My Thoughts on Macroeconomic Conditions
Before I share my own thoughts and opinions, here is a brief and simple summary of where the markets and economy are at in the middle of 2022. As a precursor, I don't recommend relying on anyone's economic predictions to make investments. It is an unreliable method of investing and gets investors in trouble trying to time the market. Instead, use macroeconomic-based selloffs as an opportunity to assess risk-reward in the market and find companies that have good long-term prospects. Regardless, fear is so pervasive in today's market that I will attempt to neutralize some of that fear below.
Through the first half of 2022, equity and bond markets saw their worst performance since the Great Depression. In simpler terms, the stock market declined roughly 25% from its highs, with most stocks falling way more than that. Bonds also sold off heavily as interest rates rose across the board (bond prices and rates move inversely). Although I haven’t been around the market for too long, the sell-off was one of the most vicious ever, especially for growth and technology stocks. This was because of the Federal Reserve’s response in the battle against inflation and excess liquidity. After finally acknowledging that inflation was a problem towards the end of 2021, they announced that they would combat it by tightening financial conditions by raising interest rates and selling bonds and mortgage-backed securities off the fed’s balance sheet. The primary goal was to slow the economy and drain some liquidity out, which are the ordinary tools used by the Fed to fight inflation. The con is that these tightening measures generally increase unemployment and slow economic growth.
As just a basic backdrop, interest rates affect the stock market for two primary reasons. The first is that higher interest rates lead to lower valuation multiples (ex: lower price-to-earnings or price-to-sales ratios) because of discounted-cash-flow analysis. Secondly, the actual earnings of most companies are generally hurt by rising rates since the rise in interest rates slows the economy down (causing decline in revenue) and makes it more expensive to borrow money. While this is a lengthy topic, having these two main points in mind will make it easier to understand my opinion later on.
From the end of 2021 through Spring of 2022, the fed’s tone became increasingly more hawkish (which means they are taking things more seriously to fight inflation and will tighten financial conditions more aggressively). This was happening simultaneously with months where CPI (one common measure of inflation) was printing record numbers not seen in decades, approaching 9%+.
The job market has remained strong with unemployment near record lows. Earnings have also not disappointed much through the second quarter with some companies beating expectations and others missing slightly. Home prices have not fallen much, at least in some areas of the country, with higher interest rates making purchasing a home prohibitively expensive.
With so much angst and uncertainty among the investing community, many investors have been fear-mongered out of the market. There is so much going on and so much noise out there, that it’s hard to zoom out of the moment and think without emotion. We have reached extremely bearish sentiment on many fronts including equity markets (stocks), recession, inflation, interest rates, and more.
Below, I will give my take on the economy and what I see within the next year or two. As the greatest investors of all time such as Warren Buffet always say, trying to predict what will happen with the economy is a fool’s errand. HOWEVER, positioning, whether bullish or bearish, sometimes gets so extreme that one can make pretty common-sense conclusions about where it will lead or how sentiment might change drastically in the near future if underlying economic conditions slightly change. This creates enticing risk-reward opportunities for patient investors. Additionally, I will talk about why I think some of the yapping and chitter-chatter on Wall Street is unwarranted, dangerous, and based on misguided information.
To summarize, my opinions are that i) the problem of inflation is behind us, ii) the Fed is trying to do too much too late, iii) the Fed will likely overshoot its tightening/rate hikes and send the economy into a recession unnecessarily, iv) inflation in 2022 is unique and cannot be looked at through a historical lens, v) we will see inflation rapidly decline, and vi) the fed will be forced to pivot hard (but this will likely be too late given their track record of being behind the curve and succumbing to public pressure). While most people are focused on the short-term headline inflation readings being atrocious, the conversation is a lot more nuanced than that and requires serious thought. I think the Fed is as mistaken in their late and aggressive tightening as they were missing inflation early on. However, so far, they have not indicated any intention of slowing down and have doubled down on their hawkish stance. While our economy at the moment is still pretty strong, that is no excuse for the Fed to send it into a rapid decline.
Below are several distinct points to consider on a macroeconomic level, which when taken together, paint a picture of slowing inflation or deflation and an economy which is unnecessarily being put at risk.
