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Per Stirling Capital Outlook – April

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On April 4th of this year, one of Per Stirling’s Directors was interviewed for an in-depth article in Barron’s Magazine, which addressed a wide array of topics that we think will be of interest to our readers.  In the following pages, we will share our responses to the interview questions that dealt with the “Fed put”, the potential for a U.S. recession, the inflation outlook, and the financial implications of the war in Ukraine.  On to the interview…

You recently wrote that the “Fed put” has expired. Explain.  Given another opportunity, I would say it in a somewhat more nuanced way.  The Fed has a long and well-established history, which started mid-way through Alan Greenspan’s tenure as Fed Chairman, of being very interventionist and riding to the rescue every time the economy started to slow or the stock or bond markets experienced a substantial decline.  This became known as the “Fed put”.

The Fed previously had the latitude to respond to these conditions with monetary stimulus, as they did not need to worry about exacerbating inflation.  Indeed, these past decades have been a period of globalization, technological advancement and productivity gains, each of which have combined to keep inflation very low, sometimes even undesirably low, as was the case two years ago.

However, in light of the current environment, where we believe that, short of a war between Russia and NATO, inflation is the single largest challenge for both the capital markets and the global economy, we believe that they no longer have that latitude.

As for the “expired Fed put”, I would amend somewhat my characterization of it as “expired”, as there is certainly some level of economic contraction or market decline that would cause the Fed to intervene, if only in the name of economic stability.  It is just that the “strike price” for that put is, in our opinion, much lower than many investors seem to believe.

Moreover, instead of serving in their more traditional role of acting as a safety net under the markets, the Fed may now play the opposite role, as they have a compelling need to fight inflation and because, when stock and bond prices move higher or the economy shows signs of strength, it actually provides the Federal Reserve with the flexibility to be even more aggressive in their battle against inflation, which is likely to be a headwind in the face of stocks in particular.

Indeed, the perceived existence of the aforementioned “Fed put” has, in our opinion, been a major impetus for the outsized portfolios gains of recent decades, and for the continued willingness of investors to buy every dip in the markets.  After all, what do you have to lose in buying every market decline, if you feel confident that the Fed will ultimately come to your rescue?

(click to enlarge the image above)

We believe that the bond market, which has already priced in the equivalent of ten quarter-point interest rate increases in 2022, two or three of which are expected to come in the form of large half-point hikes, is properly discounting what we expect to be a very aggressive tightening of monetary policy.  In sharp contrast, the March Bank of America Global Fund Manager Survey showed that, on average, equity portfolio managers are only expecting 4.4 quarter-point rate increases in 2022.  If the Fed Funds and Eurodollar futures markets are correct, there are likely to be some very disappointed equity portfolio managers.

If anything, there still appears to be a high degree of confidence in the equity markets that the Fed will ultimately reverse its inflation-fighting policies and, once again, come riding to the rescue, as soon as either the economy or the stock market hits a rough patch.  We attribute this perspective, at least partially, to the fact that the average portfolio manager is 45 years old, which means that the last time that inflation was this high, the average manager was only five years old, and thus has no experience with the pervasive impacts of inflation.

There are four main reasons why we believe that the Fed has almost no choice but to act aggressively to combat inflation through both aggressive and front-loaded rate hikes and a fairly rapid shrinking of the Fed’s $9 trillion balance sheet, almost regardless of potential bear markets and/or economic contractions.

The first of those reasons is legislative, as Congress mandated that the Fed pursue “maximum employment, stable prices, and moderate long-term interest rates”.  With a 3.6% unemployment rate, a labor market that Chairman Powell himself just described as “tight to an unhealthy level”, and 5 million unfilled jobs, the Fed would be justified in tightening monetary policy even if inflation were not so problematic.

However, that is unfortunately not the case, and we are confronted with the highest consumer inflation rate in forty years, which means that long-term interest rates are going to be anything but “moderate”, if the Fed doesn’t act aggressively to get inflation under control.  As such, we believe that battling inflation is not just a priority, but likely the Fed’s overwhelming and potentially even singular objective.

