The fourth quarter of 2021 will likely be the last quarter of above average Gross Domestic Product (GDP) growth the economy will experience for a while. Final GDP numbers reported in Q1 for the fourth quarter 2021 were revised to +5.53% year-over-year and +6.9% quarter-over-quarter versus Q3 of 2021. Growth is going to slow precipitously in the upcoming quarters, but markets have not fully priced this into consideration.
Materially important data points that are showing significant slowing include ISM Manufacturing New Orders, Small Business Confidence, Consumer Confidence, and housing (as measured by pending home sales). What could come next? The answer appears to be a cocktail of ingredients for potential market pain and suffering. Headwinds include impossible comparisons (both GDP and corporate earnings), less discretionary income by consumers as inflation has created negative wage growth and higher living expenses, lower consumer confidence, decade-low consumer sentiment readings, and the Federal Reserve raising rates and extracting liquidity from the financial system during widespread economic slowing.
Consumption numbers are stacked against last year’s stimulus checks ($600 in January, $1400 in March for qualifying individuals), and the extra Pandemic Unemployment Assistance (PUA) benefits. Consumption is the most heavily weighted component in calculating and foresting GDP. All monetary stimulus except the deferral of student loan payments has been removed. Most stimulus money has been spent and tax returns have been received and likely spent.
How much pent-up demand is there at this point for lower- and middle-income households if there isn’t money to spend?
Recently updated modeling for Q1 GDP from the Atlanta Fed’s NowCast is projecting just over 1.1% sequential (Q/Q). Additionally, corporate earnings will be reported against comparisons from Q1 2021; a quarter where the S&P 500 posted 10% Y/Y sales growth and 46% Y/Y EPS growth. Except perhaps the first visible signs of inflation slowing, the setup is even more dire for Q2. In Q2 of 2021, sales growth for the S&P 500 was +25% and EPS growth was +87%. More broadly, GDP grew at a rate of 12.2% Y/Y in Q2. There is no path in the next two quarters leading to growth rates anywhere close to what the economy and corporations experienced last year.
Inflation: Disinflation Delayed
Inflation continues to be highly problematic and highly politicized. The expectations based on the data we had in January showed a transition to disinflation (slowing inflationary numbers, not to be confused with deflation, which would be the cost of goods actually falling in price) by the end of this past quarter was highly probable. Geopolitics has changed unexpectedly and so has the data.
Much like COVID hit the markets unexpectedly in 2020, Russia’s decision to invade Ukraine on February 24th was not on the radar for anyone as a high probability event in 2022. From an inflationary aspect, this event is not the root cause of our current domestic inflationary issue, but it has lengthened the time period until we start to see Consumer Price Index (CPI) ease, mainly due to the spike in energy costs. Neither Vladimir Putin nor Volodymyr Zelenskyy are responsible for bad Federal Reserve Policy and bad domestic energy policy.
January headline inflation was reported at 7.5% and core inflation (excludes food and energy) rose at a 6% annualized rate. In February, those numbers rose to 7.9% for headline inflation and 6.4% for core inflation.
March data reflected another increase, pushing headline CPI to 8.5% and core CPI to 6.5%. January and February’s data was the highest inflationary environment measured since 1982, and March’s numbers came in as the highest reports since December 1981.
Included in March’s data set was a 20% monthly increase in gasoline cost versus February, a 10% Y/Y increase in food costs, 5% Y/Y increase in shelter costs, and a 23% increase in airline transportation costs. The cost of durable goods and used automobiles actually decelerated in March, as did certain commodities such as lumber.
Inflation will run hotter for longer, but the forecast for slowing inflation (disinflation) is intact, just delayed. In the absence of some other unknown event that dramatically alters the macroeconomic stage again, Q2 of ’22 is likely going to be peak inflation.
With “higher-for-longer” now baked into the equation, it also lifts the past-peak inflationary numbers for the rest of the year. In January, CPI was projected to be under 5% by Q3 of this year. More recent forecasts with updated data have raised CPI estimates to around 6.5% in Q3 and still hovering around 5.5% in Q4.
Federal Reserve Policy: More rate hikes & balance sheet reduction. Pushing the economy into recession?
The extreme hawkishness of the Federal Reserve may or may not be a deliberate move to put the economy into recession. It is the course-correction for the policy mistake of last year, which was providing too much stimulus for too long, thus creating inflation that wasn’t “transitory”.
