(Au)our Monthly Newsletter
Will the Federal Reserve continue to fight inflation if the economy tanks? Will the Fed pivot to lessen the downturn in the investment markets even if inflation stays above its target? How high do interest rates need to go before inflation subsides? Is this an actual recession or just a technical recession? What is a technical recession?The above are questions that have been asked of us and others. We will attempt to answer them very quickly.We think so. We don’t think so unless it gets awful. Some models suggest north of 5%, but no one knows. Not yet, but some things are pointing to it coming. Supposedly, it is two consecutive negative quarters.An old saying is that a recession is when your neighbor is out of a job, and a depression is when you and your neighbor are out of a job. Neither exists at this point. Recessions are called after the fact as economic numbers are revised long after time has passed. Political players came about the idea of a technical recession to help their side versus the other. It’s a useless term, much like most that come from politicians’ mouths {editorial comment}.Whether it is labeled a recession or something else means little. The number of people employed, the income they derive from employment, and their propensity to spend so that others remain employed. Those are the items that matter.Labeling a particular quarter or two as a recessionary period is also meaningless for investors. It is an unwelcome distraction. Investments typically are best bought during a recession—not once it passes and definitely not at the start of one. The desire to call the beginning or end of an economic downturn produces a fog that detracts from the critical aspects of investing—do the expected investment returns justify the risks?We see risks as high for the economy and asset prices. Interest rates are currently priced to drop in 2023, suggesting that investment market participants expect the Fed to complete its tightening process before year-end. For that to be true, we would need to see inflation drop dramatically soon or the Fed to prioritize asset prices over dollar stability. Two comments from Chairman Powell have us thinking the market may be too complacent.Chairman Powell: “We understand better how little we understand inflation.”Chairman Powell: “We can’t fail on that task [price stability]. We have to get back to 2 percent inflation.”Our take is that he doesn’t trust the models his team has been using to estimate inflation and that he will not be the Fed chairman that goes down in history, causing a currency debasement. The relief rally we now see seems precarious and ripe for adjustment if inflation does not trend materially lower over the coming months.We are monitoring historical relationships with inflation to help guide our expectations for interest rates. We will let pictures tell the story.
The growth of money in the system (in green above) has strong predictive power in estimating inflation (in blue above). That correlation weakened at the turn of the century. Recent data suggests the linkage is not dead. Money growth over the past two years came from fiscal and monetary stimuli. Those impulses are being worked off, but the impact may linger. How long is unknown, but if old relationships hold, we could experience higher than trend inflation for several years.
The Fed worries about the wage-price spiral. Inflation can become a longer-term issue if employers need to adjust wages to compensate. Higher wages beget higher corporate costs. The need to offset those costs through higher prices can start an undesired spiral. The Fed has stated its concern that inflation influences wage dynamics and expressed its desire to correct it before it gets out of control. There is a strong relationship between wage growth (in blue above) and job openings (in green above). The Fed intends to reduce demand enough to reduce job openings without impacting those with jobs. They are walking a fine line to slow the economy just enough to lessen the need for employees without taking the economy into a recession.
Inflation, as depicted above, is not yet showing much deceleration. As the Fed has mentioned that the data will drive its view of future interest rate movements, we need to see a material change in direction before we should hope for a kinder and gentler Fed.Some market commentators are predicting we have seen the worst inflation and that the aggressive Fed (to date) has done enough to ease pricing pressures. The data does not quickly draw one to that conclusion. There is a disparity that we cannot explain. Market expectations suggest that the Fed will accomplish its goal of taming inflation by year-end which will allow for lower rates in 2023. But the historical linkages between inflation and wage growth and money growth suggest more time and effort will be needed.We wish for a soft landing and an economy that will smoothly adjust to a new normal for interest rates but expecting it seems imprudent. Our aim of minimizing drawdowns while lowering the impact of market gyrations during uncertain times argues that we continue our defensive posturing. Our models acknowledge the recent momentum in asset prices but also respect the disruption in credit markets that have traditionally been a better intermediate-term predictor of investment returns.
Best regards,The Auour Investments Team
IMPORTANT DISCLOSURES