Hawkish Powell steers U.S. economy closer to recession

WELREX Director John Longo shares his latest views on US markets and the economic outlook.

Our last commentary ended with the Yogi Berra quote, “It ain’t over till it’s over.” Jay Powell’s hawkish comments in an 8-minute speech on August 26^th at the Fed’s annual symposium in Jackson Hole, Wyoming is the catalyst that may result in the market retesting its lows. After clearly being behind the curve in tackling the ubiquitous inflation problem, Powell now seems determined to bring inflation down, even if it causes a U.S. or global recession. Let’s explore some of the implications.

Are We in A Recession?

There has been much debate about the official vs. unofficial definition of a recession. The rule of thumb for a recession is 2 negative quarters of GDP growth, which did indeed occur over the 2022Q1-Q2 period. Nevertheless, Q3 GDP growth, driven by pent-up summer demand, is likely to be positive, but few market analysts would suggest the recession risk is over.

The formal definition used by the National Bureau of Economic Research (NBER), the official arbiter of recessions, is more complicated. They tend to closely track 6 variables, including Nonfarm Payroll Employment, Household Survey Employment, Industrial Production, Real Personal Income Less Transfers, Real Wholesale + Retail Sales, and Real Consumer Spending. Each of these factors has increased in 2022 and the unemployment rate actually ticked down to 3.5% last month. In short, there probably won’t be an official recession until the unemployment rate goes up for a sustainable period of time, which we think will occur near the end of this year or in the first half of 2023.

3 Indicators Suggest a Recession Is Near, Others May Follow

Several widely followed indicators are flashing that a recession is in the near-term cards.  These indicators include an inverted yield curve (2-10 year U.S. Treasury Spread), the Conference Board Leading Economic Index® (which dropped for a 5^th consecutive month), and the stock market itself (the bear market that began on June 13th). There are other closely followed forward-looking indicators, such as those produced by the Institute for Supply Chain Management (ISM) that show a weakening economy, but one that still projects meager growth.

Powell Has Backed Himself Into A Corner

I think Jay Powell misspoke last month when he said the Fed Funds Rate was close to a “neutral level.” In fact, his dovish remarks were one of the main reasons for the strong rally up until his Jackson Hole speech. I think he should have said, “If inflation is under control, the 2.5% Fed Funds rate is near a neutral level.” With inflation out of control, most academic models and the futures curve suggest a neutral rate is well in excess of 4%. So, the Fed has a way to go in raising rates and a rate cut may not be seen until the back half of 2023 at the earliest. If the Fed were to cut rates before then, it runs the risk of having entrenched inflation, something we haven’t seen in the U.S. since the early 1980s. Powell is mindful of his legacy and doesn’t want to be remembered as the Arthur Burns of the 21^st Century, so he will keep tightening by shrinking the Fed’s Balance Sheet and raising rates until the inflation narrative has flipped, even if it drives the U.S. and global economy into a recession.

Stocks Can’t Sustainably Rally Until the Fed Is Almost Done

As we enter the historically volatile, September-October period, it is hard to see the stock market off to the races until we have greater clarity on the Fed’s interest rate path and improved odds of avoiding a recession. A Hail Mary pass, or path, to avoiding a recession may materialize if China’s economy noticeably accelerates and the Russia-Ukraine War ends, both low probability scenarios in our view. Our base case is that the Fed Funds Rate keeps increasing to a minimum of 4% and that the economy tips into an official recession next year.

The path of least resistance for the market is sideways to down, so we suggest maintaining a neutral to defensive investment posture, hedging some equity exposure, and including non-correlated assets in a diversified portfolio. Keeping money in Cash is better than losing money, but it is not a long-term solution as long as its yields trail that of the inflation rate. We believe equities will return to favor after the midterm elections (see table below from Edward Jones) or in 2023, but to quote William Langland, “Patience is a virtue.”

Additional Source: Edward Jones

John M. Longo, PhD, CFA
Director, WELREX Ltd