May 27, 2022 | 13:02
Grow v. Fade
Markets managed to catch their breath this week after a punishing 15% drop for the S&P 500 just since late March. Firm results by select retailers dispelled some of the recent gloom surrounding that sector, while the bond market chipped in with a further moderate pullback in yields. Treasuries appear to be gaining confidence in the view that we are past the period of “peak Fed”. For example, two-year yields have now backed off 30 bps from their early May closing high of 2.78%, as traders are slowly reeling in their most aggressive expectations for further Fed rate hikes. In fact, we now find our forecast of 200 bps of additional rate hikes by early next year is pretty much exactly in line with current market pricing—so, clearly, there is no major quarrel with the market’s modest re-think on the Fed.
A key issue for the market, and one we have dealt with before in some detail, is whether that degree of Fed tightening will be nearly enough to tackle rampaging inflation. Our short answer is “just barely enough”. But an emerging issue that markets are now see-sawing on is whether that degree of tightening won’t also spark deeper-than-expected weakness in the underlying economy. And recall that the re-pricing of equities in recent months is almost entirely a function of adjusting to a higher rate environment, and not to a fundamental shift in the earnings backdrop (and, by extension, the growth outlook). So, even with all the recent chatter about a possible recession, the reality is that analyst expectations (and, thus, markets) are not seriously building in that risk.
We continue to lean to the side that looks for the economy to grind through this difficult spell, albeit with some serious growth scares along the way. To wit, the early returns for Q2 point to a decent rebound in U.S. GDP growth after the quirky 1.5% setback in Q1, with consumer spending currently on pace for a 4% advance and net trade poised to support growth (after chopping it in Q1). Even with a staggeringly large drop in new home sales last month, it looks like there is still some upside risk to our revised Q2 call of 3% growth. However, we also anticipate a notable cooldown in future quarters, and are below consensus next year with our call of just 1.7% growth (below the 20-year average growth rate of 2%).
There are two main reasons why we believe that the economy can continue to churn forward in the year ahead. First, business spending looks to remain solid as firms expand capacity to catch up with demand, and amid flush finances. Second, consumer spending is expected to hang tough, supported by both pent-up demand for some hard-to-source goods (mostly vehicles) but also by still-hefty excess savings.
Digging into that latter point, the latest personal income and spending data for April are instructive. On the one side, the saving rate careened down to “just” 4.4%, its lowest since 2008 and down from a pre-pandemic trend of about 7.5%. But that drop is precisely the point—U.S. consumers are now starting to chip away at those much-ballyhooed excess savings, to help pay for the spurt in food and energy costs. And, even with that chipping away, we still estimate that said savings are now roughly $2.3 trillion (or more than 9% of GDP). True, they are not well distributed across income cohorts—hence the wildly differing experiences by varying retailers. But, even if just a third of these pandemic savings are spent, this will readily support overall outlays through 2023.
Ultimately, the fate of the economy and the recession debate will be decided by how far the Fed needs to go on rates to quell inflation—taking us right back to the first issue: will 200 bps be enough? On that front, there was a trace of good news in the April PCE deflator data. While the gaudy headline CPI readings of over 8% have hogged the spotlight, the Fed’s preferred inflation gauge (core PCE) eased to a much milder 4.9% y/y pace last month. (Cynics would be forgiven for suggesting that it’s the preferred measure because it’s consistently among the mildest.) Aside from the past few months of over 5%, that’s still the fastest reading since the early 1980s, but seems much more manageable than the rip-roaring CPI figures. And, the three-month trend has now dipped to a 4% annual rate, a significant calming from the near-6% pace around the turn of the year.
However, probably the most helpful development at this point to help calm the inflation waters would be a cooling in energy prices, with an assist from milder food costs. Alas, those resource prices are still mostly going the other way. Natural gas briefly flared above $9 this week and is still more than double the level prevailing at the start of the year. Gasoline prices are off their peaks, but yet another uptick in oil to around $114 this week points to little serious relief anytime soon. Both wheat and corn futures did back down, but are still up 15%-to-20% since the Ukraine invasion. So, while the mild cooling in core PCE is definitely encouraging, it is far too soon to send even a semi-clear signal on inflation (let alone an all-clear).
Exactly 40 years ago this week, I began my career in Ottawa with the Bank of Canada (clearly, the Bank was still recruiting straight out of elementary school in those days). This fact is noted mostly because 1982 was the last time that Canada witnessed double-digit inflation (Sep/82 was the final month at 10.3%). By the time my short spell was done, the inflation rate had been chopped about in half by the summer of 1983 to just above 5%. While interest rates naturally plunged during this episode, the Bank’s key rate only bottomed out at around 9.5% that year (from a 1981 peak just above 21%—yes, 21%).
Compare and contrast that 9% rate to what’s expected at next week’s decision. The Bank is almost universally expected to again hike rates by 50 bps, to a less-than-towering 1.5%. We look for yet another such move in mid-July, taking the overnight rate to 2.0%, a level that hasn’t been visited since 2008. While that’s certainly on the high side by recent standards, it’s still a long, long way from past levels when inflation was anywhere close to its current 6.8% clip. And, in contrast to the U.S., we look for inflation to tick higher in coming months to above 7% and core around 5%. Historically, the Bank has needed to lift rates to around core CPI (or higher) to truly crack inflation. That’s meant as a sobering final observation, not a forecast.