Note: This is a transcript of my expected July 3rd speech on H2 outlook.
Effect of COVID-related monetary and fiscal policy
The market today is still affected by the COVID-related monetary and fiscal policies, primarily via the wealth effect. Specifically, home prices are still very high, and even the stock market is near all-time highs.
As you may remember, the Fed implemented QE in 2020 and pushed real interest rates down to -1%, which inflated the housing bubble (price/rent ratio exceeded 141) as well as the stock market bubble (S&P500 PE ratio exceeded 35).
As a result, consumers today have record wealth in home equity as well as in their investment accounts. This is still keeping consumption strong and the economy growing.
In addition, consumers still have some excess savings from the COVID-related fiscal stimulus, which is also supporting consumption. These excess savings are expected to run out by the end of 2023.
Unfolding macro trends
The market today is also affected by several unfolding macro trends.
First, we are currently in an unfolding trend of de-globalization. As part of this trend, the US has implemented a stricter immigration policy, which is reducing growth in the labor force. At the same time, due to onshoring, some jobs are returning to the US, which is increasing demand for labor.
Another trend to watch is related to demographics. Specifically, baby boomers are retiring and exiting the labor force, which is also reducing labor force growth.
These two unfolding macro trends are producing a major labor shortage in the US. This labor shortage has two effects. First, the unemployment rate is low, which supports demand. But also, the labor shortage is causing higher growth in wages due to limited labor supply. The combined effect is an increase in core inflation, particularly in the service sector, which is labor-intensive. In fact, we could be facing a price-wage inflationary spiral.
The lagging effect of recent monetary policy tightening
This brings us to the most recent monetary policy tightening cycle. The Fed has acknowledged the risk of a price-wage inflationary spiral and started to tighten monetary policy in March 2022 by reducing its balance sheet (QT) and also by increasing interest rates, up to date by 5%, which is one of the sharpest monetary policy tightening cycles ever. The goal is to return core inflation to 2%.
So, the market is currently waiting for the effects of this monetary policy tightening.
- The expectation is that a higher real interest rate, which climbed to 1.5% due to QT, would cause a fall in home prices as well as stock prices and reduce consumer demand via a negative wealth effect.
- In addition, the expectation is that higher short-term interest rates would reduce consumer spending, particularly on discretionary items.
- Further, the expectation is that an inverted yield curve would cause some credit tightness, which would reduce business investment.
- As a result, the expectation is that the unemployment rate would increase as some jobs are lost, which would ease the labor shortage and consequently wage growth and ultimately bring core inflation down to 2%.
Essentially, the Fed is trying to induce a recession to bring inflation down to 2%. But monetary policy tightening operates with lags, which means that the effects of recent monetary policy tightening might not show for some time, possibly up to 12 months. So, the market is currently waiting for these lagged effects – waiting for evidence of a recession and waiting for evidence of falling core inflation.
The expected monetary policy
However, the market is also forward-looking, which means it moves based on expected data. So, the market is trying to predict the timing between lagged effects on growth and lagged effects on inflation. There are three scenarios.
- The first scenario, which is for many a baseline scenario, assumes that the economy will enter a recession, and at the same time, core inflation will also fall towards the 2% target. This would allow the Fed to cut interest rates as the recession hits, which would make the recession relatively short and shallow – this is a soft landing scenario.
- The second scenario, which is very optimistic, assumes that core inflation would fall towards the 2% target before the economy enters a recession, which would allow the Fed to cut interest rates before the actual recession and thus the economy would avoid a recession – this is a no-landing scenario.
- The third scenario, which is pessimistic, assumes that the economy will enter a recession; however, even with a recession, core inflation would still remain sticky well above the 2% target, which would force the Fed to keep hiking despite a recession and keep interest rates higher for longer despite a recession, which would make the recession much deeper and longer – this is a hard landing scenario.
Given the assumption that core inflation is elevated primarily due to labor shortage, it’s obvious that the unemployment rate must increase to restore balance in the labor market – and that’s consistent with a recession. Thus, the no-landing scenario is very unlikely.
