On September 21, 2022, the Federal Reserve put a nail in the coffin of the U.S. economy. I don’t mean the 75-basis points (0.75 percentage points) rise in the federal funds rate; the increase to a range of 3-3.25 percent was widely expected. I am referring to the Fed’s so-called dot-plot, which they use to signal its projected path of interest rates. The dot-plot projects rates to reach a 4.75-5 percent range in 2023. The Fed out-hawked the hawks and put the economy and the stock market in danger of collapse.
Before that, on Tuesday, September 13, 2022, the U.S. Bureau of Labor Statistics (BLS) told us that inflation increased month-over-month during the prior month.
As measured by the Consumer Price Index (CPI), inflation increased by 0.1 percent in August 2022. I know that 0.1 percent doesn’t seem like much, but the direction is more important than the magnitude. Economic nerds like me had all the calculations pointing to declining prices in August. I mean, I actually wonder if the BLS got something wrong. More importantly, I wonder how much more damage the Federal Reserve will inflict upon the economy to combat inflation.
For months I have argued that the U.S. economy is in a recession. That may sound obvious to you. However, my assertion contrasts with nearly every economist and financial advisor I’ve heard from. The vocal majority has been proclaiming that the U.S. economy is not in a recession (apparently based on the definition provided by the National Bureau of Economic Research).
Gross Domestic Product (GDP) is the broadest measure of economic output. GDP for Q1 and Q2 2022 was negative 1.6 percent and 0.6 percent, respectively. This quarter, GDP is running at a meager 0.5 percent rate. If sticklers for semantics don’t want to admit that this is a recession, they should at least acknowledge the U.S. economy is flatlining. Yet, somehow, the CPI isn’t going down. I may think the BLS got it wrong, but I am willing to bet that the Fed disagrees with me. The Fed will need to work harder to push price metrics down if they don’t see what I see. And the U.S. can only stay insulated for so long in such an environment.
On Thursday, September 15, 2022, FedEx CEO Raj Subramaniam announced the company missed earnings and revenue estimates. Further, its future is so cloudy FedEx withdrew its full-year guidance. Notably, the CEO expected shipment demand to increase after COVID-shuttered businesses reopened in China. However, demand fell. China is a major global economic player. As a consequence, Subramaniam expects a “worldwide recession.” That’s a world that includes the U.S. of A.
I had predicted that the S&P 500 stock market index would find a bottom before the November 8, 2022, mid-term election in the range of 3,785 to 3,902 points. The Fed crushed that expectation, and now a retest and violation of the mid-June lows are more likely. Still, I anticipate a healthy rally going into 2023. However, I may be selling into that rally. As billionaire real estate investor Barry Sternlicht notes, “the U.S. economy is braking hard.” The Fed’s efforts will fix inflation, but at what cost to the economy? He calculated that every percentage point of interest rate hikes by the Fed adds $300 billion of incremental interest expense to businesses and consumers.
Mr. Sternlicht’s Starwood Property owns roughly 130,000 apartments, making it the largest such owner in the U.S. He agrees that the BLS got something wrong with the CPI. The CPI showed that rising shelter costs increased in the latest report. However, Sternlicht points out that rent prices may be up a lot year over year, but they rolled over on a monthly basis.
Popular inflation metrics, like the CPI, include insufficient data, which nudged the Fed into making what I consider a monetary policy misstep. Readers might recall that prior to and through the 2022 market sell-off, I found opportunities to de-risk portfolios. Later I used some tax-loss selling strategies to return to more normal allocations. Based on my feeling, the U.S. economy is in a recession despite the constant public argument that I am wrong. That’s fine; I can take the eye-rolls. GDP was negative for two back-to-back negative quarters, now followed by an essentially flat one. One thing many can agree on is that the economy is fragile enough that it would not be able to withstand the next big shock. I suspect the Fed fighting false inflation numbers is that shock.
Per Okum’s Law, a one-percentage-point deceleration of GDP growth over a year would reduce employment growth by 800,000 jobs per year. This won’t be enough to bring the Fed’s preferred gauge of inflation, the core PCE deflator, down to its 2 percent target. As the Fed continues to tighten more than I think it should, labor demand will weaken, and more workers will be laid off. Recessions happen when there is a loss of faith. If the Fed keeps raising rates, it will crush the labor market and spike the unemployment rate. That’s the stuff, the loss of faith, that bigger recessions are made of.
