Imagine my surprise when seeing this sign outside my local JP Licks Ice cream store in the Boston area. While certainly anecdotal, it still seems to be a manifestation of the problem the Fed now faces in their quest to bring inflation back to 2%. The service economy is booming, the labor market is tight, and core inflation measures have begun to creep back up. In my January 3rd column (The Monkees Were A Big Hit In 1966-67. So Was Inflation (forbes.com)) my bottom line was that recession was not obvious, and therefore you should cover your equity hedges. It was a good idea then. Should we expect a recession anytime soon? Let’s explore the macro-outlook.
In preview, it’s difficult to see a hard landing recession in the next 6-9 months. Just recently, the 2-year note yield moved back above the level of Fed Funds. It ‘uninverted’. This is not unprecedented but what it likely means is that the economy is stronger than anticipated. And there are plenty of signs like private sector labor income up at 8% (3-month annualized) and accelerating. So, we end up with $23/hr ice cream scoopers. And we ice cream eaters are content to pay because household cash on balance sheets is still about $8 trillion, more than double what it was in 2019. Elsewhere, China is growing again, and the Bank of Japan is still printing trillions of Yen to support their Yield Curve Control. You get the picture; nominal growth is still strong.
The Fed gets the picture too. The Cleveland Fed Median and Trimmed mean inflation reports in January showed a reacceleration of core inflation. We know Chair Powell watches these two measures closely. Meanwhile, there might be 3-6M fewer workers than you might have projected in 2019. They don’t yet seem enticed to enter the job market. Businesses can’t wait and so service labor costs are rising and with them so will prices. Keep your eye on the Fed dot-plot projections coming in the March meeting. If the plots show unemployment levels at 4.5-5%, the Fed members are explicitly saying they need a recession to dampen prices. Forget pausing or pivoting, the Fed is still chasing labor-based inflation.
Our governing monetary body eventually gets what they want, and you should not fight them. So, in the 9–18-month time frame, I think the Fed engineers a recession to quell inflation. There are plenty of indicators pointing in that direction during that time frame. The 3-month T-bill yield inverted (went higher in rate) the 10-year government yield back in October and most often 12-18 months later, we get a recession. Leading Economic Indicators (Conference Board and OECD) are pointing down and have good track records. Also, consumer sentiment future expectations have been consistently worse than current conditions which showcases public angst and has historically been a good indicator of a coming recession.
Through these next 6 months, if the economy remains strong, the likely path may be to higher bond yields and, yes, potentially higher equity prices. We might even challenge the August 2022 highs at 4300. There is not much oxygen above that level due to valuation and higher interest rates. And just about when everyone declares no landing and is bullish, the Fed recession hammer may hit.
Is recession priced in? Not even close. Earnings in recession could easily be down 25-30%. Credit spreads would go much higher and with them financial conditions would tighten considerably. It’s not a pretty picture that would shake up the current investor calm. But from my vantage point, if you can afford the price and the calories, keep eating the ice cream through the summer.
All data cited from Bloomberg LP and Ned Davis Research.