The COVID-19 pandemic brought the global economy to an abrupt halt in 2020. China, the epicenter of the outbreak, took the unprecedented step of shutting down its economy. This resulted in a ripple effect that was felt all over the world. Airlines stopped flying, cruise ships docked, and restaurant sales plummeted. As a result, services employment saw a significant drop.
Medical professionals did not have a cure or treatment for the virus during its early stages. The only playbook that could be followed was that of SARS, which included quarantine, isolation, and keeping the patient comfortable while hoping for the best.
A Misguided Debate
The conventional thinking regarding the U.S economic and stock market recovery from the 2020 lows as the start of a new economic and market cycle is misguided. The unusual policy response to the COVID-19 pandemic has resulted in an elongated cycle instead of a typical cycle. As a result, there has been a long-anticipated recession that has yet to materialize.
It remains to be seen how the economy will fare in the coming years. However, it is evident that the current state of affairs is unprecedented and may not follow the usual patterns. We would do well to keep this in mind as we navigate the economic landscape today.
The Unusual Elongated Cycle of the Global Economy
The global economy is experiencing unwelcome inflation as a result of the massive stimulus programs implemented in response to the pandemic. However, it is important to view the current cycle as an elongated one that began with the start of the pandemic, followed by recovery and now monetary tightening.
While history doesn’t repeat itself, the current economic circumstances are reminiscent of the double-dip U.S. recession in the early 1980s. During that time, the 2-year Treasury yield (a proxy for rate expectations) peaked in early 1980 before dipping followed by monetary tightening later that year. This period ended with high interest rates that helped alleviate inflationary expectations.
Similarly, in 2020, following a steep fall and then subsequent recovery of the stock market, the U.S. government and Fed implemented massive stimulus programs. However, this resulted in an acceleration of inflation which the Fed has responded to with an aggressive tightening approach.
A Tale of Two Markets
In the early 1980s, the U.S. stock market initially dipped before rallying and topping in 1981. A bear market followed which lasted until August 1982 when the Mexican peso crisis forced the U.S. Federal Reserve to ease. Investors at that time had an opportunity to buy into the market at a single-digit P/E ratio and the August 1982 bottom eventually turned out to be a historic low.
In contrast, in 2020-2023, investors face a vastly different market environment. While history may be rhyming, it’s important to consider the unique circumstances of both markets when making investment decisions.
Inflation Trends: A Look at Core CPI and PCE
Headline inflation has been decreasing, but core inflation rates, measured using CPI or PCE, have remained persistently sticky. This trend has been observed globally.
Although inflation rates have been slow to budge, progress is being made on the fight against inflation. Much of the stickiness can be attributed to the shelter component, which is a lagging indicator. However, positive signs are emerging as core sticky-price CPI less shelter rates are gradually declining.
Federal Reserve Chair Jerome Powell recently acknowledged that while progress is being made, risks to inflation still remain high. Core inflation remains flat, and the Fed is now focusing on this key metric as a leading indicator instead of core sticky CPI less shelter rates.
The Fed is also paying close attention to super-core inflation indicators, mostly composed of wages. The Atlanta Fed reports that median wage growth is still high at 6.3%, with job switchers receiving an average raise of 7.5%. However, the JOLTS report shows that quits are decreasing, which could mitigate the overall effects of job switching.
Despite the progress made, the Fed’s work is not yet complete. Market expectations predict one more quarter-point rate hike in the Fed Funds rate at the July meeting, with no rate cuts expected until early 2024.
The Mirage of a Soft Landing
The US Federal Reserve’s primary challenge is to bring inflation down to 2% or near that level. However, monetary policy is a blunt tool and has a high probability of inducing a recession. Although the official stance of the Federal Open Market Committee (FOMC) is to steer the economy to a soft landing, the reality of history shows that it has succeeded only thrice out of the 13 rate-hike cycles since 1955. Therefore, it’s highly unlikely that the ongoing tightening cycle will result in a soft landing.
The bullish narrative of the stock market also falls apart in this situation. The earnings estimates may be on an upward trajectory again, but a revival of growth will add to the already elevated levels of inflation, further leading to tightening by the Fed. This leads to the question of how this is bullish for equities?
The global nature of the ongoing tightening cycle is making its effects felt. Investors are becoming shortsighted and have failed to recognize that this economic cycle is an elongated recovery from the pandemic of 2020, which is likely to result in a double-dip recession akin to that of 1980-1982.
The Fed needs to tread carefully to avoid turning a soft landing into a mirage.
Cam Hui is a former equity portfolio manager, and his views were first published on his investment blog, “Humble Student of the Markets.”
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