CPI Is a Lagging Indicator:
The Consumer Price Index is the most commonly used measure of inflation. It has many components such as oil & gas, shelter, food, transportation services, new/used cars, and medical services. However, in my relatively short experience, I have realized that CPI is a lagging indicator that doesn’t reflect what is actually happening ‘on the ground.’ Many well-known investors and economists also acknowledge that CPI is a lagging indicator. The Fed uses core CPI and core PCE as well, but these also don’t tell the updated picture of what real people are experiencing.
The nitty gritty economics and data gathering is a complicated subject which I have not researched much; therefore, my observations will be mostly anecdotal and based on personal experience. For example, throughout 2020, it was VERY noticeable that everything was getting expensive. From watches to homes to trading cards to luxury goods to basic necessities, ordinary individuals noticed the tremendous price increases that took place in those months. Inflation was almost certainly imbedded in the economy but did not show up meaningfully in CPI readings until the beginning of 2021.
In the past few months, we have seen considerable declines in asset values (like stocks) which by itself slow spending by individuals who see their retirement accounts shrink. It seems like a lot of stimulus money and surplus has dried up as well. In my opinion, we have seen carnage that has and will continue to put a dent in demand. Although it is starting to show slowly in July/August CPI readings, I think the full impact of the Fed’s tightening and extreme damage to financial markets will seep through to the CPI number in the final months of 2022. (Just as a reminder, it is important to look at month-over-month data and not year-over-year, as that gives a better picture of the current trend of inflation). The reasons for this decline are discussed further below. Many people can say with a certainty though that many items have started to decline in price, especially collectibles and luxury goods such as watches which were the first to spike in price in 2020 before inflation showed up in the data – perhaps this is an early indication of the opposite occurring.
Also, the stickiest part of inflation and the largest contributor to higher CPI readings has been rising shelter/living costs. The way these are calculated includes smoothing mechanisms and complicated calculations that include outdated rent levels. Many sources and data point towards a meaningful decline in the cost of shelter within the past few months as rates have skyrocketed. CPI likely won't capture the decline in rents and home values for several months, leading to elevated readings.
These observations are to be taken with a grain of salt and are my own personal opinions. If it’s worth anything, I think the Fed is aggressively tightening/raising rates into a borderline deflationary environment, one that is dangerous and could show up in the data soon. I’m not sure why they rely on data/statistics which prove time and time again to be outdated, but that’s what we have to deal with and be concerned about.
Major Damage Has Already Been Dealt – Commodities and Assets PUMMELED:
One of the Fed’s goals in its fight against inflation is hurting asset values such as stocks, bonds, real estate, and commodities. By raising rates and draining liquidity, these assets generally decline in value. In turn, people’s net worth goes down, there is less money to spend, and there is more fear among consumers – this causes demand to slow down, with the hope that it leads to a decline in inflation.
Since the Fed’s fight against inflation began in November 2021, a MAJOR amount of damage has already been done. Thus, any further action by the Fed warrants serious concern and inquiry. Stocks and bonds have suffered their worst bear market in decades. A typical 60/40 stock/bond portfolio has had its worst start to a year since The Great Depression (1931). Even though the broad stock indices (S&P 500, Nasdaq) are down about 20%, the damage is much worse beneath the surface. These indices look inflated due to the outperformance of a select few companies relative to the rest of the stock market, most notably Apple, and defensive sectors like healthcare. The average stock is probably down 40%+ within the last few months, with many down way more than 50%. Some of the biggest companies in the world trade like penny stocks because of the uncertainty. In addition, there has been a relentless selling in bond yields, with treasury yields surging to levels not seen since 2007. We haven’t seen volatility in the treasury markets like this for many years, if at all.
Even commodity prices, such as oil, gas, wheat, lumber, and corn have absolutely plummeted from their highs in the midst of the Fed’s tightening and rate hikes. Such declines in commodities are generally indicators of a recession. Oil has been in the headlines with gasoline prices soaring, but even the price of oil has fallen about 40% from its peak in 2022. While food and oil prices have been the most volatile and major part of inflation, the prices of these are not really in the Fed’s control. First off, food and gasoline are essentials for people, and thus tightening financial conditions likely won’t affect how much they spend on food and gas. Second, these were significantly impacted by the war in Ukraine because of food and oil shortages. The Fed tightening and raising rates will probably not be the difference-maker when it comes to food and oil – thus they are throwing punches at the wrong parts of the economy causing unnecessary harm. Recently, food and oil prices have significantly fallen however, making the Fed’s job easier and giving them a red carpet to slowing down their rate hikes. However, the Fed has ignored this freebie. If we get a resolution in Ukraine/Russia, that might place further downward pressure on the prices of commodities, adding to deflationary pressures.
