Investors have had to contend with a lot over the past six months: high and sustained inflation, an accelerated pivot toward tighter monetary policy, Russia’s invasion of Ukraine, and big drawdowns in both stocks and bonds related to these headwinds.
And while post-pandemic economic tailwinds and the resilience of corporate earnings have kept investors hoping that the Federal Reserve can engineer a “soft landing” for the economy and avoid imminent recession, we are less optimistic. Specifically, after massive and unsustainable overshoots in the V-shaped economic recovery from COVID-19, the slowing down we’re observing now is more likely a return to pre-pandemic trends, rather than a real contraction in which demand falls below the long-term trend.
For one, it seems inevitable that there was going to be some “payback” in corporate earnings this year after extraordinary 2020 and 2021 results that benefited from record government stimulus and skewed consumer demand toward goods and “stay-at-home winners” earlier in the pandemic. So, we’re not surprised to now see 2022 earnings facing some headwinds with fiscal stimulus ending and consumption beginning to balance toward services, not to mention inflation’s impact on companies’ costs. These challenges were reflected in last week’s notable profit misses in retail and tech.
Here are three key reasons to take this warning seriously:
• Inflation persists. “Core” inflation, which excludes more volatile food and energy items, rose. Drivers behind the rise were “sticky” items whose prices may remain stubbornly high, such as medical care and rents. The basic implication is that inflation is now broadening out, with the potential for it to stay higher for longer historically, a scenario that keeps the Fed in policy-tightening mode. This likely portends additional rate hikes of a half-percentage point combined with aggressive balance-sheet reduction.
• Price pressures may lead to “demand destruction,” in which higher prices eventually cause consumers to forgo purchases they would have otherwise made. Note that we’re seeing slowing demand in sectors that typically do well early in an economic cycle, such as housing and autos. On the supply side, inventory rebuilding has been strong and may now start to slow. First-quarter gross domestic product (GDP) was surprisingly weighed down by a negative drag from a deceleration in private inventory investment. This means consumer demand may cool at a time when inventories have already been restocked, leading to an imbalance that could hurt businesses.
• Commodity- and currency-market volatility complicates the global growth outlook. Turmoil in stock and bond markets has now spilled over into commodities and currencies, casting a shadow over global growth prospects and fuelling uncertainty in still other markets. With commodity prices still relatively high, business and financial conditions are improving for emerging markets (EM) exporters while worsening for importers. These dynamics are exacerbated by a simultaneous strengthening of the U.S. dollar, which causes a squeeze for countries and businesses heavily leveraged to dollar-denominated debt. Shockwaves from these imbalances are increasingly reaching the broader credit market, with spreads on high yield bonds, mortgage-backed securities, and EM debt now widening generally indicating risk aversion.