Branstad: Hi, everyone. Thank you for joining us in Minneapolis at the headquarters of Thrivent Asset Management. I'm Jeff Branstad, portfolio manager, and this is Steve Lowe, our chief investment strategist.
Today, we're going to talk a little bit about what's been going on with the Fed and inflation. Two huge topics for the last year or so. So, the Fed has raised rates multiple times throughout 2022. What are your expectations for the Fed in 2023?
Lowe: Yeah, sure. You're absolutely right. It's been a huge topic. If you look at what's driven markets, it's been inflation and the Federal Reserve's response to that. And we expect those two themes to dominate in 2023. Also, the Fed is absolutely determined to defeat inflation, to slow it down. So, they're raising rates at the most aggressive pace since 1973.
Right now, Federal Funds, which is their target rate, sits at about 4–4.5% entering 2023. And remember, they started at 0%. And their first hike was early in the year. We expect them to stop pretty soon at around 5–5.25% somewhere around the beginning of the second quarter. And they'll pause. And the reason they want to do that is they want to assess the impact of rates and where they are now is at levels that are well above what are considered neutral. So, what that means is that it's actively slowing the economy.
Branstad: So, will the Fed go so far as risking a recession?
Lowe: Yeah, absolutely. Matter of fact, Powell's own words is that there’ll be pain ahead. So, they're willing to risk a recession. And the reason they do that is they think that not doing enough is more harmful in the long run. And they look at it, really, I think from a risk management viewpoint. By that, I mean that they know they have the tools. If the economy slows and tips into reception, they know what to do. They’d cut rates and maybe buy assets that they need to.
Our base case is that they do hold rates high for a while, but then they back off earlier than they expect to in the second half of 2023. You may get cuts then as the inflation slows and as the economy slows, and you already seen signs of that.
The alternative outcomes are that inflation proves sticky; in particular, service inflation tends to be very sticky and persistent. A more bullish alternative is that higher rates work, and they work a lot quicker than the Fed expects. Inflation slows, economy holds up, and we're able to stick a soft landing and the Fed eases.
Branstad: So, have we seen any signs yet? Are you seeing signs that what they're doing is working, that it's actually impacting inflation?
Lowe: Yeah, absolutely. There are plenty of signs that both the economy is slowing and inflation is slowing. So, inflation has hit consumers pretty hard; it eats into their spending power. If you look at real income – and what that means is income adjusted for inflation – it's gone down and particularly in lower income tiers, it’s had a large impact. And then higher interest rates also result in higher mortgages. The housing market has slowed significantly and just lending rates in general, and that impacts companies.
Inflation peaked at 9% in 2022. We think that will be the high. And you've already seen signs that it’s slowing. It's about 7.1%, leaving 2022; with core inflation, excluding energy, about 6%. And you can see signs that it will slow. One of the things we look at is money supply. It’s classically related to inflation. You saw money supply absolutely shoot up in the wake of the pandemic stimulus when there were trillions of dollars pumped into the economy, and year-over-year growth rates like you've never seen before, and it's fallen off real sharply now. Inflation followed with a lag on the way up and we think is going to follow money supply down and ease a good amount. And the other thing about inflation is that it's a year-over-year measurement, so it's not about the price level, it's about sustaining price increases. And that gets really hard. It's called base effects.
You can see prices correcting across the economy. Supply chains are improving, demand is softening. Inventories are very high. You can look at retailers – they're slashing prices to clear out inventory, particularly in areas that were very popular during the pandemic. There's too much inventory over-ordered – electronics and other things. Car prices are lower, rents are lower. Gas prices, the most obvious, those have fallen off sharply. The one thing that's interesting: look at our freight rates. Those have absolutely plummeted. And that's a key indicator of the demand to move goods across the economy and those have fallen off very, very sharply.
There are sticky elements. Wages and rent tend to be very sticky, the imputed cost of owning your home. So, that's a risk that inflation stays higher. The other risk is China is going to open up in 2023 after being shut down, and that could fuel inflation, particularly commodity inflation. And then I think oil markets in general, demand has softened, which is why prices have gone down. But supply has been very disciplined and that could create issues for higher oil prices next year. So, overall, we expect continued volatility; that's very common with particularly high inflation, it’s not a straight-line decline. Inflation has already fallen off on the increase again, but our base case is that it's low enough to allow the Fed to ease up.
Branstad: Let's talk a little bit about the economy. What's your outlook for the next year? What do you think the chances are of a recession?
