Threading the Needle: The Fed Faces a Formidable Challenge

David Lundgren, CFA®
June 21, 2022

Last week the Fed announced a 0.75% increase to the Federal Funds rate as heightened inflation continues to plague markets, businesses, and consumers. One could argue the beginnings of our current inflation problem dates back to early 2020 as the pandemic warranted extraordinary government and central bank actions to prevent financial collapse. These policy decisions that led to a couple of years of historically low interest rates and trillions of dollars pumped into the economy by central banks and governments across the globe are now contributing factors to our new inflation problem. And for clarity, the policy decisions at the time were needed and beneficial, but the magnitude and the time in which the stimulus lasted is the more likely culprit.

 

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To complicate things further, Russia’s invasion of Ukraine, policies that continue to hamper energy production and refining capacity, and lingering COVID related supply chain disruptions have resulted in inflation in the U.S. reaching levels not experienced in over 40 years. So now the Fed must reverse course as they face the tricky challenge of restraining inflation without the sending the economy into recession.

While we do see a plausible path for the Fed to engineer the so-called soft landing successful outcome they seek, the possibility of being unsuccessful on both fronts, with an undesirable "stagflationary" outcome, is a growing concern. And, obviously, markets have reacted to this new environment in unsettling ways as both stocks and bond markets are off to one of the worst starts to a calendar year in history.

Concerns about the future are heightened and questions from investors are numerous. The Hancock Whitney Asset Management team discusses recent market developments and provides some perspective on some of the more pressing issues facing investors today.

 

Is the U.S. economy headed into a recession?

A recession is a temporary period of economic contraction generally defined by a fall in GDP for two consecutive quarters. (There is debate in economic circles regarding this definition but we will spare our readers of this wonky discussion.) After a very healthy economic rebound from depths of the first half of 2020, 2022 started off a bit shaky as the economy in the U.S. contracted at a 1.5% annual rate primarily as a function of inventory drawdowns and net exports. At the time we weren’t overly concerned, as both consumer and manufacturing spending remained relatively strong and we felt like the chance of recession in the next 12 months was minimal. Fast forward a few months and the data is becoming a little more concerning. And we aren’t alone in this assessment. According to the Wall Street Journal, economists have dramatically raised the probability of recession, now putting it at 44% in the next 12 months, a level usually seen only on the brink of or during actual recessions. Paul Teten, CFA®, Hancock Whitney Asset Management Chief Investment Strategist, recently commented on this topic:

Disappointing retail sales report for May aggravated the uneasiness about the economy and brought a palpable whiff of recession. Residential construction indicators recently released pointed to the likelihood that the housing sector is already in recession. And the best news of late is that industrial production in May was only mildly disappointing, and while the factory sector is moderating, it remains very healthy and a bedrock of stability in the U.S. economy. For all the cross-currents and intensified recession concerns, our assessment remains that the U.S. is not likely to see a surprise contraction in economic growth this quarter, but risks have risen to the point of a probable recession next year, possibly a mild one. However, the most marked change in our assessment is that recession risks for the second half of this year have risen from our month-end appraisal of 30% to 40% and rising.

 

Will inflation slow?

Consumers don’t need to be students of economic indicators to know that prices have increased. We see and feel inflation every day at the gas station, grocery, and restaurants. And it isn’t just consumers. While businesses have the ability to pass on increased costs, they continue to struggle to keep up with higher costs of inputs including wages. With the unemployment rate near all-time lows (not normally a sign of an economy on the verge of recession), workers are demanding higher pay which further exacerbates an already challenging inflation environment. Arguably, the inflation report at the end of May was the main catalyst for the Fed’s recent more aggressive policy stance and also the starting point for yet another drawdown for both stock and bond prices. The most recent Consumer Price Index growth rate hit a new cycle high at 8.6% through May, after a head-fake down-tick to 8.3% in April. This report dashed hopes for continuing signs of peaking inflation with an unexpectedly large 1.0% increase in May. Paul Teten comments further:

