06.15.2022: The economy and markets are awash in uncertainty as the Fed grapples with inflation. May’s inflation report revealed that inflation accelerated, undercutting the belief that pricing pressure peaked in Q1 and would quickly abate. Now that inflation apparently has a mind of its own, investors worry that today’s environment is shaping up to be like the one Fed Chairman Paul Volcker faced in the early 1980s – a period when the Fed ratcheted up overnight rates to 20 per cent. Volcker’s single-minded focus on stamping out price acceleration took a toll on the economy and employment.
Odds are increasing that our economy is headed into recession sometime before the end of 2023. Business leaders agree: three-quarters of CEOs surveyed expect a recession by the end of next year, according to The Economist. The Fed’s “Probability of Recession Within 24 Months” spiked to over 98 per cent in May. We aren’t surprised that Google searches for “recession” have amped up to levels last seen early in the pandemic.
Unless pricing pressure magically abates, recession is increasingly likely. While this prospect is troubling, we expect the economic fallout to be manageable thanks to robust fundamentals. Today the global banking system is more stable, with nearly twice the share of capital reserved compared to the 2008 financial crisis, and better positioned to handle an economic pullback. Banks were bolstering their balance sheets with higher loan loss reserves as early as Q1.
Moreover, consumer balance sheets are strong. Household debt as a share of GDP is about 75 per cent; that’s down from 100 per cent going into the 2008 financial crisis. Household cash balances are high, including roughly $4.5 trillion in money market funds.
Notwithstanding that the average price of unleaded gasoline is now over $5/gallon nationally, the price of gasoline relative to wages is more favorable than it was in 2008. Based on gas prices, fuel efficiency and wages, the average American can drive a little more than 177 miles on an hour’s worth of work. That’s up from 107 miles in 2008.
The labor market is much healthier as well. At 3.6 per cent unemployment, today’s jobless rate is situated below the 4.3 per cent rate the Congressional Budget Office estimates as “full employment”. Moreover, there are roughly two job openings for every unemployed American. Wages are rising and jobs are plentiful.
Corporate balance sheets, however, are not as strong as those of households. That’s because easy monetary policy in place since 2009 encouraged massive corporate debt issuance. Non-financial corporate debt surged to 37 per cent of GDP by 2020 before retreating to 31 per cent, still a high number by historical standards. BBB-rated bonds, the lowest investment-grade credit quality category, now accounts for 57 per cent of the investment-grade bond market, according to The Economist. That’s up from 40 per cent as recently as 2007. Recession-inflicted downgrades could push an increasing share into “junk” status. Credit rating agency S&P is forecasting that 6 per cent of speculative-grade bonds could go into default next year. While that is shockingly higher than today’s 1.5 per cent current default rate, it’s half the 12 per cent rate witnessed in 2009. Bond investors concur. The high-yield bond market, sporting an average credit premium of about 4 per cent, implies an 8 per cent default rate at current levels.
The property market is another oasis of strength. Economists estimate America has a shortage of four million homes due to a slowdown in single-family home construction since the housing crisis. Mortgage rates at 6+ per cent will sap demand, but we expect the broader supply-demand imbalance will keep housing prices elevated.
Investors reckon the Fed will need to boost rates well above 3 per cent to quell the price spiral. The 2-year Treasury yield, a harbinger of Fed activity, at 3.4 per cent is situated at its highest level since 2007. The 10-year yield is slightly higher than its 2-year counterpart, their relationship implies slow growth ahead. Historically, every recession we’ve endured recently has been preceded by a yield-curve inversion, with the 2-year yield exceeding the 10-year yield. Right now, they’re close.
Persistent inflation is one of the biggest risks to the economy and market since, given the choice, the Fed would be forced to extinguish the house fire without regard for the upholstery. Higher rates will eventually hit consumer demand. However, critics argue that most of the blame for higher prices rests with supply constraints, such as China’s COVID lockdowns and Russia’s war against Ukraine, which are factors the Fed cannot control. We expect tighter financial conditions will weigh on middle-class households who rely on borrowing to purchase big-ticket items, like houses, cars and appliances. However, to get wealthy households to constrain spending, equity prices would probably have to decline to a point where they cry uncle.
Seven recessions have occurred since the 1970s, and each of them caused an equity market selloff. The 1980 drawdown, the mildest, saw a mere 10 per cent decline that took five months to recover. The 2008 equity market, on the other hand, lost more than 50 per cent of its value and took 54 months to claw back its losses. The “tech wreck”-induced selloff of 2001, the most protracted drawdown, suffered a 44 per cent decline that took 75 months to recover.
The post-COVID selloff of 2022 saw equities lose more than 20 per cent of their value in six months, matching the initial path of the 2001 decline. While the parallels to 2001 are striking, the circumstances in 2001 were very different. It was 1996 when then-Fed Chairman Alan Greenspan declared “irrational exuberance” was afoot, but the central bank kept rates artificially low until after the turn of the millennium because of Y2K-related fears. The 2001 equity market selloff, although sparked by recession fears, was magnified by the tragedy of 9/11 and the WorldCom and Enron scandals, two high-profile scams that undermined investors’ confidence in stocks for years. While the current odds of a recession are heightened, we at Cresset take comfort in knowing we would be entering it with a running head start.