These declines mean that some of the primary sources of inflation have already subsided in a significant manner. It is only a matter of time before these trickle into significant price decreases throughout the economy. As for real estate prices, these take a bit more time to fall but prices have already started to decline on a national level, with supply increasing and buyers reluctant/unable to afford payments. Although some stronger markets are immune, many areas across the country are also experiencing declines in rent – this is corroborated by many industry experts who work on the ground (aka brokers, developers, etc.).
The reason it is important to acknowledge this massacre in asset prices is that many families and businesses are reliant on the stability of income and wealth generating assets, whether it is to fund retirement, pay for a child’s education, or expand one’s small business. The Fed has very quickly and viciously accomplished its goal of destroying wealth in its fight against inflation and should refrain from deliberately causing further damage to tame a beast (inflation) that is already bleeding dry.
Inflation Mainly a Supply-Side Problem Now:
Generally speaking, inflation is caused by a demand-supply imbalance. Too little supply or too much demand causes a rise in prices. We saw both of these components as the economy reopened after COVID. However, in my view, demand is pretty much normalized now and supply-side issues have been the core driver of this demand-supply problem. The reason this matters is because the Fed’s tools and policies are geared towards destroying demand by essentially hurting the economy and consumers, not fixing supply chains.
I think demand destruction is an unnecessary, dangerous, and late solution to our inflation problem. Instead, supply-chain issues have slowly started to ease and we should allow those problems to heal and seep through to the consumer through price decreases. I think it is way more important to protect jobs and people’s livelihood than it is to forcibly and aggressively tackle a wound that is already healing on its own.
While supply-chain problems still remain, companies have said that they are improving. I imagine that companies will be more motivated to fix these problems because they were probably not incentivized to do so in 2020/2021 when they could charge, for example, double for a Rolex or Range Rover. They could earn high margins on lower volume without the headache of having to solve supply-side problems to bring costs down. Now, with ordinary peoples’ surplus liquidity dried up and prices for tangible goods coming down significantly, margins start to shrink for companies that are unwilling to fix their supply-side problems. In simpler terms, companies can’t just charge $$$ up the a*s and ignore supply chain problems as decreasing manufacturing costs matters now.
The Fed’s tightening measures don’t help supply-side problems and might make it more difficult for cash-constrained companies to invest in their supply-chain. Many companies are conservative on spending due to recession risk, or reluctant to raise capital to improve operations because of its higher rates. Higher rates also likely lead to less construction for new homes, meaning less supply of new homes which is a primary concern in many parts of the country. In theory, the Fed should look at conditions on the ground (which indicate easing supply-chain problems) and make an informed decision based on many factors, not just look at a couple of data points which are likely outdated.
However, as I will mention throughout the article, the Fed will have to act in its ordinary binary fashion, tightening until something breaks. The public scrutiny around inflation is too much for them to take the risk of prolonging the fight and leaving it in the hands of the private sector, even though that is the solution least damaging to our overall economy.
If I had to analogize the Fed’s mistake, the best I could come up with is the following. Imagine a person suffering a wound that needs to be stitched up, cleaned, and taken care of. (The wound is analogous to inflation). What they are currently doing is picking up anything they can get their hands on instantaneously such as hay, string, or super glue (you get the point) that will close the wound on the spot, but will likely lead to problems later on such as infection, scars, etc. Instead, a better alternative would be putting pressure on the wound until they can get to a first aid kid to properly sew it shut and disinfect. A little bit of patience saves a lot of headache and pain later on.