The second reason is political.  This is a mid-term election year, and all of the polls suggest that the Democrats are going to take a political beating if the Fed can’t get inflation under control before November.  When you consider that 10% of the population owns 89% of all equities, while 40% of the population doesn’t own their home, has less than $1,000 in the bank, and is being absolutely crushed by higher prices, we believe that the Fed, despite its theoretical independence, is much more likely to cater to the 40% who need inflation down, rather than the 10% who want equity prices up.

The third reason is practical.  Prolonged high inflation is much more damaging to the economy than are either deep recessions or bear markets in stocks or bonds.  Furthermore, once inflation gains a foothold, it is very hard to reverse.  Remember that the last time that inflation was at least this high, Fed Chairman Volcker needed to drive short-term interest rates up to 20%, which rocketed mortgage rates to 18% and the prime rate to 21.5%, while causing two deep, back-to-back recessions (1980 and 1981-1982).  The deep and prolonged equity bear market that resulted drove the S&P 500 price-to-earnings multiples all the way down to 8 times earnings.  It is currently almost 26 times earnings.

Of note, when recently pushed on the issue of today’s problematically-high levels of inflation by U.S. Senator Richard Shelby, Powell vowed to be as “draconian” as Volcker had been, if necessary to bring inflation under control.

The fourth reason is one of Fed credibility as an inflation fighter, and the fact that a central bank’s credibility is one of its most important inflation-fighting tools, as it allows it to effectively change monetary policy by just “jawboning” the markets.

This is of particular importance this time because, while much of the current spike in inflation is due to things outside of the Fed’s control, such as pandemic-related supply chain snafus, the huge fiscal stimulus measures of the past two years, and the war in Europe, they do bear the blame for much of the problem, as a result of the massive expansion of their balance sheet, their decision to wait far too long to start tightening monetary policy, and the change that they made a few years ago to move from a proactive monetary policy, under which they tightened policy as soon as the economy approached potentially inflationary levels, to a new policy that only addresses inflation in a reactive way, after it is already a clear and present danger.

What’s your confidence level the Fed will thread the needle to avoid a recession?

We tend to agree with former Fed Vice-Chairman Bill Dudley, who noted in a March 29th commentary that Fed policy decisions have “made a U.S. recession inevitable”.  From our perspective, it is just a matter of when.

Ultimately, by being overly stimulative and waiting far too long to start withdrawing that stimulus, the Fed is confronted with a situation where they can no longer just tap on the brakes to dampen inflation.  They will instead likely need to slam on the brakes, and that increases the likelihood of recession.

This is reinforced by the fact that the yield curve just inverted, with 2-year Treasury yields moving above 10-year Treasury yields.  This occurred only 16 days after the first rate hike, which is the fastest that it has ever happened.  Indeed, the Fed has never before started a tightening campaign with inflation-adjusted economic growth this low, the difference between long and short-term rates this small or the majority of domestic stocks in a bear market.

We believe that there are a number of reasons why a recession over the next few years is likely, starting with the facts that, over the past seven decades, 75% of all tightening cycles have produced a recession, and that this tightening cycle is likely to be much more aggressive than most.

In addition, the majority of times that consumer confidence has collapsed, as it has recently, a recession has soon followed (illustrated in grey above).  This makes sense, as consumer spending represents approximately 70% of the U.S. economy.  In addition, the price of oil has recently increased by over 50% and, while the past is not necessarily prologue, it is noteworthy that, over the last fifty-plus years, every 50% increase in the price of crude oil has produced (or at least been immediately followed by) a recession.

The aforementioned yield curve may also be particularly instructive, as every inversion of the 2-year and 10-year Treasuries that has persisted for at least ten days has accurately predicted a recession within the next six to twenty-two months, with an average lag of about twelve months.

That said, the part of the yield curve that has historically been the most accurate in timing imminent recessions contrasts the 10-year Treasury yield with that of the 3-month Treasury and, contrary to many yield curves that are inverting, this ratio is still steepening.

This suggests to us that, while a recession is ultimately likely, it is more likely to start in 2023 or even 2024, than in 2022.

