The MSCI AC World Index logged its second straight week of gains – a welcome reversal after five consecutive weeks of declines. In the United States, the S&P 500 added 1.8% while the NASDAQ jumped 2.0%. The Dow Jones lagged with just a 0.3% rise. Overseas, European stocks dipped 0.8% while Japanese stocks climbed 1.7%. Emerging market stocks eked out a 0.2% gain as Chinese stocks struggled with the country enforcing new COVID-19 restrictions. The 10-year U.S. Treasury yield surged 32 basis-points to 2.47%.
The Federal Reserve has a dual mandate of maintaining both full employment and price stability. With inflation soaring to 7.9% year-on-year in February 2022, the Fed is clearly feeling the pressure to act and has signaled that a 50 basis-point rate hike may be on the table at its May meeting. This is leading investors to wonder if a recession may be on the horizon should the Fed overtighten in response to inflationary pressures.
A “soft landing” for the U.S. economy is possible with the Fed successfully tightening monetary policy in 1965-1966, 1983-1984, and 1993-1995 without experiencing a drop in real economic growth. However, the Fed’s track record on combating inflation is less than stellar with core inflation continuing to rise in 9 of the last 11 tightening cycles. When a “hard landing” did occur, it took nearly two years after the onset of Fed tightening for the recession to form.
Walking a Tightrope
The Federal Reserve believes that it has a job to do… to ensure full employment and price stability. With the consumer price index running at 7.9% year-on-year and likely to move higher over the next few months, the Fed is clearly feeling the pressure to act. Chair Powell strongly expressed this view at the National Association of Business Economics conference, saying that, “We will take the necessary steps to ensure a return to price stability. In particular, if we conclude that it is appropriate to move more aggressively by raising the federal funds rate by more than (a quarter-point) at a meeting or meetings, we will do so.” When asked what would keep the Fed from raising interest rates by 50-basis points, he responded, “Nothing.” Unsurprisingly, the market is now starting to expect a 50-basis point rate hike at both the May and June meetings.
U.S. Treasury yields responded sharply to these comments with the 2-year U.S. Treasury yield climbing from 1.93% to 2.27% while the 10-year U.S. Treasury yield jumped from 2.15% to 2.47% by weekend. The spread between the two tenors (often referred to as the 2s10s yield curve) remained about the same (about 20-basis points from inversion). While an inversion of the 2s10s yield curve is often thought to be a precursor for a U.S. recession, Fed Chair Powell stated that he prefers the short-term Treasury curve. In his view, the short end of the curve is more accurate because it reflects when the market thinks the Fed is going to cut rates in response to weakening growth. There is some truth to that with the yield curve often steepening right before a recession, but we wouldn’t completely ignore the traditional 2s10s yield curve. While neither curve is currently signaling an imminent recession, the 2s10s curve is just 3 basis points from inversion at the time of this writing (see figure 1).
Of course, the Fed is not trying to tilt the economy into recession. According to Powell, his goal is that “The economy achieves a soft landing, with inflation coming down, and unemployment holding steady.” But what are the odds the Fed accomplishes this? It is not zero as the Fed has done it before…in 1965-1966, 1983-1984, and in 1993-1995 (see figure 2). During those periods, the Fed tightened monetary policy with no contraction in real economic growth.
To achieve its goal, the Fed may try to dampen demand in order to lower inflation. However, there are just a few examples of the Fed achieving a decline in core inflation without a subsequent recession. As figure 3 shows, during the past 11 Fed tightening cycles (as defined by Professor Alan Blinder of Princeton University), the unemployment rate continued to decline in each tightening cycle while core inflation continued to rise in 9 out of the last 11 tightening cycles. In previous periods of high inflation (1977-1980), the Fed raised rates by 1300 basis points, but core inflation did not come down until the economy tipped into a recession in early 1980 (inflation started to finally fall in January 1981). We think there are three key takeaways from figure 3: 1) the Fed is currently nowhere near telegraphing something like the 1000 basis-points of tightening that generated the hard landings in the late 1970s and early 1980s, 2) there are only a couple of examples of core inflation falling during a Fed tightening cycle, and 3) in 8 of the 11 past Fed tightening cycles the S&P 500 continued to rise. History suggests that absent a policy-induced recession, the Fed’s best hope is still a gradual normalization of global supply chains (something it has little control over). Such a scenario, would be consistent with the “robust” scenario that we have highlighted in our CIO Strategy Bulletin | Three Scenarios for the Economy and Markets.
|Fed Tightening Period||Fed Funds||S&P 500 (Monthly Average)||Unemployment Rate (%)||Core PCE Inflation (%)||Real GDP Drop (%)||Number of Months Recession Occurred After The Start of Tightening||Policy-Induced Recession?|
|Start||End||Start||End||Chg Change in FF (bps)||Start||End||% Chg Change||Start||End||Chg Change||Start||End||Chg Change|
|Jun-04||Jun-06||1.03||4.99||396||1132.76||1253.12||10.6%||5.6%||4.6%||-1.0%||1.9%||2.6%||0.7%||-3.8%||43||Monetary Policy Not Primary Driver|
|Oct-15||Jan-19||0.12||2.40||228||2024.81||2607.39||28.8%||5.0%||4.0%||-1.0%||1.3%||1.7%||0.4%||-10.1%||53||Monetary Policy Not Primary Driver|
Are There Currently Any Signs of a U.S. Recession Forming?