YoY Comparisons:
This is a basic concept but many people don’t think about it much. Headline CPI numbers are based on year-over-year comparisons. Month-over-month CPI is much more important as it shows how much inflation has risen in the past month. Year-over-year comparisons can be misleading if comparing to periods of unusually low inflation, such as those in 2020. Month-over-month increases have been substantial in 2022, showing that inflation is prevalent in recent months. However, when you get into 2023, headlines are going to be comparing YoY numbers to 2022, which are very high comps. Thus, 2023 headline CPI numbers are likely to be very low if not negative. This is because this headline YoY number in 2023 will be compared to unusually high levels of inflation in 2022. Just some fruit for thought that maybe the markets will view these low headline numbers as a positive even if month-over-month stays somewhat flat. That can be a near-term catalyst for markets and also take some public pressure off of the Fed, perhaps allowing them to back off on their fight against inflation. Even if we don’t have deflation, if YoY inflation in 2023 is in the 1s or 2s, which is very possible, that could be a signal that the extreme inflation we saw in 2022 was due to a shock to financial markets that occurred during the COVID stimulus period, and is thus not a systematic problem within America (this topic is discussed further below).
Companies Signal Inventory Surplus and Impending Price Decreases:
Some of the most up-to-date and accurate information on what is actually happening in the economy on a day-to-day basis comes from businesses. Many large companies such as big box retailers and food companies have signaled that they intend to or have already decreased prices meaningfully. They have also said that they have significant inventory surpluses (ex: Target). Price decreases and excess surplus are obviously anti-inflationary and probably pervasive throughout many industries. In addition, freight prices have dramatically fallen, which only builds upon the impending price decreases that companies have signaled. These cannot be ignored and will probably show up in CPI data relatively soon.
Lower Income Wage Growth and Inflation:
If you really think about it, moderate inflation shouldn’t harm American consumers if their wages grow at the same pace or more. While real wages on average have declined over the last year (salary increases have not exceeded inflation rate), this is largely due to the lack of wage increases for higher income individuals. Lower income individuals have actually seen a larger increase in wage growth (ex: people working in food-service industry) than higher income individuals, which exceeded the headline rate of inflation. The people who are most sensitive to price increases given their low income received higher wage increases in 2020 and 2021, negating/offsetting some of the harmful effects of inflation. Higher earners have some cushion to take the blow of lower real wages. While this is a minor nuanced point, it is worth thinking about because inflation is viewed as a treacherous evil which is destroying households. While high inflation is most certainly not a positive thing, the harm it did to lower income earners was not as bad as it probably seems or is advertised.
Why does this matter? It doesn’t really, at least as far as what action the Fed will take. As far as practical reasoning, it means inflation isn’t doing as much damage as people might think to most of the people who are most at financial risk, and thus fighting inflation should not come at the expense of harming the economy to the point where these lower income individuals might lose their jobs. (As discussed later, a potential recession will be more of a white-collar recession with higher paid tech employees being laid off rather than low-income service workers – however, the risk to those lower-income earners can increase depending on the severity of the recession and the Fed’s persistence.)
‘Cumulative’/Systematic Inflation
This section is in response to those who say that we have had easy monetary policy for far too long and that prolonged easy monetary policy is harmful. The primary concern is that assets are artificially inflated because of Fed policy and that leads to more widespread inflation. My response is that easy monetary policy is generally good for the economy and does not necessarily lead to uncontrollable inflation. We have had fairly accommodative monetary policy since 2010 (except in 2018), so let’s zoom out from 2022 a bit and look at the past decade.
Let’s look at cumulative inflation since 2012. From January 2012 until August 2022, the cumulative (or compounded) inflation rate has been 2.4% annually. Given the fed’s long-term policy rate of 2% annually, this isn’t too far off, especially considering the record-high inflation prints we had this year. BUT, let’s look at the cumulative rate of inflation from 2012 to 2020, a period of time that still had easy monetary conditions but did not have the extreme quantitative easing needed during COVID. From January 2012 to January 2020, the rate of inflation in America was just 1.5% annually, well below the 2% long-term target the Fed has always had! This low rate of inflation was during a time of easy economic policy with the Fed keeping rates low and adding to their balance sheet. I don’t think inflation is a systematic problem that is now embedded in the American economy, but rather a one-time shock caused by COVID-era monetary policy. This statistical evidence is just a simple way of showing that you can have easy monetary policy conditions without experiencing rapid inflation. Why so? Because easy monetary conditions drive innovation and productivity which offsets the threat of inflationary pressures (discussed in further detail below).
