Globally, stocks struggled last week as fears of a global recession increased with central banks across several developed markets tightening monetary policy. The MSCI All Country World Index tumbled 5.0% while the S&P 500 slumped 4.5% and the Dow Jones slipped 4.0%. The tech-heavy NASDAQ dropped 5.1% as interest rates ratcheted higher with the 10-year U.S. Treasury yield climbing 24 basis points to 3.68%.
The Federal Reserve warned financial markets to expect further rate hikes at its Jackson Hole symposium (lather), then delivered a 75 basis-point rate hike at its September meeting (resolve), and then suggested another 100-to-125 basis-points of rate hikes by year-end 2022 (repeat). In addition, Fed officials raised their forecasts from the terminal fed funds rate from 3.4% to 4.4% in 2023. This aggressive path has increased the odds of a U.S. recession.
During the “hard landings” of 1973, 1980, and 1981, inflation fell by an average of 7.5% over the next two years while the unemployment rate rose by an average of 3.4% (much higher than the 0.6% rise the Fed is predicting). Barring some help from the supply side of the economy, it would not be surprising to see unemployment rising steadily in 2023.
Although market volatility remains high, S&P 500 returns are often quite strong following the Fed’s last rate hike. During the last six tightening cycles, the S&P 500 rallied an average of 15.8% in the 12 months that followed the last rate hike. That performance improved to 25.1% over 24 months.
Lather, Resolve, Repeat
Lather, rinse, and repeat is of course the instructions found on most shampoo bottles, but it works for the Federal Reserve right now as well. Prepare financial markets for higher rates (lather), follow through (resolve), and then talk about doing it again and again (repeat) until the elevated inflation has been washed out of the U.S. economy.
Last week, Fed policymakers decided to raise the fed funds rate by 0.75% (or 75 basis-points) to an upper bound limit of 3.25%. The Fed also released its Summary of Economic Projections where it lifted its projected fed funds rate by the end of 2022 from 3.4% to 4.4% – implying that the Fed will hike rates by another 100-to-125 basis-points by year-end. That could mean another 75 basis-points in November and another 25 or 50 in December. It is also possible that the Fed raises rate by 50 basis-points at each meeting but given that the Fed seems to want to front-load rate hikes (meaning do them quickly and then slow down the pace later) the former scenario seems the most likely. By early 2023, these actions would leave the terminal fed funds rate at 4.50% - 4.75%.
Presumably at that point, the Fed will go on hold as it waits to see just how restrictive the level of rates is on the economy. If it proves to be not restrictive enough, then perhaps the Fed will need to raise the terminal rate above 5.0%. However, we believe that the odds of a U.S. recession in 2023 are now around 70% and that it may be difficult for the Fed to continue tighter monetary policy if the labor market rolls over with unemployment rising. Which leads us to the question of what typically happens to inflation and unemployment during recessions?
The best historical examples are likely the Fed’s tightening cycles in 1972-1974, 1977-1980, and 1980-1981. Those periods were times of high inflation and resulted in “hard landings” where real gross domestic product (GDP) fell by average of 2.3% over an average of about five quarters. Inflation (as measured by the consumer price index or CPI) fell by an average of 7.5% (see figure 1) over the next two years while the unemployment rate climbed by an average of 3.4% during those periods (see figure 2).
|Fed Tightening Period||Fed Funds (Effective)||Consumer Price Index (%)||NBER First Recession Month||Number of Months START *||Number of Months END**||Real GDP Drop (%)||Inflation Drop (%) After Two Years||Policy-Induced Recession?|
|Start||End||Type of Cycle||Start||End||Chg Change in FF (bps)||Start||End||Chg Change|
|Jun-04||Jun-06||Fast||1.03||4.99||396||3.3%||4.3%||1.0%||Jan-08||43||18||-3.8%||0.7%||Monetary Policy Not Primary Driver|
|Oct-15||Jan-19||Slow||0.12||2.40||228||0.2%||1.6%||1.4%||Mar-20||53||13||-10.1%||-0.2||Monetary Policy Not Primary Driver|
The Fed; however, is projecting just a 0.6% rise in the unemployment rate in 2023. While possible, that seems optimistic given that the smallest increase in the unemployment rate during periods of recession was 2.0% (2001). This coincides with recent comments from former Treasury Secretary Larry Summers who said that it would be surprising if the Fed gets inflation to 2.0% without an unemployment rate that approaches or exceeds 6%.1 It may be possible with growing supply chain tailwinds (see figure 3), but we are doubtful that their forecast will prove accurate.
