Strategy & Positioning 

 — Steve Orr 

Era End

2020 was a year we would like to forget. Now add 2022 to the list. Such is the pain we find at the end of an era. From the 1970s forward, offshoring, global trade and lower inflation were the order of the day. Inflation finished lower each decade through the 2010s. After the 2008 Great Financial Crisis, companies began to assess the costs of globalization. Global trade volume turned lower as costs became competitive closer to home. Some this movement was aided by artificially low interest rates imposed by Central Banks. The thinking post-GFC was that economies would need stimulus in the form of base money and bank reserves to heal from the crisis. 

There will be debates and research papers for decades on how long, how much or if any stimulus was needed after 2009. Regardless, 2009 through 2021 was the Age of the Central Banker. Ramping up or down bond buying (“quantitative easing”) to add money into the banking system became the economic stimulus tool for the U.S., Europe and much of Asia. Inflation, aided by supply chain shutdowns, became a daily topic in 2021. The Consumer Price Index broke above the Fed’s desired 2% level in March of 2021 and did not peak until reaching 9% last June. Probably two-thirds of Wall Street’s population had never seen price increases that high.

TLTF²

The Fed responded a year too late, in March of last year. Its seven rate increases left overnight rates in a range of 4.25% to 4.5%. Likely the Fed will finish its rate increases by the end of this spring. We think the range may end up higher than Wall Street estimates, at 5.25% to 5.5%. Changes in short-term rates take up to a year to fully impact the economy. Most of last year’s impact will not be felt until the middle of this year at the earliest. Second-half recession odds have increased recently, and a mild recession would dovetail with yield curve inversion models that suggest a recession then. Unfortunately, we will only know if the Fed raised rates too fast or too far (TF²) if the economy enters a severe recession.

Beginning

We thought 2022 would be the year of the three and a half LIE. That is 3.5% labor employment, inflation drifting down toward 3.5% and economic growth falling by half from 2021 to the same level. The results remind us of why our forecasts are near useless. Unemployment has reached and stayed at 3.5%, inflation is still double 3.5% and 2022’s GDP growth likely will register half of 3.5%. 

The historian David Hackett Fisher described four great waves of inflation since the 1200s.¹ In each expansion, the money supply has played a key role in turbocharging economic growth but eventually leading to persistent inflation and instability. Despite the Fed’s efforts, aging demographics and higher costs of regulatory burdens here at home argue for the beginning of a new average level of inflation. 

Getting inflation down from 7% today to 4% by the end of the year will require the Fed to keep short-term rates higher for longer than Wall Street wants. We believe 4% is achievable, given the slowdown in housing and its six-month lag in the CPI. Wall Street wants more “bad news” like last Friday’s slowing wage growth number. It thinks the worse things get today, the sooner the Fed will stop raising rates. Perhaps. 

History tells us the FOMC members do not forecast; they tend to look at last month’s data. The Fed sees 200,000+ new jobs in December and an average monthly gain of 305,000 since June. No recession there. Leading indicators such as the yield curve, new orders, building permits and consumer expectations all point to slowdown in the coming months. What if economists threw a recession and the economy did not come? Earnings falling a few percent and flat GDP growth in the middle of the year would not necessarily register as a recession in the NBER’s framework.

Effects

Stock charts through Thursday indicated that a lot of traders either were on vacation or just did not care. Indices traded sideways for twelve straight days in an impressive show of nothing. Friday’s lower wage growth jolted the “bad news is good” crowd into lowering interest rates and driving stocks higher. Two percent gains across the board helped all U.S. indices register weekly gains to start the year. The S&P 500 managed to eke out a small, unsatisfying Santa Rally of 0.8%. 

Barring interesting news over the weekend, the first five days of January may conclude today with positive returns. Our handy Stock Trader’s Almanac tells us that the last 47 times a positive first five days was followed by a full year of gains 39 times. That is an 83%-win rate. Gains were in the low double digits on average. In pre-election years like 2023, 13 of the last 18 years followed the direction of the first five days. Bear cycles recover at the beginning of slowdowns, but recession Bears rarely bottom before a recession starts. An interesting fact is that no recession has started in the first half of a pre-election year. 

¹The Great Wave: Price Revolutions and the Rhythm of History, David Hackett Fischer, Oxford University Press