It is certainly possible that the signals given by these yield curves may be less reliable than they have been in the past, as a result of all of the buying of Treasuries by the Federal Reserve, and how it has distorted the shape of the yield curve.

There are also analysts that question the message of the yield curve this time, as the “real” or inflation-adjusted yield curve is not yet inverted, as a result of the fact that this time, in what is a significant anomaly, expectations for inflation actually decrease steadily over the passage of time.

It should be further noted that, while the bond markets clearly seem to share our somewhat cautionary perspective, the equity markets do not, as they appear to be pricing in the probability of a “soft landing”.  That is a slowdown that is sufficient to dampen inflation, but not strong enough to cause a recession.  That goes back to the “thread the needle” component of your question.

Of note, the Fed has engineered a “soft landing” three times before (1965, 1984 and 1994), but these were times when the Fed was trying to keep inflation from going up, as opposed to the current situation where the Fed is trying to push inflation lower, which is an entirely different challenge.

Whether or not the U.S. experiences a recession is likely to be of critical importance to equity investors, as bear markets accompanied by recessions tend to be about 50% longer and much more severe than bear markets that are not accompanied by a recession.  Indeed, over the past 50 years, bear markets combined with a recession have been twice as severe and lasted three times as long as non-recessionary bear markets.

How bad could a recession be? 

Current levels of monetary liquidity are so excessively high that it is likely to take a significant amount of tightening before it has any notable impact on the economy, and that may lessen the severity of any recession.

A positive wildcard that could further offset some of the drag from monetary tightening is the positive influence of the reopening of the global economy from the pandemic.  We are hard-pressed to find any historic precedent for the current set of conditions, which makes projections difficult.  That said, we would not be surprised if we were to see one or two quarters of a -1.5% to -2.0% economic contraction.

Interestingly, if you look at the message of the futures markets, they are anticipating that rate hikes will end in mid-2023, and that the Fed will be cutting rates by 2024.  In other words, the markets are anticipating that the Fed will tighten too aggressively and cause a significant recession or bear market, which will force them to reverse course and adopt an easier monetary policy starting in 2024.  In short, as is very often the case, they are expecting the Fed to tighten until they “break” something.

The war in Ukraine has aggravated inflation. What are two or three scenarios for how the impact from this conflict could play out in the markets?  Barring a direct conflict between Russia and NATO, we believe that the biggest impact will likely be on inflation, as Russia and Ukraine are responsible for a significant portion of the world’s natural and agricultural resources, and on global supply chains.  Indeed, in early March, Moody’s noted that the Russia-Ukraine war replaced the coronavirus pandemic as the top risk to global supply chains.

In addition, the Organization of Economic Cooperation and Development (OECD) estimates that the war will cut more than 1% from global growth this year, while adding 2.5% to global inflation.  The OECD further estimates that the war will subtract 1.4% from Euroland GDP and 0.9% from domestic growth.

Moreover, according to a March 22nd report from the Dallas Federal Reserve, if the bulk of Russian energy exports is off the market for the remainder of 2022, which we consider an increasingly possible outcome, “a global economic downturn seems unavoidable”.

Put into historical context how bad current inflation is.  Aside from the hyper-inflationary period from the Vietnam War to the mid-1980s, this is the first time since World War II that we have seen such an outbreak of inflation.

The current inflation rate is sufficient to double the cost of living every nine years, which is a truly extraordinary destroyer of wealth.

While we do think that, depending on the war in Europe, inflation has a good chance of actually peaking-out sometime in the late-second or third quarter of this year, we do not expect for it to approach the Fed’s 2% inflation target anytime soon, which means that monetary policy is likely to become increasingly restrictive over the foreseeable future.  Moreover, according to the Cleveland Fed’s nowcast model, which attempts to gauge inflation in real time, inflation is projected to rise to another four-decade high of 8.4%, on an annualized basis, in March.

For anyone interesting in reading the entire article, which should also address our outlook for the capital markets, it is currently scheduled to be published in Barron’s during the week of April 11th.


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