How economic myopia is leading investors astray

I found this recent CNBC interview with former Obama CEA Chair Jason Furman on June 6 rather disturbing. Furman expressed the opinion that the Fed would need to raise rates by 50 basis points before the rate hike cycle is complete, though he believed that it would skip a hike at the June FOMC meeting. 

 

 

 

While headline inflation had been falling, core CPI hadn’t made any progress for several months, which is causing concern for the Fed.

 

This prompted a discussion of the level of unemployment needed to slow inflation to acceptable levels, which Furman estimated at 4.5–5.0% (which incidentally would trigger a Sahm Rule recession alert). The question arose, “Is such a level of unemployment politically palatable?”

 

Furman equivocated by saying that’s why you have a Fed that’s insulated from political pressure, but that was the wrong answer. Both the question and the reply demonstrated a level of economic myopia that’s sure to lead investors astray.
 

 

An elongated cycle

I believe the conventional framework of thinking about the economic and stock market recovery from the 2020 lows as the start of an economic and market cycle is misguided. It has led to a debate over a long-anticipated recession which hasn’t arrived. 

 

Instead, this is an elongated cycle because of the unusual policy response to the pandemic. What Furman should have said was, “A 4.5–5.0% unemployment rate is far better than a 20% unemployment had we not implemented stimulus measures in response to the pandemic. We were looking at another Great Depression had the fiscal and monetary authorities not acted. Now we are paying the price.”
 

 

When the pandemic came out of nowhere in 2020, the global economy came to a sudden stop. China took the unprecedented step of shutting down its economy and the ripple effects were felt worldwide. Airlines stopped flying. Cruise lines stopped sailing. Restaurant sales plummeted and so did services employment.
The human costs didn’t just stop there. There was no cure or treatment. Medical practitioners followed the SARS playbook of quarantine, isolation, keeping the patient comfortable and hoping for the best. Does anyone remember the devastating effects on northern Italy, which was the wealthiest and most industrialized part of the country? When the virus first reached American stores in Washington State, the medical system couldn’t cope with the onslaught. And who could forget the bodies piling up in New York City when the morgues were overwhelmed.
 

 

 

Had major global authorities not acted, the sudden economic stop would have amounted to a slowdown of Great Depression proportions. Instead, we saw an unprecedented level of fiscal and monetary stimulus. While the programs could have been better designed with full hindsight, it was imperfect battlefield surgery designed to keep the patient alive.

 

The global economy is not paying the price of those stimulus programs in the form of unwelcome inflation. A better framework for analyzing the current cycle isn’t to view the recovery from 2020 as part of a cycle, but the start of the pandemic, recovery and monetary tightening as an unusual elongated cycle.
History doesn’t repeat itself, but rhymes. The closest analogy for the current circumstances is the double-dip recession of 1980–1980. As the accompanying chart shows, the 2-year Treasury yield, which is a proxy for rate expectations, first peaked in early 1980 and dipped. It was followed by monetary tightening that began later that year and ended with painfully high interest rates that wrung inflationary expectations out of the system. The stock market experienced an initial dip in early 1980, rallied and topped in 1981. The bear market didn’t end until August 1982, when the Mexican Peso Crisis caused the Fed to relent and ease. Investors were afforded the opportunity to buy the market at a single-digit P/E and the August 1982 low turned out to be a generational low.
 

 

 

 

The 2020–2023 cycle

Fast forward 40 years. The government and the Fed eased dramatically in the wake of the pandemic. The stock market fell but recovered, but the massive stimulus brought an unwelcome acceleration of inflation. The Fed responded with an aggressive tightening.

 

While headline inflation has subsided, core inflation, whether it’s measured using CPI or PCE, has been stubbornly sticky. Sticky inflation is a trend that was observed around the world. The Reserve Bank of Australia surprised markets by raising rates by a quarter-point and cited strong inflationary trends. The Bank of Canada followed suit a week later with a similar action and message. The U.K. surprised markets last week with stronger-than-expected wage growth, which raised expectations of further tightening.
 

That said, the progress on the inflation fight may be better than expected. Much of the stickiness in inflation rates can be attributed to the shelter component, which is a lagging indicator. Core sticky price CPI less shelter has been coming down, which is a positive sign.  However, Fed Chair Jerome Powell stated at the June FOMC press conference that the risks to inflation are to the upside. Moreover, core inflation has been flat, indicating that the Fed is focused on core inflation as a key metric over leading indicators such as core sticky CPI less shelter.
 