I think a healthy amount of quantitative easing is an essential part of job growth, productivity, and innovation which drives the American economy. Low rates allow companies to raise money cheaply, invest that money into research and development, hire employees, pay their employees well, and create the technologies of the future. Additionally, innovation and capital expenditures tend to lower costs for businesses, which allows them to charge less for their products – this is anti-inflationary. Therefore, quantitative easing should not be an evil that spawns inflation and drowns the country with debt. Instead, it should be viewed more favorably as an accelerant to business growth that pays for itself over the long-haul due to an increase in productivity.
Restrictive monetary policy is not good for the long-term trajectory of the economy and should be viewed with extreme skepticism. It’s true that 2020-2022 were very peculiar times where COVID caused EXTREME quantitative easing to keep the economy alive. If COVID did not happen, I don’t think many people would be criticizing the last decade of easy monetary policy. Under both Obama and Trump, we had a decade of continuously declining unemployment and steadily growing GDP with low levels of inflation. That is why the Fed must not be blinded by a very unusual two years (2020-2022) of extreme policy measures in considering whether to go back to an easy monetary policy in the years and decades to come (after this bout of inflation is tamed, which I think will be quite soon).
Quick, Massive Shocks Rather than Systematic Problem:
I disagree with many economists and historians which compare the current economic/inflationary environment to prior periods. In my view, we live in a unique economic environment never experienced before. The cause is pretty self-explanatory – COVID causing an abrupt shutdown of the world economy and policymakers having to jumpstart it back up. All of this happened in a matter of two years. The two years from early 2020 through the middle of 2022 were a series of shocks for markets, causing sharp changes in economic environments that coincidentally had nothing to do with underlying financial distress. The slowdown was caused by COVID and the rapid acceleration and eventual inflation was caused by Fed monetary policy. In this short period, we saw our economy come to a halt and global supply chains shut down; just a year after, we go from 0 economic activity into an overheating economy with rampant inflation. This huge swing in circumstances was clearly caused by the Fed’s drastic and extreme quantitative easing and near-zero rates, which to their credit, saved our economy back in 2020. Just as the economy went from a screeching halt to a full sprint, the Fed’s sharp turnaround in policy in the other direction (raising rates/tightening) will likely reverse the sudden intense spike in inflation caused by them and the reopening.
This period of rapidly accelerating inflation seems in a way to be artificially injected rather than a systematic and prolonged problem with our economy. This period of inflation was due to the intensity and speed at which world events transpired and how the Fed reacted to them. Therefore, I think it is much easier to solve a self-inflicted wound by reversing the same policy which caused it, rather than inflation in other time periods and countries which had underlying and prolonged sources. In simpler terms, if the Fed could cause a rise in inflation within one year in the most stagnant economic environment ever by injecting liquidity and raising rates (2020 COVID), I think the reversal in this policy will heal the wound rather quickly and drain out the unwanted excess which kept our economy alive during uncertain times. The problem with the Fed’s current plan is an unwarranted, rapid, and aggressive reversal into already weakening conditions.
Public Pressure on the Fed:
I’m pretty sure Fed officials are not nearly as clueless as I or others make them out to be. They probably understand that the data they use is outdated and that perhaps a more conservative approach to fighting inflation might be the most prudent solution. However, the entire country has their sights on the Fed and inflation. News networks cannot stop talking about it, politicians are raving on about price increases, and ordinary people chatter about it all day long. Although the Fed is supposed to be an independent organization from the government, free from political influence, Fed officials are still ordinary people who don’t enjoy criticism. They have been forced to take an aggressive stance against inflation because of headline CPI numbers, signaling to the public that they will do whatever it takes to defeat this evil. This is the kind of tone many were looking for in the short-term, even though it could lead to consequences much worse than a couple years of elevated inflation. Thus, perhaps Powell and other Fed officials are pressured to follow the headline data so that in the small chance of any hiccups, their legacy is not entirely shattered because they “did what they were supposed to.” They are essentially barred from exercising their own judgment about the future and must follow outdated data to please the public/politicians who are ignorant of economic consequences.
Many influential investors who are short the market also go on CNBC and social media pressuring Powell to slam the breaks on the economy to tame inflation, when deep down they probably know the dominos have already started to fall. Public pressure is a dangerous yet unavoidable obstacle in the way of sound monetary policy, where experienced Fed officials are held back from tackling their objectives in slow and nimble ways. (As another example, they were probably pressured to keep rates near zero and flood liquidity into the system to support the post-COVID recovery until inflation actually showed up in headline YoY CPI data, when the pubic would likely shift its attention to inflation worries instead of economic growth).
