Market Commentary: September 2023

“It's Tough to Make Predictions, Especially About the Future” - Yogi Berra

Uncertainty is inherent in the economy. To navigate this uncertainty, economists analyze data to identify patterns in the market and utilize those insights to inform predictions and investment decisions. For months, much of the economic community has projected a recession is likely during 2023 based on available data. However, a recession has not yet occurred. Why?

A “Hostile” Fed Introduces Uncertainty

Today, there is reason to believe there is more uncertainty than normal because of a change in the position of the Federal Reserve (the Fed). Over the last ~40 years, the Fed has been “friendly,” utilizing interest rate policy and balance sheet management to encourage economic growth while simultaneously attempting to keep a check on inflation and potential bubbles.

For example, one of the most reliable signs of a recession is a yield curve inversion, which indicates that short-term interest rates have higher yields than long-term interest rates. Usually in this situation, a “friendly” Fed would lower short-term interest rates to stimulate the economy and nudge it out of a recessionary stance.

However, with the charge of reducing inflationary triggers, the Fed has adopted a “hostile” stance, aggressively raising interest rates over the past 18 months to 5.25%-5.50%, creating and then exacerbating a yield curve inversion, which has now been in place since July 2022.

We haven’t seen a “hostile” Fed in over 40 years. Sure, there have been moments of Fed opposition in the aftermath of multiple looming bubbles over the last four decades (e.g., 1987, 1995, 1999, 2006), but all of these led to rate increase cycles peaking prior to the previous peak (Figure 1). This means the Fed felt it was appropriate to limit monetary policy to a point short of the restriction level of previous cycles – which is not what we’re seeing today, with rates higher than they’ve been in 22 years.

Figure 1: In 1987, 1995, 1999, and 2006, Federal Funds Rate increase cycle peaks were lower than previous rate increase cycles. This is not the case in 2023.

                                                                                                 Source: The Federal Reserve Bank of St. Louis

Without the foundation of a “friendly” Fed, the patterns we use to understand markets still hold, but may differ in magnitude and timing. Remember that the Fed pinned short-term rates at essentially 0% for much of the period from late 2008 to early 2022. Does this mean the market must tilt bearishly to resolve the uncertainty introduced by the “new normal”? Not necessarily. However, it does mean the ride will likely be bumpier as magnitude uncertainty and timing uncertainty become more of a challenge.

Why a Recession Hasn’t Happened – Yet

With interest rates the highest they’ve been in 22 years, and a shrinking balance sheet, historical data suggests a recession is likely. Having said that, it is a well-known axiom in economics that central bank monetary policy acts with “long and variable lags,” where the timing is uncertain between the Fed’s policy changes and the impact of the changes. It has been 18 months since the first rate hike, historically a reasonable lag before the subsequent recession. In fact, because the pace of rate hikes has been far swifter than in the past, many suggested the recession would come more quickly this time. However, there may be good reasons why the recession has not yet come to pass and why it does not look imminent. Here are some examples:

1. ‍Historically Strong Consumer Balance Sheets. There is no doubt the rate hikes (as shown in Figure 1) are steep by historical standards. After the Fed’s expansion during the coronavirus and, to a degree, the Global Financial Crisis (Figure 2), it is now allowing some balance sheet runoff — letting maturing bonds expire without reinvesting the money in new bonds. This runoff has been relatively insignificant when compared to the magnitude of the expansion. Additionally, there are expanded assets in the form of consumer balance sheets. Put differently, consumers have more cash and net assets (i.e., assets less liabilities) than in this stage in previous expansions. Thus, they are better positioned to weather higher rates and a tightening money supply in the short term.‍
2. Continued Loose Fiscal & Monetary Policy. In the wake of the debt ceiling confrontation, the Treasury Department drew down its Treasury General Account almost entirely during the first half of 2023, injecting liquidity directly into the financial system. In addition, the Fed suspended its Quantitative Tightening program in March to ameliorate the Silicon Valley Bank collapse and extended liquidity lines, leading to a temporary re-expansion of its balance sheet. At the time, the S&P was relatively flat for the year, and since that point, the U.S. markets are up ~23%. In the short term, these actions buoyed the economy and markets. However, if the Fed intends to prevent a recurrence of inflation, these actions will lengthen the timeline of its monetary tightening. ‍
3. Tight Labor Market. The labor market remains tight, as evidenced by continued low jobless claims and a low unemployment rate. So, even though corporate profit margins have shrunk to a degree with recent inflation, the margins have not shrunk enough to beget mass layoffs, except for a few industries. This, on top of the prior point, is keeping consumers in the game longer than would have otherwise been expected.‍
4. The Effect of Higher Rates Has Not Yet Trickled Through. During the pandemic, longer-term debt was locked into at lower rates, so the effect of higher interest rates on corporate and personal cost of capital has been muted until now. This debt will mature at some point for corporations, but not imminently en masse. Moreover, consumer debt is even more locked in, as by far the largest consumer liability, the personal mortgage, is locked in for decades on average. This is likely to continue to negatively impact the housing market in the form of reduced supply available, as we have seen in the recent months, but it will also continue to positively affect the money being spent in the economy as consumer continue to enjoy the fruits of their locked-in low mortgage payments. ‍
5. Increased Interest Income. As interest rates have surged, interest income to savers’ income has risen sharply, representing a source of consumer confidence to spend.

Figure 2: The Fed expanded during the Global Financial Crisis and the coronavirus pandemic.

Why A Recession Might Still Happen

Given all of this, can we say for sure the recession has been avoided? We think it remains too early to suggest that given the headwinds that continue to present themselves; as the old saying goes, things may be delayed rather than denied.

Ponder the following:

1. ‍Is it possible inflation can be structurally eliminated in the absence of a recession? It is, of course, possible, but history would suggest that is likely not to be the case without an explosion higher in supply side. Contemplate that inflation usually re-accelerates after its first bout has been stymied.[1] As energy prices resume their ascent and recent labor union settlements lead to higher-than-expected wage rates, a resurgence of inflation is not out of the cards.‍
2. Will the Fed have the patience to let monetary policy actions over the last 18 months filter through the proverbial “long and variable lags”? Or will they be inclined to act proactively if inflation makes an encore appearance? If so, what effect will this have on demand and corporate margins? Will the “Fed put” seen over recent decades make a reappearance, or is it dead for the foreseeable future owing to an excess of caution after our recent inflationary spike?‍
3. Are we to believe the yield curve inversion is signaling something different this time? The yield curve inversion has predicted every prior recession without any false positives (i.e., predicted a recession when a recession did not end up occurring) or false negatives (i.e., did not predict a recession when a recession ended up occurring), as shown in Figure 3. As we have said many times in the past, it is always possible it is different this time, perhaps owing to many of the COVID-related anomalies, some of which we have already mentioned (e.g., excess fiscal and monetary stimulus that will take longer to wear off, excess demand for labor, a stronger-than-normal consumer). However, it is generally unwise to assume this time is different.

Figure 3: To date, the yield curve inversion has predicted every prior recession without any false positives or false negatives.

Conclusion

Of course, it is by no means a given that a recession is a given. Denial will win the day over deferral if positive factors outweigh the headwinds, including but not limited to, for example, if artificial intelligence provides the needed productivity boost to offset inflationary pressures or corporate price increases affect sales more than margins, leading to expansion, not contraction, in margins and earnings.

Circling back to our original point, uncertainties abound at this moment, leading to what we believe to be many more economic paths in the realm of possibilities than is normal. In such an environment, prudence and discretion remain essential in portfolios. As developments change, we will continue to update the level of uncertainties and that the means likely for the economy and for markets.

[1] By stymied, we do not mean merely that the year-over-year inflation numbers are easing on account of the base effect that comes from anniversarying higher inflation numbers from the prior year; rather we refer to a true structural amelioration in the month-over-month data.

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