So, it really comes down to timing. The economy could enter a recession even with full employment simply as consumption slows due to higher interest rates, but employers are still reluctant to reduce headcount. This implies that core inflation would remain elevated and sticky even in the first phase of a recession.
Thus, the Fed might have to keep monetary policy tight even in a recession until the labor market returns to balance and price-wage spiral risks disappear. This is consistent with the hard-landing scenario and higher-for-longer policy assumption. Currently, the market is pricing one additional hike in July, and subsequent pause until December 2023, with policy easing starting in January 2024.
The market scenarios
- The no-landing scenario suggests that: 1) the stock market bottomed in October 2022, and we are in a new bull market; 2) the US dollar would start falling as the Fed cuts; and 3) cyclical commodities would start rising as the new growth cycle emerges.
- The soft-landing scenario suggests that: 1) the stock market would have another downturn, possibly back to October lows; 2) the US dollar would rise or stay steady until the Fed starts cutting; and 3) cyclical commodities would continue falling.
- The hard-landing scenario suggests that: 1) there is a major downturn in the stock market forthcoming, well below October lows; 2) the US dollar would continue to rise until the Fed starts cutting; and 3) cyclical commodities would continue to fall.
Given that the Fed does not have any control over supply-side issues related to de-globalization or demographics, it can only restore balance in the labor market by inducing a recession, which might require very restrictive policy, even as the growth contracts. Thus, I view a hard landing as the most probable scenario.
The current situation can be altered by several other variables.
First, the geopolitical situation with Russia and China is very tense, and an unexpected shock can boost inflation via potential commodity price shock or supply-chain shock. This would broaden inflationary shock and require even more restrictive monetary policy.
Second, China’s economy is slowing down and many expect major fiscal stimulus in China. This, if it happens, would boost commodity prices and emerging market economies including export-oriented EU countries, also causing a lower USD. As a result, the US recession could be further delayed, but it also could likely push headline inflation higher resulting in more restrictive monetary policy.
Third, expansionary US fiscal policy could also delay a US recession resulting in more restrictive monetary policy. In both of these cases, a short-term boom would be followed by a much deeper burst given the lagged effects of even more restrictive monetary policy.
Fourth, there are liquidity issues with the Fed’s balance sheet. Specifically, the US Treasury needs to replenish the TGA account, which could cause a sudden liquidity drop and bubble busts without a recession, which could force the Fed to ease prematurely.
Finally, there is currently a “hype” in generative AI. The S&P 500 has been rising in 2023 led by seven mega-cap stocks under the AI theme. This is creating a trend-following bubble under the false pretense of a new bull market. Also, this is potentially delaying a recession due to an increase in sentiment and might force the Fed to push rates even higher as it interferes with the negative wealth effect objective to lower inflation.
Where are we currently?
Looking at the high-frequency leading indicators, based on initial claims for unemployment, the labor market is starting to weaken, although this data could be noisy due to revisions. Also, the Redbook weekly retail YoY sales are approaching 0%, which suggests that consumer spending is stalling and is likely to contract in Q3. Yet, core CPI inflation data is still expected to remain sticky above 5% over the near term.
The data supports a weakening economy with still elevated and sticky inflation. However, the stock market continues to trade based on the AI theme, ignoring fundamentals. Cyclical commodities, like copper (CPER) and oil (USO), are falling as expected, while the US dollar (UUP) is in a narrow range, as expected. Bond prices (SHY) are predicting one additional Fed hike, while the Fed is signaling at least two more hikes.
Thus, over the near term, the bond market needs to price in a more hawkish Fed policy, suggesting a 2Y yield over 5%, while the stock market needs to start pricing in a hard landing scenario – a contracting economy and a higher-for-longer Fed policy. For the S&P500 (SP500) this likely means a fall back to the October 2022 lows in the first phase, and likely further drawdown as the recession becomes obvious.