One Major Difference Between 1970s and Now:
The following is a topic I have thought about on my own and have not spent time researching at all. I’m not sure how much merit it has in the field of economics but it’s just some fruit for thought. As a brief background, the 1970s is the most comparable era to current inflationary pressures when it comes to magnitude. It took many years for the Fed to tame inflation back then and it had to take drastic measures such as raising rates to double digits.
Another response I have to those who look to the 1970s for guidance on how inflation will be tamed in 2022 (in addition to the reasons mentioned in the prior section about quick shocks) is that we live in a much more connected, efficient, and competitive environment which solves the problem of inflation much better than before. Perhaps this is why we did not experience high inflation for many years before COVID despite easy monetary policy. Below are some aspects of our current economy to think about before comparing to other times.
1) We live in a time of innovation where software and automation are constantly driving prices down by lowering costs for manufacturers. There are multi-billion dollar software companies whose business model is built upon lowering costs for its enterprise customers.
2) We live in a well-connected world with instantaneous data. Price decreases are likely to trickle down from suppliers to the end-consumer much quicker than a few decades ago. I’m sure the largest companies have sophisticated algorithms and software to price their products based on consumer data, supply costs, and softening economic conditions. Price changes can be made with very little notice as communication between corporate and retail stores is instantaneous. Thus, inflation should theoretically come down a lot quicker now than prior to the internet/cloud revolution.
3) Pricing competition among companies is much more intense nowadays. Every company has their products listed online. Consumers are able to compare prices almost instantaneously between competitors, whether it is manually or through a third-party website/software. This does not allow companies much leeway to raise prices when conditions change. Once the first domino falls in an inflationary environment and consumers weaken, companies must quickly adjust and drop prices to stay competitive or risk losing customers. Unlike now, 50 years ago people purchased items in stores and did not have the capability of comparing prices unless they went store to store. This likely allowed companies to be greedy in inflationary environments and scalp higher prices until things got really bad. We don’t have that problem today, allowing for quicker and more efficient price changes.
For the reasons mentioned above, perhaps inflation in the modern era is not as sticky and hard to solve as before. Other than this ‘adrenaline’ that was injected into our economic system to save it, there seem to be many anti-inflationary forces at work due to innovation in the past decade. Perhaps once this ‘adrenaline’ is quickly drained out by the Fed (which has likely already occurred), the magic of the American economy can go back to work and stabilize financial conditions without the need for a Fed-induced slaughter.
(As a side note that is relevant to this section, I disagree that moderate quantitative easing in general is bad policy and that it just creates 'free money' without worthwhile benefits. In simple terms, my view is that QE takes money from less efficient sources (government), and gives it to people who will make more productive use of it (private companies/innovators). While more liquidity can inflate asset prices such as stocks by expanding multiples, the larger view picture is that it drives innovation by providing the ample capital required to do so. The effects of 'printing money' get significantly offset by the remarkable productive capability of the US economy and the amazing entrepreneurs that we have. I wasn't an economy major nor do I have professional experience in the field, so this is just the hamster wheels turning in my head.)
Employment and Recession:
The labor market has shown incredible strength in the past two years, with demand for workers far exceeding the supply. This imbalance causes wage inflation, leading companies to raise prices on consumers to pay for the increased cost of labor. Unemployment has been historically low the past year and this has given the Fed runway to slow down the economy as they believe the strong labor market is an indication that the economy can endure excessive tightening and rate hikes, However, even unemployment data looks to be outdated and the Fed is relying on a very limited set of information in determining whether to keep monetary policy restrictive.
Many companies have recently announced significant layoffs or a freeze on hiring. The job market on the ground is not as strong as it looks in unemployment data. This is particularly true for white-collar employees. At least for now, lower-wage jobs, such as those in food service industry or retail, have been more resilient. However, many technology companies have already started to cut employees and plan to continue to do so. Part of the reason is that technology companies over-hired during COVID because of increased business. Another reason is that many growing technology companies pay their employees in stock rather than cash. As technology stocks have gotten absolutely hammered, the companies have a tougher time raising money and would significantly dilute shareholders if they continued using stock-based compensation to hire employees at these depressed valuations. Some have coined the term ‘white-collar’ recession for what they expect in the coming year.
