The Fed's Challenge
By Jim Reardon | February 2023
“We need to act now, forthrightly, strongly as we have been doing. It is very important that inflation expectations remain anchored. What we hope to achieve is a period of growth below trend.” —Fed Chairman Jerome Powell
The Fed has a tough challenge ahead of them with very few options. Most of the aggregate growth in the economy was financed by massive deficit spending, credit creation, and a reduction in consumer savings. The massive debt levels provide the single most significant risk and challenge to the Federal Reserve. It explains why the Fed is desperate to return the current high inflation to low levels, even if it means weaker economic growth.
The Fed’s hiking interest rates and reducing liquidity seeks to reduce demand by increasing borrowing costs, thereby reducing inflation. The recession will likely be evidenced by a sharper increase in unemployment, and/or a downward spike in consumer spending and fixed investment (which together make up over 80 percent of nominal GDP).
Since interest rates affect payments, increases in rates negatively impact consumption. The rise and fall of stock prices have everything to do with the average American consumer. Consumers are interested in the “here and now.” To them, interest rates are a big deal. Bigger houses, televisions, computers, video games etc., all require cheaper debt to finance them. As a result, increases in interest rates divert more of their disposable incomes to service the debt. High interest rates will ultimately deter economic growth.
There have been absolutely ZERO times in history when the Federal Reserve began an interest rate hiking campaign that did not eventually lead to a recessionary outcome.
What is a Recession?
The National Bureau of Economic Research (NBER) Business Cycle Dating Committee—the official recession scorekeeper—defines a recession as “a significant decline in economic activity that is spread across the economy and that lasts more than a few months.”
NBER uses Gross Domestic Product (GDP) as a proxy for economic growth. GDP is the best single indicator we have. The chart (above) plots real GDP since 1947—not real GDP growth, but the actual output, adjusted to 2012 dollars. You can see from the generally constant angle of the log scale how long-term growth has been quite steady, although the angle flattens noticeably after 2008. Note how the shaded recession bars correspond with periods when GDP declined. That’s not coincidence. Declining GDP is recession, or at least a necessary element of it.
The fact that the NBER committee looks for a ‘significant decline’ in activity that is broad-based puts this year’s -1.6 percent rate contraction in real Gross Domestic Product (GDP) into context. Far from being a broad contraction, the most negative contributor to the negative estimates of the growth rate in 2022 was a function of inventories and a slowdown in net exports.
Bullish Market Signals Persist
Consumer spending and fixed investment (which together make up over 80 percent of nominal GDP)—grew at a 3.0 percent real annualized rate in 2022 indicating solid, above-trend growth. The fact that unemployment has held at a historically low 3.5 percent in the past four months also has an effect on the recession picture. Payroll employment grew at a 3.4 percent annualized rate. In fact, 1.1 million new jobs were created in 2022. Recessions don’t occur when economic output is rising.
The Sahm Rule
An often-cited indicator of recessions is the “Sahm rule” (named after economist Claudia Sahm). The rule maintains that a recession is likely underway when the three-month moving average of the unemployment rate rises by at least half a percentage point (50 basis points) relative to its lowest point in the previous 12 months. The Sahm Rule Recession indicator ) is -0.07. This is far below its +0.50 basis-point threshold and provides another indication that the economic expansion remains ongoing.
Trends in the data used to determine a recession are not indicating an imminent downturn in the first half of 2023, but the data is always subject to revision. There is hope that the strength of the labor market and of consumer balance sheets may help the economy transition from rapid growth to a steady and more stable output (“soft landing”).
While the bulls and the investment media focus on the monthly economic data points, such myopic observations often overlook the larger picture. For example, that strong employment report in January certainly gives the Fed plenty of reasons to continue tightening monetary policy. If its goal is to reduce inflation by slowing economic demand, job growth must reverse.
If we look closely at employment growth, it is indeed slowing. The 3-month average of employment growth has turned lower. The trend suggests that employment growth is likely to turn negative over the next several months as the chart indicates above. Despite solid payroll numbers, ZERO net full-time employment gains have occurred since last May. Temporary jobs have filled the gap and they do not support a more robust economy, so an employment downturn may be in the works.
Looking ahead, we know that the U.S., along with the rest of the global economy, faces significant headwinds:
- Earnings and forward estimates are declining.
- Inflation, while declining, is still running well above 5%, which has preceded every recession in history.