If weak economic growth is indeed on the horizon, which seems almost assured with Atlanta Fed’s GDPNow tracker estimating just 0.3% growth in the third quarter, then it seems reasonable to suggest that market lows are not yet in with the S&P 500 often bottoming about four-to-five months before then end of a recession, not before one (see figure 4). A potential silver lining is that much of the economic pain has already likely been priced in with the average S&P 500 recessionary drawdown about 9.0% lower than the S&P 500’s performance year-to-date.
|Using S&P 500 Performance||Average||Median|
|Length of Recession||281.1||209.0|
|Number of Days that Peak Occurred Prior to Recession||111.4||134.5|
|Peak Prior to Recession to Trough During Recession(%)||-32.6%||-27.1%|
|Days Between Peak and Trough||257||261.0|
|Days into Recession that Trough Occurred||170.0||117.0|
|Depth into Recession that Trough Occurred||51.6%||59.3%|
While seasonality is on investors’ side and the S&P 500 tends to rally after mid-year U.S. elections, Citi Global Wealth Investments’ Global Investment Committee believes that a defensive position still seems appropriate. Please see our latest CIO Strategy Bulletin | A Fed Too Far? Positioning Portfolios for What's Ahead for more details. That said, it is possible that investors see sunnier skies in 2023 with market returns following the Fed’s last rate hike often quite strong. During the last six Fed tightening cycles, the S&P 500 rallied an average of 15.8% in the 12 months that followed the last rate hike. That performance improved to 25.1% over 24 months (see figure 5). While the Fed is currently testing investors’ resolve, we think it is important to remember that bear markets are often followed by bull markets.
|Cycle Dates||Last Rate Hike||Fed Funds Rate||S&P 500 Performance|
|12-Months Later||24-Months Later|
|'83 - '84||8/9/1984||11.5%||13.8%||43.1%|
|'86 - '89||5/17/1989||9.81%||11.7%||17.3%|
|'94 - '95||2/1/1995||6.00%||35.7%||67.1%|
|'99 - '00||5/16/2000||6.50%||-12.3%||-25.1%|
|'04 - '06||6/29/2006||5.25%||18.1%||0.4%|
|'15 - '18||12/19/2018||2.50%||27.9%||48.0%|
What Should U.S. Investors Watch in the Week Ahead?
Durable goods orders for the month of August will be released, which should help to firm third quarter U.S. GDP estimates. The Department of Commerce will also release the August read of the Personal Consumption Expenditure deflator, which is the Fed’s preferred measure of inflation. Given the Fed’s recent comments, their path forward appears clear, but a taming of inflation would always be welcomed by financial markets. There are also a lot of Fed speakers on the docket now that the blackout period is over. Fed leaders Bostic, Mester, Evans, and Daly are all expected to speak publicly this week.
|Index||Weekly Chgchange in percent||YTDyear to date change in percent||12 Months12 month change in percent||Div. Yielddivision yield in percent|
|Instrument||Weekly Chgchange||YTDyear to date||12 Months12 month change||Level|
|10-Year Treasury Yield (%)||23.5 bps||217.4 bps||225 bps||3.68%|
|Index||Weekly Chgchange in percent||YTDyear to date in percent||12 Months12 month change in percent||Div. Yielddivision yield in percent|
The Week Ahead
|9/27||8:30||Durable Goods Orders||AugAugust P||-0.3%||-0.1%|
|9/27||10:00||Conf. Board Consumer Confidence||SepSeptember||104.5||103.2|
|9/27||10:00||New Home Sales||AugAugust||500k thousand||511k thousand|
|9/30||8:30||PCE Deflator YoY year on year||AugAugust||6.0%||6.3%|
|9/30||8:30||PCE Core Deflator YoY year on year||AugAugust||4.7%||4.6%|