ur guiding principle for setting market strategy is “don’t fight the Fed.” One year ago, our bearish market outlook was premised on our belief that soaring inflation would finally force aggressive tightening moves by the Fed. After a year of the most aggressive tightening since the early 1980s, Fed Chairman Powell is signaling continued aggressive interest rate increases in 2023.
Powell is disappointed that after the biggest rate increases in 40 years, unemployment remains low and labor markets relatively healthy. We are worried that nothing short of a painful recession will deter Chairman Powell from his tightening campaign. As a result, our “don’t fight the Fed” philosophy suggests investors prepare for recession and another 20% decline in equity markets. The relentless downtrend in the S&P and its pattern of lower highs and lower lows support this gloomy outlook.
Despite the most aggressive Fed tightening since the early 1980s, there is still time to avoid recession. Outside of housing, the US economy has proven surprisingly resilient to the Fed’s tightening campaign. We believe the source of that economic resilience is the $1.7 trillion in excess savings sitting in consumer savings accounts. This unprecedented consumer war chest resulted from COVID stimulus far exceeding the economic needs of US consumers. A large percentage of stimulus checks were simply deposited at the bank.
As shown in the chart below, for the past several months consumers have drawn down these excess savings to maintain their spending levels. At the current pace of consumer withdrawals, excess savings could support the US economy throughout most of 2023. Unfortunately, Fed Chairman Powell views the economic resilience made possible by excess savings as a sign that Fed policies have yet to impact the economy. The Fed is on track to keep tightening until these savings are exhausted and unemployment soars. By that time, the Fed will have tightened monetary policy far too much and pushed the US economy into an unnecessary recession.
Although the monetary policy trend is grim, there remains a glimmer of hope. Opposed to the hawks is a growing chorus of dovish Federal Open Market Committee members (FOMC). They agree with our assessment that the inflation battle is largely won, and that the Fed should adopt a “wait and see” approach to further tightening moves. If investors are to avoid another big market decline, these dovish voices will need to gain control of monetary policy early in 2023. The question is whether the Fed’s preferred measures of inflation will drop fast enough to convince several hawks on the FOMC to switch sides. The aggressive tone of the most recent Fed minutes suggest that the doves have a tough fight ahead of them.
We believe that Chairman Powell created our current inflation problem by printing nearly $7 trillion to finance President Trump’s and President Biden’s COVID deficits. Although nearly every economic textbook highlights the inflationary dangers of financing giant deficits with printed money, Chairman Powell and members of the FOMC were reassured by the muted signals coming from their preferred inflationary indicators.
Although these inflationary indicators failed to warn of impending inflation on the way up, Powell and FOMC hawks continue to rely on these same indicators (unemployment, CPI, etc.) as they try to manage inflation back down. These backward looking indicators are now causing Fed decision makers to miss clear signs that inflation pressures are receding. Unless the doves can assert control over Fed policy, the Fed’s focus on the wrong indicators will lead to over tightening and a 2023 recession.
For example, Powell contends that labor markets are too strong and that millions more Americans need to lose their jobs before inflation can be contained. Powell believes that low unemployment leads to rising labor costs. Companies react to higher unit labor costs by raising prices, which makes workers demand more pay increases, and so on.
There is a slight problem with Powell's theory. The blue line in the graph below shows the historical relationship between unemployment and labor costs. This flat regression line indicates that labor costs are equally likely to go up or down after an increase in unemployment. There is simply no consistent historical pattern of “unemployment up/labor costs down.” Contrary to Powell’s theory, sometimes unemployment rises and unit labor costs go up because employers hang on to experienced, higher cost workers. That is why the term “stagflation” was invented. Employers are particularly likely to hang on to experienced, higher cost workers in the current environment. Companies spent much of the past two years unable to attract enough of these workers. Powell’s single-minded focus on driving up unemployment will not necessarily lower labor costs or reduce inflationary pressures. It is very likely, however, to produce a recession.
Housing costs are another area where Powell’s choice of economic indicators leads him astray. Powell, in numerous speeches, has argued that the statistically smoothed housing inflation data within the CPI index provides the best measure of housing inflation. As shown in the graph below, CPI’s housing inflation data was about 3% per annum in 2021 when Zillow’s market measure of inflation was approaching 27%. CPI’s lagged data completely missed the clear build up in inflationary pressures in 2020 and 2021. That lagged CPI data is now reflecting housing inflation from a year ago and is significantly overstating current inflationary pressures.
As noted by the Wall Street Journal, “if the CPI only measured market rents, core inflation would already be close to 2%.”
In stark contrast to our hawkish views in 2020 and 2021, this time we agree with the doves. After spiking to more than 25% during Powell’s money printing frenzy, money supply is now shrinking for the first time in 50 years. By draining money out of the economy, the Fed is directly attacking the root cause of our inflation problem. Add in steep declines in market-based measures of housing inflation, plummeting commodity prices, and an accelerating decline in the Chinese economy and we expect inflation figures to be down sharply by the end of 2023. Unfortunately, Chairman Powell appears inclined to dismiss inflation declines the same way he dismissed inflation increases in 2021 – by labeling them as “transitory”.
The COVID bubble in 2020/2021 and subsequent bust in 2022 has left US large cap stocks around 15-20% overvalued, based upon Caravel’s Price Driven capital market assumption process (see the graph below). Equity markets typically fall to fair value in mild recessions (down-15% to -20% from current levels) and drop all the way to -25% or more undervalued in a severe recession (down 40% or more from current levels). Despite the pain investors endured over the past year, a recession will likely mean significant additional downside for equity markets.
We believe that consumer excess savings and strong corporate balance sheets should prevent a severe recession despite over tightening by the Fed. Even a mild recession would suggest another -15% to -20% decline on the S&P 500. If we see a reversal in Fed policy to a more dovish stance, those same strong consumer and corporate balance sheets should provide for a strong economic recovery. However, pricey equity valuations and a shrinking money supply would likely limit best case 2023 investor returns to around 5% to 10%. As a result, large cap equity markets enter 2023 priced for more downside risk than upside potential. Investors should remain underweight their long-term equity targets.
With the S&P priced for below average long-term returns and elevated short-term risks, we suggest investors increase their weighting in intermediate maturity corporate bonds. For the first time in 14 years, corporate bonds offer attractive long term returns and a meaningful hedge against a declining stock market. We are forecasting inflation to be sharply lower by year end. If we are correct, then we think factor-based asset classes like Dividend and Low Volatility will continue to provide attractive relative returns. Both asset classes are priced close to fair value, which should help them outperform in a difficult equity market environment.