- The Federal Reserve is still hiking interest rates, albeit slower, but with no signal of rate cutes on the horizon.
- The market continues to ignore the Federal Reserve’s balance sheet reduction and cut to liquidity (QT).
- Manufacturing indexes continue to contract to recessionary levels.
- The consumer, which comprises ~70% of GDP, is beginning to struggle to make ends meet amid high inflation.
- Unemployment at very low levels has always preceded a recession and valuation contraction.
- Russian Aggression and the effect on European stability.
Stock Market Earnings Estimates Still Too High
Corporate earnings estimates at the beginning of 2023 were not reflecting a reversion to pre-pandemic trends, nor an actual economic slowdown. With that in mind, results are likely to disappoint. Operating margins, nominal revenues, and inflation-adjusted consumption were all above long-run trends and 10-year averages, and expectations are for that to continue. Just a reversion to longer-term averages would see a reduction in earnings. In addition, a continued tight labor market and higher inventories can create a drag on company margins.
The run up in the stock market we saw to start the year does not coincide with earnings expectations increasing. With stock prices rising while earnings decline and expected to continue to decline, it gives the picture that the market remains overvalued.
The Bear May Not Be Dead Yet
Instead of investors sticking with the familiar mantra of “Don’t Fight The Fed,” it is now a standoff between the bulls and the Fed. After a tough year in the markets, the hope for 2023 is that the Fed will eventually “pivot” in its monetary policy campaign and begin to ease before the end of the year. Thus, without the evidence of an imminent recession, the stock market has been experiencing a positive reflexive bounce.
While the bulls cling to historical statistics about market returns, the problem is the Fed remains clear that it will not back off its current inflation fight. Yield curves remain deeply inverted, the economic indicators remain weak, and the only support currently remains a strong jobs report.
We Don’t Pick Sides
We avoid the idea of being either “bullish” or “bearish.” Once you pick a side, you lose objectivity to what is occurring within the market.
Historical data suggests there is a high chance that the U.S. stock market may record positive returns this year after the three major indexes closed 2022 with their worst annual losses since 2008. Back-to-back negative years for the stock market are rare historically.
The chart (above) is a weekly price chart of the S&P 500. It is significant that the market cleared the 40-week moving average (blue line). The downtrend that began in February of 2022 (black line) has been broken. Both of these acted as market resistance during the entirety of 2022.
Furthermore, the October low found and held support at the 200-week moving average (red line). This line has continued to serve as a support level for the S&P 500 since the 2009 lows. Holding the red line and breaking out of the downtrend gives a much better picture for the market. Any short-term pullbacks need to hold above the downtrend line to avoid a false breakout.
Since the start of the year bullish market signals have continued to build. While it is easy to dismiss the short-term bullish signals as speculative market chasing, the intermediate picture is improving as well. Longer-term signals have also improved, but we are still waiting for some to turn positive.
The problem for investors is the dichotomy of bullish signals and bearish fundamentals. On the one hand, bullish signals are flashing. However, on the other hand, the fundamental data caution that the bear market is not dead yet. For now, short-term opportunity exists.
Not all stocks suffered in 2022. Two thirds of the stocks in the S&P 500 have prices that are above the 200 day moving average now and the prices of numerous stocks are making all-time highs. It’s a “stock picker’s market” and we have committed more resources in an effort to participate.
Recession Data is Not Reliable as a Stock Market Indicator
Because the NBER committee depends on government statistics that are reported with various information lags, it cannot officially designate a recession until after it starts.
There are plenty of reasons to be very concerned about the markets over the next few months. But it is important to remember that markets are always way out ahead of the recessionary economic data. Given the stock market is one of the leading economic indicators, we must respect the market’s action today for potentially what it may be telling us about tomorrow.
How long will the current rally of 2023 last? We have no idea. But when the fundamentals and technicals change, we will adjust accordingly.
Stay Tuned….
Jim Reardon is a financial planner and advisor, and the Chief Investment Officer for ProActive Capital Management, Inc. He has over 20 years of experience pro-actively managing assets for clients and non-profit organizations. A Certified Financial Planner™, Jim is a graduate of Kansas State University and Washburn University School of Law. He holds licenses in law and securities and was admitted to the Kansas Bar in 1973.
Certifications and Licenses: Series 7/63/66 Securities Licenses, Certified Financial Planner™ (CFP®), J.D.
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