The CPI Y/Y rate of 8.6% growth is the highest since 1982. The May disappointment is largely an after-shock of the Russian invasion of Ukraine, which has disrupted food and energy prices, together accounting for 22% of the CPI and rising 1.2% and 3.9% respectively in May. Apart from food and energy prices, the Fed’s preferred measure of underlying inflation trends, the personal consumption expenditure deflator, excluding food and energy prices (Core PCED), is showing a pattern of peaking inflation trends. With its Q/Q annual rate of 4.5%, below the Y/Y of 4.9%, the Core PCED trends strongly suggest the probability of lower inflation readings ahead. And while consumer surveys show that year-ahead CPI expectations have risen, the implication in those surveys is that the CPI Y/Y rate is expected to begin a steady deceleration in the months ahead.

 

How does the stock market perform going forward?

Recent headlines have likely caused worry and second guessing among many investors. And, as discussed, there is no shortage of items causing concern as many market indices have started the year off down more than 20%. Martin Sirera, CFA®, Hancock Whitney Asset Management Director of Equities comments on the current market environment:

While consumers in the U.S. have the capacity to draw down savings in order to continue to propel personal spending higher, the significantly higher costs of core necessities is crowding out spending on other things. Equity markets are reflecting this as perhaps the major source of concern as it threatens top line sales for corporations. The next concern is of course related to inflation as well: higher input costs which potentially negatively impact corporate profit margins. Soaring inflation has thus become a huge impediment for future aggregate growth, which is the underlying message from 2022’s falling stock prices. And of course, messy politics both abroad and at home are not conducive to happy and robust markets. 

More from Martin Sirera on expectations for stock prices going forward:

Excessive gloom among equity investors can be and usually is a meaningful contrarian indicator. When attitudes have been depressed the most in the past, markets have generally found a bottom and begun meaningful rallies. However, with inflation accelerating in a manner not experienced since the mid-1970’s, the current macro situation is somewhat unusual in nature and so normally reliable indicators like investor sentiment have to be considered in the context of the higher degree of uncertainty plaguing market psychology at the present time. Equity markets, which have seen volatility steadily trend upward since last September, are likely to continue to experience elevated volatility until more clarity on the fight against inflation front emerges.

 

Will interest rates continue to rise?

In 2020 as the pandemic was beginning, the Federal Reserve (Fed) took extraordinary measures to prevent economies from slipping further and/or deeper into recession. As a result, overnight interest rates dropped to near zero while longer term rates also declined to at or near all-time lows. Fast forward a couple years as pandemic restrictions eased and the U.S. has started to ‘return to normal’, so too has the Fed. The expectation is that the Fed will continue to raise rates for the rest of 2022 and may raise the Federal Funds rate another 0.75% at their next meeting in July. Jeff Tanguis, Hancock Whitney Asset Management Director of Fixed Income, discusses the recent move from the Fed and what to expect moving forward:

The Federal Reserve policy committee met and responded to the recent red hot May CPI inflation report with an aggressive 75 basis point (0.75%) rate hike to 1.60%. The move was the largest since 1994 and signaled stepped-up Fed concerns that long term inflation expectations among consumers were in danger of becoming unmoored. Chairman Powell provided forward guidance that both 50 and 75 basis point increases are on the table for the July meeting. Market expectations currently anticipate a combination of 50 and 75 bps hikes lifting the fed funds rate by roughly 2 percentage points to 3.60% by yearend 2022. Longer term market forecasts see the funds rate peaking at approximately 3.70% to 3.80% by late summer of 2023.

 

While longer term yields definitely react to changes in Fed policy, other factors such as expected long-term growth and inflation also influence the movement of rates. In fact, the longer the maturity, the less influence Fed rate decisions may have on market yields. Longer term rates have moved significantly upward so far in 2022 as U.S. Treasuries with maturities of 2 years or more are now yielding more than 3%. While short-term interest rates (1 year or less) are clearly moving up for the rest of 2022 as the Fed is expected to continue to raise rates, longer term rates are very likely to continue to drift higher, but at a more modest rate of change.

 

Solid financial advice and insights are always important, but especially during times of financial turbulence. The Hancock Whitney Asset Management team is ready to provide insights that can help you reach your financial goals. 

 

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