The Fed Decides

Not a great week for U.S. stocks last week. The Dow Jones was down 2.0%, the S&P 500 was down 2.7%, and the NASDAQ was down about 3.5%. It was a bit surprising given that oil prices fell 5.6% last week, which should have alleviated recession concerns a bit, but the 10-year U.S. Treasury yield jumped 27 basis points, which of course, hit technology stocks yet again. The key takeaway is that markets are still trying to find their footing and looking for positive catalysts.  

Clearly, what is happens in the commodity complex is of utmost importance with the potential for rising energy costs to dampen global economic growth – particularly in the Eurozone. However, we think it’s important to remember that the United States’ reliance on oil has changed dramatically since the 1970s. In 1970, energy goods and services accounted for about 13% of total consumption. Now, that number is just about 4.8% (see figure 1).

This graph shows the U.S. Energy Goods and Services Spending as a Percentage of Total Spending

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Having come down materially, the economic drag from higher oil prices should be less than in prior supply shocks. As our Citi Research colleagues point out, with energy related consumption accounting for about $750 billion of total consumer spending, a 20% rise in energy prices would mean about $150 billion of lost spending on other goods. If mapped to real gross domestic product (GDP), it would potentially drag down growth by 0.7 percentage points. That is notable, but it is a far cry from the oil embargo of 1973 and 1974. At the time, the price of West Texas Intermediate crude oil jumped from $4.30 per barrel in the fourth quarter of 1973 to $10.11 in the first quarter of 1974 – a 134% jump in prices. During that quarter, spending on energy goods and services dragged down growth by 2.4%. On its own, the rise in energy prices seems unlikely to drive the U.S. economy into a recession. However, investors also need to consider the forthcoming U.S. monetary policy response.

It is widely expected that the Federal Reserve will move forward with a 25-basis point rate hike at its March 15 and 16 Federal Open Market Committee (FOMC) meeting with Fed Chair Powell having already said publicly that he supports a 25-basis point rate hike instead of a 50-basis point rate hike. However, it remains unclear if the Fed sees material risk to growth from the ongoing Russia / Ukraine conflict. Thus far, the market seems convinced that the Federal Reserve will hike interest rates by the equivalent of seven rate hikes by the end of 2022 (see figure 2). The Fed may also announce its plan to start reducing the size of its balance sheet by June.

This graph shows the Number of Fed Rate Hikes Expected by the End of 2022

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Much of this has likely already been priced into markets with the S&P 500 down 11.9% since January 3, 2022. Interestingly, the S&P 500 is virtually flat since the invasion of Ukraine on February 24, 2022. With the U.S. stock market dealing with several headwinds, the path from here may be driven by two people…President Putin and Fed Chair Powell. We remain hopeful that successful negotiations between Russia and Ukraine can be achieved and it would clearly be welcomed by the global community and financial markets, but even if such an optimistic scenario unfolds, an immediate removal of imposed sanctions seems unlikely and the shift in global energy supply chains is already underway with many nations seeking to limit their dependence on Russian fossil fuels. As such, it will be critical for the Federal Reserve to monitor international developments and to recognize that its ability to combat inflation that is caused by supply chain disruptions is likely limited. While inflation, as measured by the consumer price index, may head towards 8.5%-9.0% in coming months, we are not ruling out a pause in rate hikes at some point given that U.S. financial conditions are already modestly tightening (see figure 3), and the odds of a U.S. recession have climbed some (not our base case, but see figure 4). As Steve Jobs once said, “the most precious resource we all have is time.” The Fed may need to be reminded of that if it hopes to avoid a hard landing for the U.S. economy.

This graph shows the U.S. Financial Conditions Index vs. Periods of U.S. Recession.

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This chart shows the Probability of a U.S. Recession in Next 12 Months.

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