initial jobless claims, hours worked, and wages paid, but it is too slight and too tentative to constitute a deflationary trend so far.
The “all items” CPI index came in at 4.9% for the 12 months ending in April. This was the smallest 12-month increase in the broad inflation measure in two years. Declines in energy prices contributed greatly to the moderation in the all-items index; however, gasoline was actually up in April. Food was unchanged for April, as it was in March. The “core” index (all items less food and energy) has not retreated by as much and appears somewhat stuck in the 5.5%- 5.6% range. Shelter, used cars and trucks, insurance, recreation, and personal care all rose in April. Airline fares and new vehicles declined. Inflation is moderating and is well down from its peak at 9.1%, but core inflation remains well above the Federal Reserve’s 2% target.
The “easy” part of the inflation battle may be behind us. What remains—the “stickier” parts of inflation—may prove more difficult to tame. Unfortunately, the kind of demand destruction we associate with recessions provides a certain and powerful antidote to all types of inflation. It remains to be seen whether, with the benefit of time, the combined antidotes of higher rates and tighter money can, by themselves, bring inflation back under control.
The FOMC met on May 2 and 3 and raised their target for overnight rates by 0.25% to an upper bound of 5.25%. However, the big news that day was that the Fed, in both their press release and in the Chair’s press conference, telegraphed the message that they may “pause” any future rate increases until (and unless) additional economic data indicates that more are needed to combat persistent inflation. Regaining control over inflation involves both the scope of the interest rate increases and the amount of time they are allowed to operate on the economy. The Fed will continue to reduce its bond holdings, which has the effect of reducing liquidity (money supply) in the economy at a rate of $95 billion per month.
The S&P 500 stands at 4,205 at this writing, having started the year at 3,853. The index has been caught in a bit of a range lately, between 3,855 and 4200. It may not break out to the upside until it is supported by profit growth. It may not break out to the downside unless the US enters a recession. If the Fed is finished with rate increases, that should clear one important obstacle to the market finding new highs. However, if inflation proves tougher to tame, and more rate increases are required, downside pressures will persist. The price/earnings ratio of the S&P 500 is around 24, well down from recent peaks, but also significantly above its long-term average of 15. So, stocks aren’t cheap relative to earnings, but they’re not perilously high either.
At 4205, the S&P 500 is up over 9% compared to the start of the year. However, this index, like so many others, is cap-weighted, meaning that the most valuable companies by market capitalization have an outsized influence on its moves. Since the start of 2023, the seven largest technology stocks have accounted for the vast majority of the index’s appreciation. The remaining 493 stocks in the index are only up about 1%, as a group.
Almost the entire length of the yield curve for Treasuries is inverted, with the peak in rates occurring at the very near end. There is some positive slope from the 10-year out to 30 years, but the extent of the inversion is quite remarkable. The bond market is quite persuaded that the Fed will be forced to cut rates in the latter half of this year in order to stave off a recession. If inflation proves more durable, other outcomes are certainly possible. Some analysts believe that rates may have to go all the way to 7% in order to quell persistent inflation, but they are in the minority. It is certainly also possible that rates will have to stay higher for longer than the bond market indicates in order for inflation to return to the 2% target.
While short-term rates are more attractive than they have been in many years, fixed- income investors with longer horizons may want to consider positions in quality intermediate bonds. Although intermediate rates may be lower than short-term rates, they may also prove more persistent in the event that rates do come down over the coming year.
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This information is for informational purposes only and does not constitute investment advice. Sources:
GDP – Bureau of Economic Analysis
Employment & Inflation – Bureau of Labor Statistics
Interest Rates – Federal Reserve
P/E S&P 500 – multpl.com
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