My new fear is that the previous stock market correction bottom isn’t a range of 3,785 to 3,902 points. There is now a larger-than-tail risk probability of a full retest and violation of the mid-June 2022 lows. Then what? Well, I expect a rip-your-face-off rally before the “real” recession of 2023 begins.
On September 13, 2022, the day of the August CPI report, zero stocks in the Nasdaq 100 stock market index increased. None. That level of violent selling has occurred 13 other times since 1996. The median gain one year later for the Nasdaq 100 has been 21 percent.
I believe inflation peaked in June 2022, but the Fed isn’t acting like that’s the case. The Fed is likely to overstep in its interest-rate-hiking campaign. The result is that the Fed doesn’t just put the brakes on the economy but breaks the economy. In this case, any year-end rally should be faded because the 2023 market could make 2022 look like chump change. Investing in bonds will become en vogue once again. Short-term bonds may become more attractive than stocks for absolute returns for the first time in a long time.
Still, as I indicated above, I think inflation peaked in June 2022. Supply chains are improving. Commodity prices have collapsed. Rent prices are rolling over. Using data other than what’s in the CPI, used car prices are down 11 percent year-to-date (but it’s up 1.5 percent using the CPI’s components). Retailers are gagging on inventory. Shipping rates from Asia to China are 60 percent off their peak. Prices paid for inputs by manufacturing firms dropped to their lowest since June 2020. This is important because back in the day, the S&P 500 bottomed after each headline CPI peak.
Also, keep in mind that the S&P 500 selloff after the August CPI report was one of the worst day 5-day selloffs post-CPI. After previous extensive post-CPI-report declines, the market was up an average of 18.8 percent six months later.
I paint a rosy picture. Yet I still fear for the markets in 2023.
I am reminded of the Harry Truman quote, “Give me a one-handed economist. All economists say, ‘on one hand…’, then, ‘but on the other.’” I am guilty of that today because the Fed’s reaction to misleading inflation data may lead to a longer and larger recession. Allow me to put my right hand in my pocket and give you my current best guesses and subsequent tactics for the next 6-12 months (all of which are subject to change as we get more information).
- The S&P 500 will bottom before the November 8, 2022, mid-term elections. I had expected a range of 3,785 to 3,902. The Fed has now set up the market for a violation of the mid-June 2022 lows.
- Data will eventually show that inflation peaked in June 2022.
- The six months following the pre-mid-term election low will be a good period for stocks. The market will return north of 15 percent, perhaps getting within view of its 2022 highs.
- The Fed will have raised the Federal Funds rate to 4.75 percent by January 2023 (which is higher and faster than my previous expectation).
- As the stock market rallies into 2023, I will reduce selective equity positions and buy short-term bond funds and buffer funds (essentially “portfolio insurance”).
- Despite the Fed pausing its rate increases at its March 2023 meeting, it will push the U.S. economy into a recession. And not just an “Allen Harris says it’s a recession” recession. It’ll be the type of recession we can all agree on.
- The “true” bottom to this bear market will be 3,400 to 3,561 points on the S&P 500 sometime in 2023.
I am changing a lot of my feelings regarding a pre-election bottom. I still expect a bottom; however, I think the Fed will be overly tough on the economy, so it won’t be the bottom. There’s a lot of money to be made in the stock market between now and early 2023—possibly erasing this year’s losses. But the real recession is lurking beyond that.
Allen Harris is the owner of Berkshire Money Management in Dalton, Mass., managing more than $700 million of investments. Unless specifically identified as original research or data gathering, some or all of the data cited is attributable to third-party sources. Unless stated otherwise, any mention of specific securities or investments is for illustrative purposes only. Advisor’s clients may or may not hold the securities discussed in their portfolios. Advisor makes no representations that any of the securities discussed have been or will be profitable. Full disclosures: https://berkshiremm.com/capital-ideas-disclosures/ Direct inquiries to Allen at AHarris@BerkshireMM.com.
