The economic storm clouds on the horizon reported in the news and on social media conjure up the metaphor of “storm watching” when allocating assets in today’s financial markets. Erik Larson’s historical novel, Isaac’s Storm: A Man, A Time, and the Deadliest Hurricane in History, recounts the failed forecasting and monitoring of the 1900 Great Galveston Hurricane which was the deadliest natural disaster in United States history.
The science of hurricane forecasting in 1900 was limited primarily to barometric pressure readings and shared observations. However, focusing on those two tools would have been enough to alert the citizens of Galveston of the impending disaster.
We use the analogy of the botched Galveston Storm forecast of 1900 as a reminder of the importance of identifying the key relevant metrics for monitoring the economy as the upcoming Federal Reserve fight against inflation kicks into gear.
Inflation and the Fed are the source of most of the uncertainty and volatility in financial markets. We noted in our January newsletter that 2022 would be an interesting year because of the Federal Reserve’s unenviable task of taming inflation. CPI measured 7.9% in March and is forecast to peak at 8.5% to 9% this year, making it the highest level of inflation since 1981. The market is predicting Federal Reserve rate hikes of 2.50% over the remainder of the year.
The market has anticipated where Fed policy is headed, and interest rates have moved up dramatically in the past few weeks with both 2 year and 10-year US Treasuries yielding around 2.70%- and 30-year mortgages now above 5%.
Normalization of the Federal Reserve’s balance sheet which grew from $4trillion to $9trillion over the past 4 years will necessitate removal of
excess liquidity from the banking system. This monetary correction will be in addition to the expected rate hikes noted above. If the Federal Reserve is too aggressive in its timing, the economy could go into recession which may be the “economic cost” of having increased the money supply by over 40% (as measured by M2) since February 2020. However, if Fed action is aggressive but fails to squelch inflation, then “stagflation” could be the outcome.
According to the “advance estimate” of U.S. GDP, which was released on April 28th, First Quarter 2022 economic growth slowed dramatically at – 1.4% versus +6.9% in the fourth quarter of 2021. However, most economists forecast 2022 GDP growth in the U.S. to be +2.5%.
Economic conditions remain robust and positive enough that a so called “soft landing” of the economy could be the eventual outcome of Fed monetary tightening. Therefore, the market is not pricing in a recession, though some market observers look to the flat and slightly inverted U.S. interest rate curve as “the canary in the coal mine” signaling a recession ahead.
Another reassuring statistic is that U.S. household free cash flow remains at very strong levels as reflected in strong consumer spending observed in the recent GDP estimates. Furthermore, even if the Fed does raise interest rates to 2.75%, real interest rates will remain negative and below the rate of inflation. Negative real interest rates reflect an accommodative monetary policy which supports economic growth and asset prices.
One can also see positive economic data points in the first quarter corporate earnings reports which reflect continued growth albeit at lower levels than in the prior quarter or versus the prior year period.
Energy and food prices, supply chain disruptions, the Chinese COVID lockdowns, and the war in Ukraine are all in the mix adding to the possibility of market dislocation and drawdowns. All of these are quite serious and are very painful at the human level and require continued monitoring.
We may not yet appreciate the magnitude of the war in Eastern Ukraine and its impact on global food, particularly wheat, sunflower oil, and corn as well as its impact on agricultural fertilizer. Not only can food supply disruptions contribute to higher inflation in the U.S., but it also has the potential to unleash further mass immigration from countries in Africa and Asia toward Europe and the West.
However, the current key metrics which reflect accommodative money, low tax rates, strong consumer spending, low unemployment, and continued growth in corporate profitability provide a more reassuring context for the market corrections we have seen to date.
The bottom line for us remains the same as at the start of the year. We have continued a modest level of further de-risking across our moderate growth strategies while adding to our allocations of real assets and liquid alternatives. The continued rise in interest rates has begun to open the door to fixed income offering a more meaningful offset to the cost of inflation and a more attractive allocation option in certain situations.
The challenges for the Fed are significant, but the economy remains strong which should last into the fall. We are monitoring real interest rates and the money supply as critical metrics while markets navigate the treacherous currents of inflation, slowing growth, and war. Like barometric pressure readings in 1900, monetary policy success will be our critical forecasting tool.