Hot inflation, stagflation concerns, recession fears and a hawkish Fed.
The ugly combination of sharply higher inflation, aggressive Federal Reserve tightening, plunging business and consumer confidence, and slower economic growth have increased stagflation worries among investors. On the positive side of the ledger, the labor market, consumer spending, housing and manufacturing have all been strong, but they are all showing signs of decelerating growth. In our view, this week’s sizzling inflation news has increased the odds of recession.
Peak inflation? Consumer Price Index (CPI) retail inflation hit a new 41-year nominal high in June of 9.1% year-over-year (y/y), while the nominal Producer Price Index (PPI) wholesale inflation surged 11.3% y/y in June, just off a record 10-year high of 11.5% in March. With commodity prices across the board starting to recede in recent months due to growing recession concerns, could inflation be peaking as the Fed is ratcheting up the removal of monetary policy accommodation? Growth in average hourly earnings has also slipped from 5.6% y/y in March to 5.1% in June, but that still represents a worrisome 4% loss in purchasing power.
Confidence falling With inflation soaring, the Michigan Consumer Sentiment Index plunged to a record low of 50 in June, down from a two-year, pre-pandemic high of 101 in February 2020. Likewise, the NFIB Small-Business Optimism Index plummeted to a nine-year low of 89.5 in June, down from 104 in October 2020.
Fed dead serious The Fed is now appropriately and aggressively raising interest rates and shrinking its bloated $9 trillion balance sheet in an attempt to manage the Phillips Curve trade-off between a potential increase in unemployment and slower inflation. Market speculation is rampant it will hike rates by 100 basis points in its next meeting July 27. The last time it jumped that magnitude was March 1984.
Will the Fed declare victory over inflation it its annual symposium at Jackson Hole, Wyo., in late August and telegraph a downshift on rate hikes at their September, November and December meetings? While those decisions will be data dependent, the fed funds rate could peak at 3-4% by the end of this year.
Labor market slowing To be sure, nonfarm payrolls rose by a stronger-than-expected 372,000 jobs in June, but May and April were revised down by a combined 74,000 jobs, erasing nearly 70% of the upside surprise. Meanwhile, JOLTS have slipped from 11.86 million job openings in March to 11.25 million in May, and Challenger job cuts have surged in June 57% from May and by 59% from a year ago. Initial weekly jobless claims have risen 47% over the past 16 weeks, and the smoother four-week moving average is up 38% over the past 14 weeks. The ADP private payroll survey (which halted its publication for two months in June and July to revise its methodology) suffered a huge miss in May at 128,000 jobs, down 79% from a gain of 601,000 jobs in February, as small company hiring (an important engine of U.S. growth) fell for four consecutive months. The household survey lost 315,000 jobs in June, declining for the second time in the past three months, and the participation rate at 62.2% in June is down from the pre-pandemic cycle high of 63.4% in February 2020. Finally, the unemployment rate for low-skilled workers leapt to 5.8% in June from its 30-year low of 4.3% in February.
Challenging second-quarter earnings season Results have just begun, and they will be compared to the 88% y/y gain last year, the strongest earnings growth since the fourth quarter of 2009. Profit margins should shrink, due to higher labor, commodity and transportation costs, along with declining worker productivity. FactSet expects second-quarter earnings to rise by a modest 4.3% y/y, which would be the slowest growth since the fourth quarter of 2020. Energy earnings are forecast to more than triple y/y, while industrials, materials and REIT’s should experience solid y/y/gains. Financials, consumer discretionary, utilities and technology could be laggards.
Recession brewing? From a new 61-year record high in February, the Leading Economic Indicators have declined in each of the last three months. Benchmark 10-year Treasury yields have declined from 3.50% to 2.95% over the past month—with a modest 2/10 yield-curve inversion—which suggests the bond market is anticipating slower economic and corporate profit growth, and maybe an eventual recession.
Cutting our GDP estimates again The fixed-income, liquidity and equity investment professionals who comprise Federated Hermes’s macroeconomic policy committee met on Wednesday to discuss the continued surge in inflation, a more hawkish Federal Reserve and the expected deceleration in economic growth:
- GDP growth in the second quarter of 2022 will be flashed on July 28. The Fed has hiked interest rates at an accelerating pace in March, May, and June, and has started to passively shrink its bloated $9 trillion balance sheet. Despite a solid 7.5% y/y gain in “Mapril” retail spending, we reduced our GDP estimate from 2.3% to 0.8% (versus -1.6% in the first quarter). The Bloomberg consensus is currently at 0.5%, the Blue Chip consensus gutted its estimate from 2.8% to 1.1% (in a range of -0.4% to a gain of 2.9%) and the Atlanta Fed’s GDPNow model is at -1.2%.
- We expect the Fed to aggressively hike interest rates at its July and September meetings. In conjunction with a potential dock workers’ strike on the West Coast, this could negatively impact important Back-to-School (BTS) spending. We reduced our estimate from 1.9% to -0.2% in the third quarter of 2022. The Blue Chip consensus lowered its estimate from 2.6% to 1.7% (in a range of 0.1% to 3.1%).
- We expect the Fed to slow its pace of rate hikes in November and December, so Christmas spending could be marginally better than BTS, but likely less than half of last year’s strong season (when retail sales grew 16% y/y). We cut our GDP estimate in the fourth quarter of 2022 from 1.7% to 0.1%. The Blue Chip consensus cut its estimate from 2.3% to 1.4% (in a range of -0.4% to a gain of 2.7%).
- Those quarterly cuts reduce our full-year 2022 GDP estimate from 2.4% to 1.7%. The Blue Chip lowered its forecast from 2.6% to 2% (within a range of 1.3% to 2.6%).
- We raised our full-year 2022 forecast for core CPI from 5.4% to 5.6% (compared with an actual 5.9% in June 2022), and our full-year 2022 forecast for core PCE from 4.7% to 4.8% (compared with an actual 4.7% in June 2022).
- We reduced our full-year 2023 GDP estimate from 1.5% to 0.6%. The Blue Chip consensus cut their estimate from 2.1% to 1.1% (within a range of a decline of 0.5% to a gain of 2.3%).
- We raised our full-year 2023 forecast for core CPI inflation from 3.8% to 4.1% and for core PCE inflation from 3.2% to 3.6%.