The Fed cannot pump $5 trillion into the economy in the midst of damaged supply chains and not ignite an inflationary firestorm. Inflation is now at levels not seen since Carter and Reagan were President. The Federal Reserve must commence with demand destruction to slow the economy and put slack back into the labor market. It’s an unenviable position, but also a self-inflicted wound.
The Fed remains caught between a rock and a hard place while inflation and politics pull on policy decisions. This is an election year and high inflation is not good for incumbents, but neither is a recession.
At present, the market is anticipating between 8 and 9 interest rate hikes between the next Fed meeting in May and the end of the year. While the March rate increase was only 25bps, May’s Fed meeting likely brings a ½ percent or 50bps rate hike.
Will we get 8 or 9 total rate hikes this year? While it is tough to say, it is fair to assume that if credit markets become too unstable and equity markets get too volatile, some level of pivoting to a more dovish stance would occur. Credit, equity, and housing market turmoil could result in May’s rate hikes being the last for 2022. While this runs in the face of consensus, it would not be a surprise to us.
In addition to the Fed raising the Fed Funds rate, tapering asset purchases to zero is now complete. In other words, the Fed is no longer buying assets and adding to its balance sheet to provide economic stimulus.
Instead, it is anticipated that Chairman Powell will confirm during the May meeting that the Fed will be selling roughly $90 billion of assets per month starting mid-year with the goal of shaving $1.1 trillion off the current $8.9 trillion balance sheet.
Lastly, the yield curve has flattened, and for a few brief moments became inverted in the last few weeks. This is a bearish indicator for markets.
Of historical significance, the last three prior occasions that the yield curve inverted were ultimately followed by pronounced market sell-offs. This happened most recently in 2018 leading to a 20% market decline.
Before that, the curve inverted at the end of 2005, which preceded the Great Financial Crisis. In 1999, the yield curve inverted just before the 40% market crash during the dot.com bubble.
Looking Ahead
The next few months could be challenging for financial markets. Below the surface of day-to-day price movements in the broad stock indices, other risk-related indicators are flashing warning signs.
The Volatility Index (VIX), a measure of fear in the market, has remained stubbornly elevated.
Currency volatility has spiked globally, and the trend of a strengthening U.S. Dollar is causing issues for emerging market economies.
High yield spreads widening signals uneasiness in the credit markets. Slowing economic growth and contracting profit margins will exacerbate any developing issues that the corporate bond market is currently facing.
The risk of recession is rising. The data supports the possibility, history says similar setups have resulted in recession, and the more “recession” is discussed by the media, the more likely it becomes.
The Federal Reserve also needs it to break the inflation cycle. Like last quarter, I believe another misstep by the Fed is in the works and it is the biggest risk to markets by overshooting on rate hikes and quantitative tightening. It would not be a surprise to see multiple rate hikes and balance sheet reduction, followed by new rate cuts and new quantitative easing measures later this year.
The “smart money” is not the pundits on CNBC. It also may not be the hedge fund industry.
Many have already suffered 20-30% losses this year, and some have liquidated and closed. Many continue to be leveraged into crowded trades in Google, Meta, Apple, Netflix, Amazon, Microsoft, Tesla, etc.
The true “smart money” is not chasing overbought and over-owned stocks because of fear of missing out on the next market advance.
Hope is also not a successful portfolio management strategy. Instead, the foundation of any disciplined approach must start with risk management.
Influential value investor and author of the famous book, The Intelligent Investor, Benjamin Graham, summed things up nicely in his quote, “The essence of portfolio management is the management of risks, not the management of returns”. Truer words can’t be spoken. If the first is handled correctly, the second comes as a result.
We are at the precipice of the most challenging market environment anyone has seen for a few decades.
While it is true that during every prior period of volatility, the market has recovered 100% of its losses. Sometimes it happens fast like 2020, sometimes it takes longer like the Great Financial Crisis of 2008/2009.
The key to successfully navigating 2022 is keeping a commonsense approach to proactive risk management, controlling emotion in the decision-making process, and having patience.
Michael Meily
Managing Member
Referenced Sources:
- www.federalreserve.gov
- Hedgeye Risk Management
- Bloomberg
- U.S. Bureau of Labor and Statistics
- CME Group
- Yahoo Finance
- Atlantafed.org
- Investopedia
- www.fred.stlouisfed.org
