Are the Federal Reserve’s efforts to curb inflation working? And will they tip the economy into a recession in 2023?
Are the Federal Reserve’s efforts to curb inflation working? Is a recession down the road in 2023? Stayed tuned for the answers and much, much more.
From Thrivent Asset Management, welcome to episode 45 of Advisor’s Market360™. A podcast for you, the driven financial advisor.
Over the past year or so, we’ve spent a lot of time discussing inflation, the risk of recession and the Federal Reserve’s role in each. Today, we’re going to talk about those issues again, but with the goal of understanding how their interplay will affect the economy going forward.
As is often the case, we tapped on the shoulder of Steve Lowe, CFA, Thrivent’s Chief Investment Strategist to hear his insights. The first topic that Lowe addressed was the Federal Reserve, or Fed, and its ongoing campaign of raising rates throughout 2022 and now into 2023. Here’s what Lowe anticipates from the Fed for the remainder of 2023.
“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.
“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.”
Of course, as rates go up so too does the risk of recession. Is the Fed willing to “go there” in its battle with inflation? According to Fed chair Gerome Powell, the answer is yes. And in Powell’s own words: there’ll be pain ahead. Lowe shares his perspective…
“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.”
And those tools would be cuts to rates and potentially buying assets if needed, according to Lowe. So, how long will the Fed hold rates? And what might prompt them to eventually cut? Lowe thinks that rate cuts would come sooner than what the Fed is expecting.
“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.”
Determining which scenario plays out starts by looking at the present. As we look at the Fed’s rate moves, are we seeing any signs that indicate that it’s working to slow inflation? Lowe says...
“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.”
Lowe provides some context to back up his optimism.
“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%.”
One sign that Lowe and his team look at is money supply, a key factor that’s classically related to inflation. Listen to how he pieces it together.
“You saw money supply absolutely shoot up in the wake of the pandemic stimulus, 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.
“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. 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.”
Lowe did note that there are some areas where inflation might be more difficult to tame.
“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.”
Another subject we wanted to get Lowe’s input on is the possibility of a recession coming this year. Here’s how he’s approaching the matter.
“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. 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 are certainly areas that have been hurt. If you look at lower income tiers, inflation has a higher impact there and they're more stretched.”
Another sign that Lowe points to in evidence of a mild recession – should a recession come to fruition – is that companies are doing relatively well during this period of economic uncertainty.
“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.”
We had to ask Lowe the question that’s hanging over our heads. What does he think the odds are that the economy will tip into recession?
“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 then just looking at large metrics of the economy; in particular, PMI; surveys of manufacturers and service companies. Those have fallen pretty significantly.”
As a reminder, PMI in this context refers to the Purchasing Managers Index. We asked Lowe what else he looks at as a precursor to recession.
“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.”
Asked what he thought about the likelihood of recession, Lowe confirmed that a recession in 2023 is more likely than not, but can’t say with absolute certainty. Since we’re in the wake of a pandemic unlike anything we’ve seen before, the economic cycle could wind up looking different.
When asked about the timing of recession, if it comes to pass, Lowe’s opinion is that it would be sooner rather than later when compared to historical recessions, due to the Fed aggressively raising rates. Lowe’s current belief is that a recession would be more likely to hit in late 2023 or early 2024.
With the caveat that the economy might not dip into recession, Lowe also provided more context about what he thinks it might look like.
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.
Based on that scenario, Lowe described how a recession would impact the markets:
“Yeah, if you look at [history], the S&P median return is down about 24%. The average is about 30%. 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.”
There you have it. We want to thank Steve Lowe for his insights. We hope he answered your questions about inflation, the risk of recession and how the Fed is operating in response.
Thanks for listening to this episode of Advisor’s Market360™. All episodes are available on Apple Podcasts, Spotify, and Google Podcasts. Email us at firstname.lastname@example.org with your feedback, questions and topic suggestions for future episodes. Advisors: do you have a story share? Email us and you might hear it in a future episode. And as always, you can learn more about us at thriventfunds.com and find other insights of interest to you, the driven financial advisor. Bye for now.
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