Investing has been considered an expectations game ever since John Maynard Keynes famously compared the stock market to a beauty contest: The best strategy to win is to select the contestant who you believe the majority of people will pick rather than your personal favorite.
But this analogy only goes so far in understanding what happens when markets are unusually volatile. Consider, for example, the profound changes in expectations that have occurred of late.
At the start of the year, investors were upbeat about the prospects for the economy even though inflation accelerated in the second half of 2021. The main reason is they concurred with the Federal Reserve’s assessment that the pickup was transitory. Accordingly, they anticipated that the Fed would raise rates very gradually – by 25 basis points a quarter — to bring inflation closer to its 2 percent average annual target.
But when inflation surged to a four-decade high this year, the Fed was compelled to raise the funds rate by 50 basis points and 75 basis points, respectively, at the May and June Federal Open Market Committee meetings. Moreover, it is expected to make another 75 basis point hike at next week’s meeting in the wake of the June CPI report that showed headline inflation topped 9 percent.
The Fed’s aggressive stance has heightened investor concerns that it could be making a policy error and tip the economy into recession. The U.S. stock market and bond market both posted their worst first half returns since the early 1970s and 1980s, respectively. Meanwhile, prices for commodities, including oil, liquified natural gas, lumber and copper have declined significantly from their peaks in anticipation of global weakness. Consequently, some observers contend that inflation has peaked.
So, what is happening to produce the heightened market volatility?
My take is it is an illustration of George Soros’s concept of reflexivity. In his formulation, there is an underlying economic reality and a perception of it by investors. As their perceptions change, so do market prices, which in turn alter the economy. Instead of investors being rational, as economic theory presumes, their views can be mistaken and generate market instability.
The initial mistake investors made was to believe that inflation would be transitory. Now, some commentators believe a recession is already underway. Their argument is that real GDP fell by 1.6 percent at an annual rate in the first quarter (mainly due to swings in trade and inventory levels), and the Federal Reserve of Atlanta’s tracker for the second quarter points to a modest decline.
Economic conditions, however, are more complex than this rendering, as the data are mixed. With the unemployment rate near a record low, jobs growth solid and final demand positive, it is hard to believe a recession is underway. Also, there has never been a recession when real interest rates were negative.
What is not in dispute is that the economy is softening. The focus now is on consumer spending, which accounts for almost 70 percent of GDP. It slowed in the first half of this year as real income growth turned negative due to high inflation. The latter has also shaken consumer confidence with the University of Michigan survey plummeting to an all-time low while the Confidence Board survey shows a smaller decline.
On the positive side, household balance sheets are strong and personal income is well above levels before the pandemic owing to record government transfer payments: Accumulated savings since the pandemic struck are estimated to be in excess of $2 trillion. Also, jobs are readily available, which should help to cushion the impact of negative growth in real incomes.
Looking ahead, the key issue relates to the sensitivity of the economy and inflation to higher interest rates. Pessimists believe the U.S. economy is very sensitive to rising interest rates. However, the experience over the past four decades suggests it reacts more to changes in the availability of credit than to the cost of credit.
This lesson was learned in 1980 when the fed funds rate reached 20 percent and the Federal Reserve implemented a voluntary credit restraint program to slow bank lending. The economy swooned soon after, and it then rebounded when the program was removed. It was not until mid-1981 that record-high interest rates caused the economy to slip into recession.
A key difference today is that inflation expectations are not firmly entrenched. Indeed, the Fed’s motive in raising rates is to maintain investor confidence that it will not allow inflation to spiral out of control.
Whether it can avert a recession hinges on how quickly inflation and inflation expectations are curbed. As commodity prices come off their peaks, inflation expectations are moderating as indicated by a narrowing in the spread between Treasury yields and TIPS (Treasury inflation-Protected Securities). Also, the U.S. dollar is super-strong, reaching parity versus the euro for the first time in 20 years and climbing to a two-decade high versus the yen.
These developments indicate that investors have not lost confidence in the Fed as they did during the 1970s. Indeed, the bond market is pricing in that the Fed will ease monetary policy next year.
The risk, however, is that core inflation that excludes food and energy may remain well above the Fed’s 2 percent target for some time. The primary reason is that the cost of shelter, which accounts for one third of core CPI, is poised to rise further due to the steep increase in mortgage rates this year and home prices previously. Therefore, the Fed may be compelled to raise the funds rate beyond what is currently priced into markets.
Weighing these considerations, the most likely outcome is a milder version of stagflation than in the 1970s. If a recession were to materialize, it would likely be short-lived for two reasons. First, balance sheets of households and businesses are solid, and there are no major sectoral imbalances. Second, the financial sector is sound as banks were recapitalized after the 2008-09 Global Financial Crisis. This lessens the risk of a broad-based credit crunch that typically accompanies deep recessions.
Consequently, with a lot of bad news already priced into markets and valuations more reasonable, investors should not over-react to the talk of recession.
Nicholas Sargen, Ph.D., is an economic consultant with affiliations with Fort Washington Investment Advisors and the University of Virginia’s Darden School of Business. He has authored three books, including “Global Shocks: An Investment Guide for Turbulent Markets.”