 

 

The Fed is also focused on its super-core inflation indicator, which is composed mostly of wages. The Atlanta Fed’s wage growth tracker shows the picture of a hot labour market. Median wage growth is moderating but it’s still very high at 6.3%. Job switchers are receiving raises of an astounding 7.5%, though the JOLTS report shows that quits are falling, which should lessen the overall effects of job switching.
 

 

Needless to say, the Fed’s job isn’t done yet. Current market expectations call for one more quarter-point rate hike in the Fed Funds rate at the July meeting, and no rate cuts until early 2024.
 

 

 

 

The soft landing mirage

The Fed’s main challenge is getting inflation down to 2%, or near 2%. Monetary policy is a blunt tool, and it’s virtually certain to induce a recession. Even though the FOMC’s official view is to navigate the economy to a soft landing, the Fed’s own staff economists are forecasting a recession to begin in Q4 2022. In the history of 13 rate hike cycles since 1955, there have only been three soft landings. In all probability, the current hiking cycle isn’t complete yet.
 

 

The soft landing narrative promoted by equity bulls doesn’t make sense. Earnings estimates are starting to rise again, but if growth were to revive it would add to inflationary pressures in an environment of elevated inflation. The Fed’s reaction would be to tighten further. That’s equity bullish?
 

 

 

The tightening cycle is global and we are seeing its effects. Jeroen Blockland recently highlighted a close correlation between Chinese producer prices and global EPS. If the relationship were to hold, an earnings recession is just around the corner.

 

 

In conclusion, investors have become overly myopic about the nature of the latest economic cycle, which should be viewed as an elongated recovery from the 2020 pandemic that’s likely to lead to a double-dip recession in the manner of 1980–1982.

 

12 thoughts on “How economic myopia is leading investors astray

  1. If rate hike expectations are overly optimistic, bonds would be more attractive here than equities a year or two out, right?

  2. A couple of interesting stats from Investech that show how weak this 20% rise to a ‘bull’ market.

    In the eighteen 20% up moves since 1932, the average time to get to that level from the low is 64 days. When markets bottom, they lift off quickly. This one now took 164 days the second slowest. And the slowest only went up another 4% before falling into a bear market in 1947.

    They show a chart with every start from the eighteen historic low points with the Small Cap Index performance. It is striking to see the current Small Cap line at about 10% up from the October low with the lowest other line up 30% and the average up over 50%.

    If this can be called a bull market, it is an extremely weak one using these metrics.

    Cam’s analogy of the early 1980’s seem right as the economy was coming off of that inflation boil of the late 1970’s with the Volker Fed determined to keep rates punishingly higher for longer to crush it. Eventually, stock markets, the economy, inflation psychology, and investor sentiment fell.

  3. My post above talks about the analogy Cam proposes of how Volker killed inflation and started a super cycle in stocks and bonds.

    Will the current Fed do the same? Key question. I see the social situation is very different. People are not willing to accept hard choices and politicians sense this and refrain from making them.

    In 2018, when the market fell about 20%, Powell pivoted from tightening to normalize interest rates even though the economy was strong.

    After the 2008 GFC, the GOP congress kept Obama deficit spending in check, so the Fed invested new ways (QE, and others) to offset any pain and spur the positive ‘Wealth Effect’.

    The Fed is raising interest rates to quell demand while the Federal government runs a 2.8% huge deficit to successfully simulate it. The Fed kept the Wealth Effect going for a decade and now the government is taking over with high spending and NO tax increases.

    In 1980, everyone was pissed about inflation and was willing to bear sone hardship to bring it down. In 2023, the home and stock owning folks that have benefited greatly from the Wealth Effect boosting both, have benefited great from inflation. If these folks have to pay five percent more on their living expenses that is maybe $5,000 a year while their home and stock portfolio goes up $100,000 or much more. Inflation, I gotta love you. Healthy upper income folks keep on spending keeping the economy stronger that expected. Unfortunately, inflation crushes the non-home and stock owners and their statistics are currently failing along with their Consumer Confidence numbers. But they are small spenders in the overall situation.

    To get inflation permanently tamed, it appears to me that there must be much pain of an ‘Anti-Wealth Effect’ of lower home and stock markets. This means lower government spending and higher taxes. There is absolutely no political will to do this by a the American political system that favors the wealthy and is heading for a key Presidential election.

