Economic Monitor: Is History Repeating Itself?
BY: Mark Drachenberg
Leisure suits, bell bottoms, disco β these are only a few of the many reasons why most people are happy to leave the Seventies right where they are: in the past. Unfortunately, there are plenty of economic reasons to not want to revisit that decade, too β like volatile markets, runaway inflation, a war, an energy crisis, and political turmoil. Yet here we are, dealing with all of that, plus Covid, in 2022.
As a result, many investors are fearful and searching for answers. While we're not experiencing '70s-style stagflation (i.e., slow growth and high inflation), it's possible that some of the same strong medicine from the Fed may be necessary to get things back on course. In 1980, the Fed had to raise interest rates to 20% to combat double-digit inflation. That effort, combined with needed cuts in tax rates and spending, subsequently paved the way for an almost two-decade-long period (notwithstanding a short recession in 1990β91) of growth in the 1980s and β90s.
Are we headed to those extremes? Not likely, since our economy is still growing, and the Fed is finally taking action. But much more needs to be done to minimize the damage. There's good news to consider, like greatly improved metrics on the Covid front, a robust and expanding economy, improving labor supply and wages, and progress in easing the supply-chain crunch. Even the recent pullback in the markets is helpful, as we were long overdue for a correction that, combined with strong earnings, has allowed market valuations to come down. Letβs just hope it isnβt a dead-cat bounce!
Financial Markets
March provided some welcome relief from the pain delivered by January and February. While we did reach correction status during the first quarter, Marchβs results calmed the waters. The Dow Jones Industrial Average gained 2.49% during the month, while the S&P 500 added 3.71%. All major equity indices were in the green, which helped improve year-to-date returns. Unfortunately, the news was not so good for bonds: March was another bad month in the worst quarter for bonds in more than 40 years, with the U.S. Aggregate Bond index falling 2.78%. Some fear that the recovery in equities is just temporary and that all we are seeing is a dead-cat bounce before the red tide comes rolling in again. For now, we're happy for the respite, and with earnings still strong, equities may sustain their growth for a while longer. The sell-off in bonds may also provide some opportunities in the fixed-income markets.
Economy
Finally, it seems that Covid is beginning to retreat (*knock on wood*), and the focus is shifting from avoiding the virus at all costs to simply learning to live with it. While the data shows vast improvement in cases and deaths, the economic effects of the shutdown are still being felt two-plus years after the first lockdowns.
- Gross Domestic Product (GDP): The overall measure of our nationβs economy grew at a rate of 5.7% in 2021, including a strong 6.9% rate in the fourth quarter. Expectations are for the economy to slow in 2022 to around 3.7%. Longer-term expectations of a slowing economy have not changed, and it's still likely that it will revert to pre-Covid activity levels as early as 2023, resulting in GDP gains of only 2% to 2.5% per year.
- Inflation: February data shows the rate of inflation rose 0.8% for the month and 7.9% over the past 12 months. Clearly, this needs to be dealt with, and the Fed has finally started raining rates in response. While there are many reasons for rising inflation, the rapid increase in money supply over the past couple of years has played a leading role, alongside supply-chain issues and strong consumer demand. Energy prices were already on the way up as economic recovery gained momentum, but they've been exacerbated by government policies and the Russia-Ukraine conflict. The inflated cost of energy will be felt for some time, even if prices at the pump decline. Virtually everything we use today, in one way or another, will be impacted β from plastics, roads, and fuel, to food, clothing, and shipping. It will take some time for this to sort itself out, no matter what actions the Fed takes. While we are not yet seeing the sorts of numbers that hallmarked the Seventies, it's easy to understand why people are fearful of history repeating itself.
- Unemployment: This is one picture that's improving. The participation rate is increasing, meaning more people are back on the job or looking for work. With continued strong demand for workers, higher wages and better benefits will likely follow. How high those numbers go, however, will have an impact on growth and inflation in the long-term.
- Other: Manufacturing activity remains strong and auto sales are improving, but prices and supply remain issues. Housing supply is still a concern, and the impact of higher mortgage rates is only beginning to be felt.
Fed Watch
Last month, we discussed the expectation that the Fed would begin to raise rates. Now the focal point is on how many times the Fed will pull the trigger, and how fast. Inflation is certainly much higher than most expected, and it's proving to be stickier than expected, too. The Fed needs to raise rates faster and higher, even if it causes some short-term economic pain. It appears that it's moving in that direction, as it's expected to raise rates as often as nine times this year, including the quarter-point hike in March.
Since there are only six more meetings this year, it is safe to assume that at least two of those hikes will be for fifty basis points. Will this be enough to prevent stagflation? It's too soon to tell, but some progress is better than none. Will these steps drive us into a recession? The yield curve has inverted, as the 2-year Treasury is yielding slightly more than the 10-year Treasury, and that can be an indicator of a coming recession. But, at least for right now, the economy is growing, and a recession is avoidable if the Fed is able to usher in a soft landing.
Outlook/Summary
Bearish sentiment peaked at almost 54% in late February, as the markets sold off before dropping in March, when they recovered somewhat. Sentiment can be viewed as a contrarian indicator, where a substantial number on either side could be an indication of a peak or trough in the markets. Remember what Warren Buffett said: βIt is better to be fearful when others are greedy and greedy when others are fearful.β
Sentiment numbers will be all over the place this year, as the Fed fights inflation, the war rages on, and economic factors adjust. While this may create opportunities, we continue to focus on being diversified, but fully invested, concerned about downside risk by favoring hedged equity and floating rate funds. Energy, certain commodities, and dividend- paying stocks with strong balance sheets may prosper in this uncertain environment, and we will seek to take advantage of those as appropriate.
Bond yields are increasing, which may offer opportunities to lock in higher rates. Data shows mid-term election years are volatile, but the markets have usually recovered and moved higher within a year. We continue to monitor the Fed, the economy, and other news as we enter the second quarter, to assess their impact on portfolios. To discuss yours, please reach out to me or any member of the Wealth Management department at (608) 826-3570. We look forward to speaking with you soon!