October 4, 2022
The roil that has defined markets this year continued during the third quarter. Asset prices rose broadly through July into mid-August, sparking hopes that an end was in sight for the bear market in stocks and bonds. A fanciful narrative fueled the summer rally: Inflation will abate enough to allow the Federal Reserve to slow raising interest rates, thereby averting a recession. In short, the story held the central bank would navigate the economy to a soft landing. The problem with such a neatly constructed narrative is that it is an exercise in hope over experience. In investing, as with most things, hope is not a strategy.
This narrative flies in the face of reality, as it essentially asserts that the Fed will avoid a policy mistake by overtightening and pushing the economy into recession. From our perch, any Fed action taken is to correct the policy mistake made last year when it failed to realize that the inflation so clearly before it was anything but transitory. Yet this narrative focuses on the avoidance of recession when the economy has already registered two consecutive quarters of shrinking gross domestic product — a pattern that by convention defines recession. Upon closer examination, the criteria used by the arbiter of recessions, the National Bureau of Economic Research (NBER) reveals an economy not in immediate danger of a major contraction. Rather, it appears to remain in relatively good health.
NBER peers through a wide lens to determine whether the economy is in recession or not. The committee measures economic declines through consideration of depth, diffusion, and duration. It evaluates these features by examining real personal income less transfers, household and establishment (business) measures of employment, real personal consumption expenditures, wholesale and retail sales adjusted for price changes, and industrial production. It also uses gross domestic product and gross domestic income (two data sets that measure the same thing: economic output) to set business cycle peaks and troughs.1
Surveying the data reveals that the economy does not appear to be in recession despite the declines in GDP during the first two quarters. Employment, whether measured through household or establishment surveys, continues to grow. Personal income also continues to advance, as does the spending it enables. Industrial production remains in fine fettle. The only indication of problems appears in wholesale-retail sales, which have been contracting of late. Even here, the severity of the contraction is not at levels associated with recession. (Exhibit A)
Another important data set is the comparison of gross domestic product (GDP) with gross domestic income (GDI). These two measures should be equal as they attempt to measure the same thing: economic activity. GDP tallies from the expenditure side of the ledger while GDI measures from the income side. Since someone’s expenditure equals another’s income, the two should be “conceptually equal.” However, they are rarely actually equal due to timing differences, coverage differences, and sampling errors in the data. Importantly, despite these measurement challenges, these different measurement techniques tend to correlate exceptionally well.2 Unlike GDP, GDI has not contracted this year, although the most recent readings show almost no growth. (Exhibit B)
And why is all this important?
Pondering criteria set by a quango calling the tops and bottoms in business cycles is hardly the stuff of riveting conversation. However, understanding how economists measure economic activity is important in order to gain a line of sight into how central bankers will react to the statistical landscape before them. Monetary chieftains facing problematic inflation will alter their approach to a growing versus shrinking economy. Moreover, no central banker wants to commit the cardinal sin of letting inflation get out of control. History treats these bankers unkindly. Policy pivots that involve slowing interest rate increases in the face of enduring growth-driven inflation are difficult to pull off successfully. To be sure, the growth present and inflation’s persistence militates against the Goldilocks and soft-landing narratives that are succor to investors of late.
The look of normal
The market commentariat contemplation of the price of money has the air of a Victorian parlor game. It is entertaining but not helpful. Indeed, the Federal Reserve itself discusses the conditions and the targets it hopes to achieve but fails to articulate money’s ideal relationship to prices.
I placed voice to this oddity during a recent Bloomberg Television interview. Ahead of me was the Bank of England chief economist. He related that money should have a real price that reflects the real growth in an economy. It is rare to hear a central banker make such a straightforward articulation of how normal should look. Noticing his comments, I reiterated them and offered that central bankers should adopt a policy of “talking less and saying more” as the BoE’s chief economist just demonstrated.3
The question before investors remains: Where will inflation settle? Market-based measures indicate investors believe inflation will fall to roughly 2.6% in five years’ time, from the current 8%. Indeed, they expect a quick resolution, as two-year breakevens are 2.46%.4
Whether inflation can fall enough to meet expectations or not remains an open question. An aging labor market, slow population growth, low productivity growth, de-globalization, and wars of the hot and cold varieties will make the return difficult. Mr. Market is, as ever, an optimistic sort. The consequences of disappointing market expectations are severe.
In our Q3 Market Outlook, we cautioned to be on guard for a bear market rally. These rallies can easily be mistaken for the pivot from a bear to a bull market and are cruel as they draw investors in on the hope of better days only to shatter those hopes as losses resume. The summer increase of 14% in U.S. large- and mid-cap stocks from mid-July to mid-August exhibited the features of such a rally.5
The time and difficulty required to arrest inflation appear to be repricing in markets. This reality appears to be displacing the prevailing Goldilocks narrative, leading to the resumption of the bear market. Conditions could worsen as another similarly sized one in December follows the recent 75 bps rise in the Federal Funds Rate.
The harrying of asset prices from rising interest rates extends beyond stocks and bonds. Gold has suffered as real interest rates have moved higher. Even prices of recent digital confections, such as Bitcoin, have fallen as a reconsideration of their usefulness as an inflation hedge has unfolded. Worryingly, reports are emerging about the loan syndication market, where deal financing is struggling, which leaves banks sporting sizeable losses on debt that fails to sell at profitable prices. The drop in asset prices in the public markets is rolling into private markets as reports of “down round” financings emerge. Failure to complete deal financing represents an elemental risk in the private market ecosystem.
Natural gas prices are up 79% this year and inflation is running at 8%.6,7 As interest rates rise and the economies of Europe reel from energy shortages that hobble commercial activity, it is hard to see how they can avoid falling into recession. (Exhibit D)
Anticipating a reversal of the summer rally in share prices and fearing the worst in Europe, we continued to reduce equity exposure and raise cash during the quarter. This follows the risk reduction made in March, though this time we focused on our international developed market exposure. While equity market valuations in Europe remain reasonable, indeed attractive, uncertainty driven by war and policy makes reducing exposure to Europe prudent. We left our U.S. exposures untouched since the Federal Reserve’s policy response to higher inflation appears to be ahead of the European Central Bank’s efforts at policy normalization.
Rising interest rates intersecting with falling inflation will eventually create profitable opportunities for the cash raised this year. Now, corporate credit in both investment grade and high yield varieties are beginning to look attractive. The roil present in markets of late will surely continue as the reality facing investors replaces the narrative of hope.
For those who embrace the Goldilocks narrative of finding the “just right” it is worth remembering that in pursuit of that ideal, Goldilocks broke into the bears’ house, ate their food, broke their furniture, and messed up their beds only to flee into the forest never to be seen again.
The Fed and investors should take note.
1 National Bureau of Economic Research, Business Cycle Dating
2 Bureau of Economic Analysis, “Why do gross domestic product (GDP) and gross domestic income (GDI) differ, and what does that imply?” The difference between these measures is called the statistical discrepancy. On an annual basis, the correlation between GDP and GDI is 0.97, which is an extremely high level of correlation.
3 Bloomberg interview August 5, 2022
4 Breakeven inflation is calculated by subtracting the real yield of an inflation-linked bond from the yield of the closest nominal treasury of a similar maturity. Data via Bloomberg.
5 Based on the Russell 1000 Index
6 Bloomberg, New York Mercantile Exchange, Natural Gas Active Contracts
7 Bloomberg, U.S. Bureau of Labor Statistics, Consumer Price Index, All Urban Consumers, NSA