08.29.22

Fed’s inflation-fighting resolve spooks stocks

The last week’s market highlights:

  • Markets digested a more hawkish message from Federal Reserve Chair Jerome Powell at the Fed’s annual Jackson Hole, Wyoming, symposium on Friday and didn’t like what they sampled. Stocks and bonds sold off in anticipation that interest rates would remain higher for longer in order to cool inflation. The S&P 500 lost 3.4% (-4% for the full week), leaving it in negative territory for August.1
  • U.S. consumers began the third quarter with a welcome fall in PCE inflation — thanks mainly to declining gasoline prices — and saw their real incomes rise by the most since July 2021.2 Consumer confidence readings continued to improve, as well.
  • Last week, Beijing announced a 1 trillion renminbi (about $146 billion) stimulus program designed to offset some of the pain inflicted by President Xi Jinping’s draconian Covid-19 lockdown policies and a snowballing property sector downturn. That sector accounts for about one-third of China’s GDP. Few economists believe this package will lift the Chinese economy out of its doldrums in order to reach the government’s 2022 annual growth target of 5.5%.
  • July’s U.S. employment report (+528,000 payrolls) was shockingly strong. On Friday, we’ll see how August stacks up. Job creation should moderate but remain robust (in the 200,000-300,000 range), with the unemployment rate staying at 3.5%.

Each week, we present our featured topics in the context of the major themes from Nuveen’s most recent global investment outlookOpens in a new window:

  • U.S. economy: Recession has become a 50/50 proposition by the end of next year.
  • Global economy: High commodity prices threaten emerging markets and energy importers.
  • Policy watch: Central banks are tightening but now risk going too fast, too far.
  • Fixed income: Corporate credit and municipal bonds offer some recession protection and compelling value.
  • Equities: Too soon to call a market bottom with recession risks looming, but U.S. growth stocks have cheapened a lot.
  • Asset allocation: Plenty of opportunities for investors with a tolerance for volatility.

Quote of the week:

"Too many people spend money they haven’t earned, to buy things they don’t want, to impress people they don’t like."  –  Will Rogers

The U.S economy appears to be headed for a “soft landing,” while Europe’s doesn’t

After registering year-over-year headline inflation of 6.8% in June, the Personal Consumption Expenditures (PCE) price index cooled to 6.3% in July, helping to refresh the U.S. economy by boosting consumers’ purchasing power and allowing them to refill their coffers.3 We believe this decline signals that inflation has peaked.

You might say that consumers “deserve” to see their money go further. After all, they’ve shown considerable resilience during the pandemic in the face of massive lifestyle disruptions and sharp price swings.

That resilience includes a healthy dose of adaptability. Take gasoline, for example. Over the past year, drivers have been buying less gas as prices at the pump have soared 44%.4 Not all expenses are as easy to cut amid surging inflation, though, as we’ll see with home heating costs in the coming months.

Adaptability during volatile price shifts is just one factor that explains consumer strength. Another is the lasting legacy of (1) pre-2022 ultra-low interest rates that left most households with manageable debt service costs and (2) over $2 trillion in “extra savings” this year.5 (In this context, the term refers to the amount by which people’s cash reserves during the Covid-19 crisis exceeded what they would have normally saved.) According to Goldman Sachs, nearly all of this excess savings is being held in liquid bank accounts, so it’s readily available and could be spent quickly, providing a rapid boost to the economy. (Consumer spending makes up about 70% of U.S. GDP.)

Job security is another major factor supporting consumers. Expectations for a steady paycheck provide peace of mind, making it easier to draw down savings. At the same time, a still-tight job market offers some assurance that if people are laid off, they should be able to find another position with comparable pay fairly quickly.

July’s PCE inflation release wasn’t the only data drawing attention on Friday. Both personal income (+0.2%) and consumer spending (+0.1%) undershot expectations.6 However, with inflation losing steam, real spending growth was solidly positive, helped by the largest monthly increase in real disposable personal income since July 2021. (It’s still down nearly 4% over that stretch, though).7

Meanwhile, the mission for central banks is to lower core inflation without creating a large increase in unemployment. Right now, investors increasingly think the European Central Bank (ECB) will have a much tougher time accomplishing this than the Federal Reserve. Why? The average rate of inflation implied by the U.S. Treasury market over the next two years has fallen well below 3%, while in Germany it’s over 7%.8 Such hot expectations make declaring “mission accomplished” on inflation far more challenging for the ECB.

In addition, the Federal Reserve has more flexibility in interest-rate policy than the ECB because inflation data appears to be trending in the right direction. That makes it less necessary to “shock” markets with extra doses of significant, painful rate hikes. And it suggests that the Fed will have an easier time achieving a “soft landing” — containing inflation without tipping the economy into recession — than its European counterpart. But that doesn’t mean investors couldn’t use an occasional jolt of reality. Indeed, they got one from Fed Chair Jerome Powell at the Fed’s annual symposium at Jackson Hole, Wyoming, held on Friday (see below).

Powell leaves no doubt that the Fed means business

Over the past few weeks, investors seemingly were sitting on pins and needles waiting for Jerome Powell’s speech from Jackson Hole. Apparently, hearing from him after each Fed meeting, in addition to occasional speeches and his semiannual Congressional testimony, wasn’t enough given the Fed’s increased importance during this period of hot inflation worldwide and slowing global growth.

Powell made clear that the Fed hasn’t seen nearly enough evidence of disinflation (i.e., a decrease in the rate of inflation) to pause its tightening efforts, let alone begin lowering rates. He not only stuck to his post-meeting script from June and July — emphasizing that the central bank must remain resolute in its mission to lower inflation — but also stated that bringing prices down might entail “some pain” for households and businesses.

This hawkish stance threw cold water on traders’ bets that next year the Fed would reverse at least some of its 2022 rate hikes. In fact, the current state of monetary policy is far tighter than most economists could have anticipated back in January, March or even in early June, before 75 basis point rate hikes have seemingly become the norm. We still expect another such increase at the Fed’s next meeting in September, followed by a handful of smaller hikes.

The outlook for the U.S. economy has brightened over the summer thanks to declining energy prices, steady consumer spending and solid payroll growth. This will likely only provide more justification for the Fed to stand firm on raising rates and keeping them elevated. Anticipating looser policy in 2023 is actually pessimistic, because it suggests a weak U.S. economy will force the Fed to choose between supporting growth and combating inflation. If the Fed doesn’t have to make that decision — because consumers and businesses continue to look healthy — the U.S. will probably have avoided a severe recession.

To our readers: The next edition of the Weekly Market Update will be published on Monday, September 12.

Sources:
  1. Marketwatch, FactSet
  2. Bloomberg
  3. Bureau of Economic Analysis
  4. Bloomberg
  5. Goldman Sachs
  6. Bureau of Economic Analysis
  7. Bloomberg
  8. Bloomberg

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