Central banks tighten, stocks slide, bond yields jump

The last week’s market highlights:

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:

"This is the job. Don’t wait for it to happen. Don’t even want it to happen. Just watch what does happen."  –  Sean Connery (as Jim Malone in “The Untouchables”)

The Fed tallies a titanic tightening trifecta

Last Wednesday, the U.S. Federal Reserve raised interest rates by 75 basis points (bps) for the third straight meeting, bringing the “summer of 75” to a close and its target fed funds range to 3.00% - 3.25%, its highest level since 2008.⁴ Coming into the meeting, markets had priced in about a 20% chance of a 100 bps hike, driven by August’s hotter-than-expected “core” Consumer Price Index (CPI) inflation data. The Fed opted to keep the pace of hiking constant, though, perhaps cognizant of markets’ sensitivity to hawkish policy surprises.

Looking ahead, the Fed’s “dot plot” showed a slim majority of voting members anticipates at least one more 75 bps move (probably in November), followed by a 50 bps raise in December. Officials also signaled they don’t intend to cut rates materially in 2023, and Chair Jerome Powell used his press conference to caution against premature policy loosening.

For their part, investors were a bit late in coming around to the Fed’s line of thinking. July’s fierce equity market rally was lifted by optimism that inflation had begun to soften meaningfully. However, those hopes were dashed following continued strong labor market data, along with last month’s CPI print. Accordingly, traders amped up their bets on higher borrowing costs. Just prior to last week’s meeting, they’d priced in another 125 bps of tightening over the Fed’s final two gatherings in 2022.

The potential impact of the Fed’s systematic hawkishness was evident based on its latest set of 2023 forecasts and first since June. The median projection for GDP growth fell to 1.2% compared to 1.7%, while the unemployment rate is anticipated to rise to 4.4% from 3.9%. Inflation is expected to remain persistent, with the median core Personal Consumption Expenditures price index — the Fed’s preferred inflation barometer — edging up to 3.1% from 2.7%, still well above the Fed 2% target.⁵

Having staked a claim as an inflation fighter regardless of the pain raising rates inflicts on the economy, Powell, in our view, will remain focused on this mission until the pace of price increases slows to within 2% or so. The Fed has already brought the housing market to its knees (see below) and is determined to push the U.S. growth rate below its 1.8% long-term trend, which should discourage companies from hiring new workers. As we see it, lowering both wages and spending growth is now the Fed’s only way to reduce inflation over the next 12 months.

How are rising rates affecting the U.S. economy?

The broad increases in interest rates over the past eight weeks have been remarkable — and not in a good way. For example, the yield on the 2-year Treasury, which closely tracks the outlook for monetary policy, has risen 131 bps since August 1, to 4.20%, more than half the 216 bps surge from January 1-July 31. Meanwhile, the 10-year yield, a gauge of long-term inflation and growth expectations, has soared 102 bps, to 3.69%, over that short time frame, nearly matching the 115 bps burst over the prior seven months.⁶ And, as discussed above, the Fed is determined to dramatically lower inflation.

This spike in rates will almost inevitably result in slower economic growth. The only questions, in our view, are (1) by how much will the economy decelerate and (2) which parts of the economy will suffer most. Tighter policy has already left its mark in the places we’d expect, like the housing market. The rate of new home construction has fallen 11% since December, while the rate of building permit applications has dropped 20%.⁷ That’s not encouraging news, especially for an economy that requires more housing in the medium to long term.

Housing is a major component of GDP, generally making up 15%-18% of overall economic growth. This year, it’s acted as a “canary in a coal mine” of sorts. Residential investment, which contributes around one-third of that percentage, detracted significantly from second-quarter GDP and may act as a negative headwind in the third. Moreover, homebuyers tend to fill up their new dwelling with items like refrigerators, appliances and furniture, boosting consumer spending — the U.S. economy’s main engine.

But costs for most of these (and other) big-ticket items have already started to fall or are rising less quickly due to shifting consumer preferences toward services. Now there may be a second reason for their declining prices: Not enough people looking to purchase houses and buy such “stuff.”

Fortunately, builders are still completing homes whose finishes were delayed due to shortages in workers and/or materials. Consequently, housing supply hasn’t dropped off a cliff, but based on plummeting sales data, housing demand has.