We think it is too early to make a U.S. recession call with our U.S. recession dashboard showing just three of eight metrics as flashing potential recession signals. Two of those metrics we feel reasonably confident in (a potential peak in the percentage of small businesses saying that now is a good time to expand and a potential peak in consumer confidence – both occurring in June 2021). The other metric is highly debatable with initial jobless claims hitting just 187,000 claims on March 19, 2022 – its lowest level since 1969. We think there is a chance that reading marks the trough, but we have no way of confirming that until we see more data. Based on these tentative signals a recession could be possible between March 2023 and March 2024 (see figure 4), but it seems way too early to make that call.
(Sorted By Longest Lead Time)
|Average # of Months Before Recession||Possible Signal Date||Implied Recession Date|
|NFIB: Small Businesses Saying That "Now is a Good Time to Expand": # of Months from Peak to Recession||34||1||Apr-24|
|Initial Jobless Claims: # of Months from Trough to Recession||13||2||Apr-23|
|Yield Curve (10-Yr U.S. Treasury Minus 3-Month Treasury Bill): # of Months from Inversion to Recession||12||?||?|
|Consumer Confidence (Present Situation): # of Months from Peak to Recession||8||1||Feb-22|
|Unemployment Rate: # of Months from Trough to Recession||7||?||?|
|Conference Board Leading Economic Indicators (YoY%): # of Months from Zero to Recession||6||?||?|
|Average Hourly Earnings (YoY%): # of Months from Peak to Recession||4||?||?|
|S&P 500 Stock Price Index: # of Months from Peak to Recession||3||?||?|
What Happens to U.S. Stocks in These Types of Scenarios?
Our base remains that the U.S. will avoid a recession, but we cannot completely rule out a “hard landing.” If that were the case, then historical returns suggest a peak in the S&P 500 about three months prior to the onset of recession with about a 30% drawdown in the S&P 500 during recessionary periods (see figure 5). Once a market bottom is reached, the S&P 500 often recovers quite quickly with the bulk of the recovery occurring in the first 12 months after the market bottoms. Therefore, we encourage investors to focus on “time in the market over timing the market” with the best gains often occurring within just weeks of the worst declines. During Fed tightening cycles when the Fed does achieve either a “soft-landing” or “softish-landing”, S&P 500 has returned about 7.4%. With such a wide range of outcomes, we continue to believe that a well-diversified portfolio and a defensive strategic asset allocation remains the best approach. We continue to favor pharmaceuticals, consumer staples, dividend growers, and natural resources stocks.
|Periods of U.S. Recession||S&P 500 Drawdowns||S&P 500 Returns After Trough|
|Economic Peak||Economic Trough||Months of Contraction||S&P 500 Peak||S&P 500 Trough||% Decline||12 Months||18 Months||24 Months||Second Year Gain/Loss|
|Average Duration:||10 Months||Average (Decline / Gain):||-30.3%||37.2%||39.8%||46.8%||9.5%|
|Index||Weekly Chg change in percent||YTDyear to date change in percent||12 Months12 month change in percent||Div. Yield division yield in percent|
|Instrument||Weekly Chgchange||YTDyear to date||12 Months12 month change||Level|
|10-Year Treasury Yield (%)||32.3 bps||96.3 bps||83 bps||2.47%|
|Index||Weekly Chg change in percent||YTD year to date in percent||12 Months12 month change in percent||Div. Yield division yield in percent|
The Week Ahead
|3/29||10:00||Conf. Board Consumer Confidence||MarMarch||107.0||110.5|
|3/29||10:00||JOLTSJob Openings and Labor Turnover Survey||FebFebruary||11000k thousand||11263k thousand|
|3/30||8:15||ADP Employment Change||MarMarch||450k thousand||475k thousand|
|3/31||8:30||PCE personal consumption expenditures Deflator YoY year on year||FebFebruary||6.4%||6.1%|
|3/31||8:30||PCE personal consumption expenditures Core Deflator YoY year on year||FebFebruary||5.5%||5.2%|
|4/1||8:30||Change in Nonfarm Payrolls||MarMarch||490k thousand||678k thousand|
|4/1||8:30||Average Hourly Earning YoY year on year||MarMarch||5.5%||5.1%|
|4/1||10:00||ISMInstitute for Supply Management Manufacturing||MarMarch||5.5%||5.1%|
|4/1||10:00||Wards Total Vehicle Sales||MarMarch||13.85m million||14.07m million|