Lowe: Yeah, I think the market is obviously very concerned about a recession, but whether the economy goes into recession or not is, I think, in some ways a distinction without a lot of difference. In other words, I think the economy is likely to slow. That happens when the Fed raises rates and financial conditions tighten. But if there is a recession, I think it would be mild. So, the point is that the difference in growth between a mild recession and just a slowing economy probably isn't that large.
And the reason we think the difference is probably pretty small is that consumers are still in relatively good shape. They went into the recession with very low debt levels. They have healthy savings – they’re lower than they used to be, but people saved a lot of money with the pandemic stimulus. And the jobs market is very strong. There’re certainly areas that have been hurt. If you look at lower income tiers, inflation has a higher impact there and they're more stretched.
Elsewhere, if you look at companies, they're in good shape coming in and earnings are falling, but they're still in decent shape. In particular, balance sheets are very, very strong. And importantly, there are no huge imbalances in the economy like you had with housing during the Great Financial Crisis.
Branstad: So, what do you think the odds are that it would actually tip into a recession?
Lowe: If you look at the Fed's own projections, they're about 50/50. That's much lower than most economists expect; they think it's more likely than not. We already are seeing clear signs that inflation and rates are slowing the economy. You can look at consumer confidence is very low, and that's really a function of inflation, largely. Inflation has also impacted particularly small businesses. Confidence there is very low. Layoffs are starting to rise. You’re starting to hear more and more news about large layoffs, but they're still relatively low. The other area is net worth markets. We just went through a very tough 2022 and that impacts the way people behave, particularly people who are in the markets, higher income. Over time, that impacts demand and confidence. And the other large areas – wages are up, but real wages are down – meaning that, once you factor in inflation, you're still making less, so you can buy less with that. And then just looking at large metrics of the economy; in particular, PMI; surveys of manufacturers and service companies. Those have fallen pretty significantly.
Branstad: So, what else would you be looking at?
Lowe: Yeah, well, we tend to look at forward-looking areas. So, there is the leading economic index, what's called the LEI – that's actually at levels where you've always gone into recession in the past. The other thing that markets and we watch closely is the Treasury curve. It's very deeply inverted, which it does before a recession. It always – every recession has been preceded by an inversion. And not every inversion signals a recession, but it's a sign that markets are concerned about slower growth because long term rates fell. And then you can look at futures, in particular the Fed fund futures – the market is pricing in a chance that the Fed cuts early. And the only reason they would do that really is if we hit a recession.
Branstad: So, when do you think we might be hitting that recession if there is one?
Lowe: The Fed is raising rates really aggressively right now. So, I think it would be earlier compared to the average, which would put it – again, they started hiking early 2022, and I think that would put a recession toward midway or later in 2023.
Branstad: Okay. So, what's your opinion? Do you think it's going to happen?
Lowe: Yeah, I think a recession is probably more likely than not. It's certainly not a foregone conclusion. And, one thing, the cycle could be different. We've never had a pandemic, thrown trillions [of dollars] into the economy and shut down the economy temporarily. It just hasn’t happened. So, it could be a little bit different. We haven't seen this scenario exactly before. We've seen high inflation environments.
But I think a soft landing is plausible. Under that scenario, inflation continues to fall because of higher rates. Recession or not, though, I think either way, we're going to have slower growth and it's probably well into 2023 before we see growth rebound.
Branstad: So, what kind of impacts would there be on the markets in the scenario of a recession?
Lowe: Yeah, if you look at [history], the S&P median return is down about 24%. The average is about 30%. There's a huge variation there, from down in the mid-teens to down almost 60% or so. But we've already hit a low. The low point was down 25%. So, we're not far off of a recession average from that point. Earnings will fall; the average fall is about 15% or so. Earnings have not come down. The market is actually still positive for 2023 slightly. So, I think that that is embedded, though, in multiples which have fallen already. Rates would fall in a recession probably, through 3% down to 2% or so. And you see credit markets do poorly. Spreads would widen and you’d see defaults increase. All that said, I think markets have priced in a pretty good chance of a recession already. So, there's still downside in markets if there is a recession, but a lot of that is priced in already.
Branstad: So, if it's a soft landing, it'll be a little lighter. And if it's a deeper recession, it would be a little worse.
Lowe: Yeah, [in a very deep recession,] you would see markets react harshly. A soft landing, I [think markets] would move on relatively quickly and start setting new highs again.
Branstad: All right. Thank you, Steve. And thank you, everyone. We'll see you next time. Bye.