While employment has been strong enough to endure rate hikes and tightening, the pace and aggressiveness they are doing it at threatens many workers at a rapidly alarming pace. Is it better to have people with no jobs, or have everyone pay slightly more for stuff in the short-term? The Fed can probably strike a balance between unemployment and taming inflation but refuses to do so at the risk of not taming inflation immediately and being ridiculed. (As a side note, the Federal Reserve has a dual mandate of stable prices and maximum employment). There are many forces currently helping to subside inflation – however, if the Fed induces a recession that could have been avoided, fixing the problems of unemployment and economic growth will prove much more challenging. The alarms of significant layoffs are ringing, but the Fed is turning a deaf ear to it because unemployment data is still strong. I don't know how long that will last.
Higher Rates Coincidentally Raising Cost of Living:
Some of the stickiest parts of inflation right now are housing and car prices. Coincidentally, raising rates makes it more expensive to buy homes or finance the purchase of a car. Until the prices of the underlying asset (home/car) give in, the Fed has significantly increased the cost of living for ordinary individuals rather than taming it. The rapid rise in rates has created short-term shock and unaffordability. Mortgage payments have nearly doubled from a year ago for new homebuyers. The Fed is hurting many people it doesn’t need to on its path to fighting inflation. They are trying to fix the problem in the shortest period of time possible by hiking rates at a pace not seen in decades. However, a more patient and careful approach with more conservative rate hikes would likely get the job done and not cause havoc in the meanwhile.
Yield Curve:
The yield curve is a relationship between the yields on a security and their time to maturity. By far the most closely watched yield curve is that of US treasuries. Normally, the yield curve is upward sloping with shorter time to maturities (ex: 2 year) yielding less than longer maturities (ex: 10 years). This indicates a relatively healthy economy expected to grow. However, flat or inverted yield curves (when longer maturities yield less than shorter maturities) signal impending recessions. We currently have a somewhat flat to inverted yield curve, with the 2 year yielding more than the 5, 10, and 30 years. While there can be many possible conclusions to draw from the curve, it is warning that the risk of recession is real and also that inflation is expected to subside. The reason this happens is that investors buy longer-dated treasuries as a safe-haven, thus pushing yields down (because US treasuries are essentially guaranteed returns), rather than investing in riskier assets like stocks, commodities, or low-quality bonds. Additionally, an inverted curve also suggests investors don’t expect this level of elevated inflation to persist over the coming years (higher inflation warrants higher nominal yield to compensate).
While the yield curve is informative and has been a reliable metric for decades, we live in a very weird period of high inflation that will probably subside rapidly, and a strong economy that is weakening meaningfully. If we start to see deflation in the coming months and 2023, real yields (nominal yield – inflation rate) on treasuries will skyrocket and many investors will likely pile into them. With most treasury maturities trading currently at 4% yield, any deflationary environment would offer real returns on treasuries in excess of 5%. This risk-free high yield would be irresistible to investors which would push yields down. Therefore, if inflation subsides rapidly, then rates will not only halt their incessant rise, but will likely plummet. This will leave many investors who sold out of stocks or bonds to be confused, perhaps panicking back into longer-duration risk assets. However, the relationship between macro and the stock market/other risk assets is a much more in-depth topic to be discussed at another time. In summary, the yield curve is telling the Fed to slow down or risk significant damage to the economy.
Conclusion
To conclude, my ‘prediction’ is that even though the Fed will need to slow down, they won’t do so in time. The only thing that can save us is probably several months of low month-over-month inflation data to end 2022 which will give the Fed the green light to pivot. Otherwise, they will continue their blind destruction of the economy to fix a problem that has already subsided meaningfully. If inflation subsides significantly or we have deflation, then the Fed will have to stop raising or cut rates ASAP to avoid a longer recession. In my view, unless something drastically changes in the coming months, inflation will rapidly decelerate (as we have somewhat seen already), with eventual negative month-over-month readings. The importance of understanding macroeconomic conditions is not to try to time markets or call bottoms, but rather to understand the current risk-reward dynamic in markets. In another article, I will discuss the risk-reward dynamic in the stock market and which sectors of the market have caught my attention most. Once again, take everything here with a grain of salt because trying to make predictions about the economy is not a reliable method of investing unless the risk-reward is compelling enough.
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