As of Monday morning, financial markets look likely to continue their trend from last week. Stocks are off more than 2% and interest rates continue to climb—the 10-Year Treasury rate is up another 0.10% to 3.25% while the 2-Year rate, an important proxy for market expectations of monetary policy, is close behind at 3.20% (up 0.15%). No new news broke Monday. Rather, there is continued worry about the inflation backdrop and what, by extension, the Fed will need to do to curb it. In short, the market is asking “will the Fed need to be so aggressive as to cause a contraction in the economy.” To be sure, the more the Federal Reserve has to hike rates, the greater the probability of a negative economic outcome.
The Fed Meets This Week
The FOMC meets later this week in an extremely difficult environment for any central bank. Inflation is high and there is no evidence that it will moderate soon. Growth is still solid but is set to slow—the only question is how much. It’s an unpleasant situation reflected in the poor performance of financial markets. So, what is the Fed to do? Unfortunately, there are no good answers. With inflation elevated and unlikely to ease meaningfully in the near term, the Fed absolutely must keep inflation expectations in check or the sort of persistent stagflation that characterized the late 1970s becomes a possibility. That means that they have to remain hawkish, despite mounting concerns about growth and financial market volatility. And that is what we expect for the Fed meeting later this week—they are going to be hawkish because they have to be.
The US Consumer could be why we avoid a Recession
High inflation numbers are feeding a growing narrative that the US consumer is in distress. In our view, consumers actually remain in a position to endure this bout of higher inflation, and our forecast calls for the US economy to continue expanding for the foreseeable future. And while we acknowledge the risk of stubbornly high inflation, there’s a path to a slowdown rather than a recession, and the strength of household finances will be key to achieving that path.
While wages haven’t kept pace with inflation, the aggregate household paycheck—which includes the number of people working and the number of hours they work—has kept pace. Even accounting for still-elevated inflation, the US household paycheck is up 2.0% year over year. That’s consistent with the long-term average, and suggests little reason for concern about final sales, which drive gross domestic product (GDP) over time. We expect the labor market to weaken, but a gradual weakening is unlikely to cause a sudden economic stop.
Further, based on first-quarter Fed data on household balance sheets, the amount of liquid savings rose in the first quarter, indicating that households managed to maintain strong consumption without dipping into excess funds built up during the pandemic. Relative to the long-term trend, there’s now about $2.5 trillion dollars (roughly 10% of GDP) held largely in checking accounts—a massive cushion that can help smooth spending even in volatile economic times. It’s also a key reason to think that even a labor slowdown doesn’t need to be catastrophic. What’s more, household net worth remains at or near record levels in every meaningful respect.
And Yet, Consumers Are Borrowing More
That said, household borrowing data present a mixed picture. April’s revolving-credit numbers jumped up for the second consecutive month, raising concern that households are being forced into high-interest-rate loans to make ends meet. Clearly, some households are in distress, particularly at lower income levels where energy and food are a larger share of consumption. With those prices surging, we’re certain that some households have had to resort to credit cards to continue consuming. At an aggregate level, however, we don’t see cause for alarm at this stage. Even after recent increases, overall revolving credit is nearly the same as it was before the pandemic—and overall consumer debt isn’t particularly high relative to recent history.
The Base Case, the Bear Case
To sum it all up, while markets continue to wrestle with big-picture macro concerns, we believe that the US consumer remains in a solid position. The US economy is primarily consumption-driven, and with households in decent shape, our view is that the most likely path for the next few quarters is continued expansion, despite headwinds from inflation and tighter financial conditions. Our base case, for the moment, in this economic cycle is a modest growth slowdown and the strength of the consumer is an important part of that journey.
However, we must also, always, acknowledge a more negative outcome than we forecast. That outcome would be rooted in stubborn inflation that does not recede through the back half of 2022, despite the Fed’s efforts. Continued supply chain disruptions would be present in that scenario, and perhaps an un-anchoring of longer-term inflation expectations toward higher levels than we’ve seen in decades. In this bear case, the Fed would need to tighten policy earlier and more aggressively than consensus forecasts, increasing the likelihood that the price paid for controlling inflation is economic contraction.
What to Do
It’s often difficult to stand by and do nothing in the face of market volatility. Please know, however, that our portfolio managers are actively managing their positions—liquidating when the thesis looks unlikely to be met against the evolving backdrop and adding positions when opportunity presents itself.
Investing involves risk, including loss of principal invested. This information does not constitute an offer or solicitation and should not be relied upon as investment or financial advice or a recommendation of particular courses of action for all investors. Equitable Advisors, LLC and its affiliates and associates do not guarantee the accuracy or completeness of any statements, statistics, data, opinions, forecasts, or predictions offered herein.
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