No, we are not referring to the 1954 thriller directed by Alfred Hitchcock. We are referring to what Fed Chairman Powell seems to be looking through in driving monetary policy. Rear-view driving ends badly; when the Fed does it, the resulting accident could produce a historic policy blunder.
Granted, the Fed has a tough job, given its contradictory mandate to control inflation while facilitating maximum employment. But the Fed is looking through the wrong windshield and has completely misunderstood that the unique disruptions from the pandemic on incomes, growth, and inflation are an anomaly. The Fed continues to use backward-looking measures, particularly concerning inflation and the labor market.
There are many forward-looking economic measures that the Fed could use instead. An example is the Conference Board’s Index of Leading Economic Indicators, which has fallen for six consecutive months. The Conference Board’s probability model now predicts a 96% likelihood of a recession in the next 12 months, and its forecast expects it to begin by the end of this year.
Unlike the Fed, we think inflation is on its way down substantially in the year ahead. Instead of looking at trailing inflation over the past twelve months (in the form of the CPI), the Fed should consider that investors in the bond market have sharply reduced their expectations for inflation. The market-implied inflation rate expected over the next five years is now only 2.1%, down from 3.7% in March (and far from the 8% trailing inflation index that has alarmed the Fed). Many commodity prices have already plunged from their peaks: copper, a critical metal for the economy, is down by 30%, lumber is off 70%, and wheat is down over 30%. And trans-Pacific shipping rates have collapsed 90% from their highs.
The Fed’s faulty conclusion has been that a low unemployment rate and high inflation over the last 15 months require extraordinary intervention. As a result, in March the Fed began raising the Fed Funds interest rate at record speed and continues to do so despite clear indications that the peak of inflation is behind us.
Besides using the rear window, the Fed has been using a cracked crystal ball. They entered the year forecasting 4% GDP growth for 2022; now it is close to 0%. The Fed’s economic and interest rate forecasts have been astonishingly off the mark for years. It is a shame that so many businesses rely on the Fed’s forecasts to make hiring and spending decisions, since now they have too many workers and too much inventory. Yes, the Fed says the labor market is tight, but there are many problems with the measurement. If it is so tight, why, for example, has the average workweek fallen? Maybe because businesses have been replacing full-time jobs with part-time.
Fed policy affects the economy with variable lags, with interest-rate-sensitive parts of the economy reacting first. The more than doubling of mortgage interest rates this year has stunned the housing market (mortgage applications are down 68% versus a year ago), but the Fed’s policy of draining funds from the financial system will take much longer to work through the economy.
In addition to economic statistics, corporate earnings forecasts have started to fall sharply. FedEx recently cut its earnings forecast by a third. The CEO was unequivocal: “We are a reflection of every other business, and we see things before others do.” Economic statistics are often rough estimates (and later revised substantially), but there is no ambiguity about what FedEx thinks of the economy’s prospects.
We entered the year expecting far worse economic conditions and stock market returns than the consensus of Wall Street and outside observers. So far, it is turning out that way. The economy has had no growth, and the S&P 500 has had its third-worst year since 1931.
On the other hand, we expected solid returns from bonds, given our expectation of weakening economic activity and moderating inflation. To say that bonds have not performed as expected is an understatement. We have been wrong so far, and how! High consumer inflation compared with a year ago panicked the Fed into raising short-term interest rates, and fears of lasting high inflation have scared bond investors away. As a result, bonds have had their worst start to a year on record.
We think the resulting spike in yields has created an excellent buying opportunity in bonds. Whether the U.S. economy is already in a recession or not is irrelevant. A recession is inevitable, and inflation falls in recessions, as economic slowing and financial strains reduce spending, while excess supplies of goods build. Historically, bonds have outperformed stocks by large margins in recessions, and we expect the same this time.
Back to stocks. The rough nine months of the year for the stock market (capped by September’s 9% drop) left the market “oversold” and due for a rebound. This is no surprise. Bear markets do not go straight down. Sharp rebounds are not unusual within bear markets, which often last 18-24 months. Such gains, however, are fleeting. Bear markets feature high volatility, both up and down, though surprisingly the biggest one-day market gains have occurred during bear markets. (Bull markets generally have few large one-day gains). Go figure.
We are usually loath to guess what developments might cause stock prices to move. And yet, the Fed will eventually end its sharp rate increases and later start cutting in response to a severe recession or a financial accident. Given the Pavlovian response that investors developed years ago to cuts in interest rates, stocks will likely rise sharply. Today’s pessimism could end quickly.
That, however, is not how bear markets have ended over the past century. As legendary investor Warren Buffett said, paraphrasing philosopher Friedrich Hegel, “What we learn from history is that people don’t learn from history.”
In the past, bear markets have ended only after several conditions have been met, none of which is close to occurring. They include the Fed cutting (not raising) interest rates, the yield curve reverting to normal (short-term rates lower than long-term rates), a total market decline of 35-55% over a longer period (usually 18-24 months), sharply falling corporate earnings, extremely low market valuations, and large declines in bond yields that approach the dividend yields on stocks (dividend yields rise as stocks fall). We believe it will take several more quarters before these conditions are reached.
Since we expect few widespread capital gains from stocks until prices fall much more in general, we continue to emphasize high dividend yields and defensive market sectors such as telecommunications, health care, consumer staples, and real estate investment trusts (REITs).
Our investment strategy is based on history, which shows that we should expect high market volatility and challenging conditions. The takeaway: Maintain high cash levels, buy bonds, and be alert to pockets of opportunity in stocks while expecting more widespread opportunities later.