COVID-19

Covid-19 is still causing turmoil, but interestingly, it won’t cause an incredible amount of imbalances in the U.S. It’s more of an impact on the global supply chain and the issue in China. Today, we’re seeing a spike in cases in Shanghai, which is a very important city for the global supply chain—when they shutdown and lockdown—suddenly the supply chain breaks down. When there are container ships waiting in ports to be unloaded, but there is limited space for ships to disembark given the massive demand of goods in the U.S. , we experience a lodge jam further up in the supply chain. The good news is China has typically very efficient ports, so once we get through the Covid-19 turmoil, goods and products will reach the U.S. as quickly as possible.

Geopolitical tensions and military conflict

Another issue creating turmoil is geopolitical tensions and military crisis. Historically, the stock market looks through geopolitical tensions and they are short-lived. Similar to what we saw during the Crimea invasion in 2014, stocks rebound and recover swiftly.

Inflation

The main turmoil is inflation. We know that Russia and Ukraine are commodity rich, Russia with energy, wheat and corn which puts pressure on inflation. The big question we’ve been hearing for a long time is, how much of this inflation is transitory. Things like energy and food are typically transitory, meaning the price spikes don’t last but historically things that are sticky include housing or shelter, restaurants, hotels and transportation.

So, as we have been saying over the past few quarters, some of this inflation would be transitory but it’s higher than the Fed thought, so maybe it’s not as transitory as predicted. We believe history repeats itself on these kinds of issues, and inflationary contributors that are transitory will continue to be transitory—they move up and they move down based on supply and demand. Even if the transitory drops down, you could still have inflation at 3-1/2% to 4% range which is pretty high for the Fed which leads to some the turmoil.

Consumer confidence

There is a low probability of a recession this calendar year, however the risks are rising for a recession in the second half of 2023. Let’s take consumer confidence as an example. We hit Covid-19 recession and then rebounded quite swiftly. However, due to some of the turmoil and inflationary pressures we’re dealing with, all of a sudden, confidence started to come down. But the level is just as important as the trend. Today, at 107.2 we’re still at a very elevated level which supports an economic expansion.

If you look back at 2008, you know that confidence is at a historic low, employment rate is nearly 10% and job security was a major concern. Fast forward today and it’s a very different story. Sentiment, which is driven by personal finances, is at a historic low, so inflation is the primary culprit. Confidence is still pretty high and can be tied back to what’s happening in the labor market. Right now, the unemployment rate is where it was before the pandemic. So, is there turmoil in consumer confidence? It depends. Yes, inflation is high, but we think a job market like this can be supporting of the overall economy. The same goes for consumer finance being in good shape which could be driven by what is going on in the housing market right now.

Housing market

With higher mortgage rates, one of the questions we get is, could housing be a catalyst for the next recession? Some worry that we may be in a housing bubble that could lead to further economic turmoil, but our view is that we’re not in a housing bubble right now—but we’re always on the lookout for crafting the foundation. One potential indicator of those crafts would be construction activity. Except for a short-term disruption due to Covid-19 recession in early 2020, homebuilding has been steadily climbing higher for about 15 years. Historically, we’re still well below the levels in terms of homebuilding and we’re still on the lead after the great financial crisis.

Given this, could we experience a recession because of what’s going on in the housing market? We think it’s unlikely given that home construction makes up less than 5% of GDP, but the biggest thing is just the supply and demand dynamic is so different this time around. This will be a key figure to monitor should it start to roll over and to climb, which usually occurs to build up, especially during an economic slowdown.

Labor market

The labor market is a good indicator for what is happening in the economy.And the bottom line is the labor market remains very robust. We know a lot of people exited the labor market during the Covid-19 recession, but we are seeing the participation rate continues to grow to deal with this turmoil. We can also see that during the Covid-19 recession due to stimulus, the savings rates were very high, and are now coming back down to normal levels. Over the long-term, we know the savings rate has historically been 5%-10% but since Covid-19 and the resulting stimulus, the number has been all over the map the last few years. It’s important to note that the savings rate has moved back to its long-term trend over the last few months. From a labor market perspective, with the level of excess savings and more people seeking employment, overall, it’s a good sign for the economy.

The Fed

The biggest risk we’re facing right now is some sort of overreaction from the Fed. We know inflation is high with headline inflation above eight now but the non-transitory part is in the 6-1/2-7 range. This isn’t the overshoot the Fed was looking for. They were hoping inflation would go up three for a while and that could be their overshoot. Over the five- to 10-year period, they want it to average 2-1/2% range which it did before. They now need to get it back down somewhere closer to this. The market starts to be concerned with this and what it means for the economy.

And one of the interesting things that happened in the bond market is the short end of the bond market has shot way up waiting for the Fed to move and has caused the yield curve to flatten out. This thing called the slope of the Treasury curve, gets a lot of headline noise, a lot of people follow it. The two- to 10-year Treasury slope has a very good historical track record of inverting before we go into a recession in the latter stages of an expansion you might say. But you can also see that it tends to do that sometimes a year or a year and a half before. So, the Fed is sending completely different signals. In the three-month to 10-year slope, which the Fed likes to follow, it is nowhere near—not even in the ballpark of something that’s sending a signal that we’re headed towards a recession.

Bond market

Some interesting things are happening in the bond market right now. The two-to-10 is causing a lot of turmoil. We would say look also at the three-month to 10-year and we don’t think there’s a signal. The bond market is not signaling that a recession is six or even 12 months away. We just don’t see that. So, you can easily say that the Fed is a massive participant in the Treasury note rate market right now and they probably are manipulating it at least somewhat. So, it’s a little harder to be as confident in those old indicators like the two to ten-year because the Fed is overly involved in the markets right now. We have to be cautious about these indicators.

The Fed funds rate

The Fed funds rate, which is the control, minus inflation, is an important indicator because if you look at the history of our country, we’ve never had a recession that was a natural recession, not an exogenous recession like Covid-19, but an economic recession that wasn’t preceded by having the real Fed funds rate above 3%.

Somewhere in the 3% to 4% range is what has always been required in order for the Fed to slow down the economy and cause a recession. So, we are not anywhere in the same universe as the type of Fed funds or monetary policy that’s typically been associated with slowing down the economy and causing recession.

We have a long way to go before Fed funds is in the overly tight range that could shut down the economy the way it has in the past.

2022 Economic Forecast

Fundamentals of the U.S. Economy:

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