    My guess is that inflation and interest rates stay higher for longer with the Fed and government (GOP or DEM) continually backing off before it is tamed. Somewhere in the future, the mathematics of debt overwhelm friendly politics.

    1. As regrettable as may it seem a money manager or trader is measured by performance against the S&P 500. Economist forecast is a dismal science no better than charlatans, astrologers and fortune tellers. We were told by all the famous economist that we would have a recession by the second quarter of 2023, Now it is pushed to the end of 2023. Sometimes one needs to appreciate the fact that the economy and the stock market do not have to be perfectly aligned i.e. There is no perfect number of months before or after a recession that a bull market starts. Labels of “a rally in a bear market” are a misnomer if the rally is 30% or more like the Nasdaq.

    2. I would add that today, no one at the Fed wants to be thought as another Arthur Burns.

    3. Powell reversed his aggressive stance on hikes quickly in late 2018.

      Based on the media reports, the Fed members today seems to be split with Powell leaning dovish. No one at the Fed may want to be thought of as Arthur Burns but they don’t want to cause 5% unemployment or trigger a major recession either. That won’t look pretty with 2024 campaign in progress and elections next year.

      The monetary policy leads the actual impact on the economy by 12-18 months. The Fed hiked to ~4% in late Dec. Let’s give it at least until early 2024 to see the real impact on the economy.

      If the Fed continues to hike, Powell’s name will enter in the same Hall of Fame as Arthur Burns’ but for the other illustrious achievements.

  4. The pandemic of 1918 was followed by a depression in 1921 which cured itself. Times were different then.
    How China survived it’s lockdown for so long, I dunno, I think some pieces are missing.
    When Volcker killed inflation the debt was nowhere near what it is now and the memory of gold had not faded completely.
    We are now so indebted to everyone. The problem as I see it is not the debt as much as “why” we got into debt. Going into debt that is persistent is not a sign of strength, so how does a weak economy fight it’s debt?
    In the 80s 90s there was a deflationary tailwind due to outsourcing. China has it’s own issues, and on-shoring is likely to be inflationary.
    Federal deficits put money into the economy which is inflationary.
    Good luck JP!
    But is there a short squeeze of some kind building? I read of a large short position but that was a month or 2 ago, and how true is that? So what the market will do is anyone’s guess after all if bad news can be good, then awful can be even better.
    My thinking is that this is a bear market, things have been distorted by the huge stimulus and money will slowly get destroyed through defaults etc.
    As more and more people feel poor and see the top 1% buying 2000$ shoes etc there will evolve a political force to tax the rich. How and when I have no idea, but at some point the poor can put whomever they want in office .
    Near term, something systemic will break and inflation be damned we have to save the system. But history shows that when rates plummet, the market does not do well.

  5. Good arguments for both Bulls and Bears. Pain trade has been for bears or defensives like me. Switching takes a leap of faith as much as economic forecasts. I am taking baby steps to move to less bearish stance.

    Inflation is still high and I firmly believe Fed will finish the job. Will it lead to recession? I am not as sure!

    1. We’ll see the full impact of Fed’s rate hikes in 2024. Commercial R/E on the coasts will likely crash just like the CRE in San Francisco. Regional banks have already tightened their lending standards. Many zombie corporations and small-and-medium size businesses won’t be able to refinance their loans or get credit. I think we’ll see a major recession next year.

      The sentiment is very bearish (Cam is not alone). Positioning is very defensive. As the Shorts are forced to cover, and investors get margin calls, while bulls plough ahead dreaming for Fed rate cuts, and soft landing, the market will climb the wall of worry and continue to go higher.

      For now, enjoy the party as the Wall Street. Just don’t be the last one to leave the party.

  6. Demanding perfection leads to procrastination and most likely inaction. There is no best time to invest. There is not a time when you have all the info. When you have all the info the game has changed and renders your info obsolete. Treat market movement as words from an oracle. If market tells you to move you do it. Simple as that. I enjoy listening to stories but that does not help my investing. Long time ago Pink Floyd already told you that. “Then 10 years have gone by and no one told you when to run. You lost the starting point.” When you lost the starting point the compounding effect in the world around you will you set you back and you can’t recover. Only price pays.

  7. Perhaps this could be an alternative interpretation of the bullish view:

    Econ/Earnings continues to grow but inflation winds down, completely sidestepping the soft landing. Turned out inflation was more directly fueled by the crypto and nft bubble instead of fiscal stimulus directly. Ie, as coins wither and die, inflation also slowly fades away while the econ grows at a more sustainable pace.

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