By Randy Myers
The Federal Reserve’s battle with inflation will likely inflict short-term pain on the U.S. economy, Jeff Grills, head of the emerging markets debt team at Aegon Asset Management, told participants at the 2022 SVIA Fall Forum in early October.
Grills traced this year’s sharp uptick in inflation to a confluence of factors that included not only an injection of money into consumer pockets via federal pandemic relief programs but also broad changes in the macroeconomic environment—changes that have also impacted many businesses. Heading into the pandemic, he noted, businesses were benefitting from decades of globalization, efficiency gains and just-in-time inventories—all of which helped to hold down inflation. Today they’re wrestling with de-globalization, a drop-off in productivity gains, geopolitical unrest and labor market shortages—all of which are contributing to inflation.
Having failed to take preemptive measures in 2021, Grills said, the Fed is now trying to restore its credibility as an inflation fighter by seeking to reduce aggregate demand—the nation’s total consumption of goods and services. The downside of that course of action is that it will likely send unemployment climbing—the Fed expects the unemployment rate to rise about 100 basis points to 4.4%—and weaken the economy.
To dampen aggregate demand, the Fed has been raising interest rates. It boosted its target for the federal funds rate four times between May and September, by a total of 250 basis points, to a range of 3% to 3.25%. At its September 2022 meeting, the Fed released projections showing it anticipates the target rate to be 4.4% by the end of 2022.
While U.S. financial markets have been pricing in expectations that the Fed will pivot away from further rate increases before the end of 2022, Grills said Aegon does not expect that change of course to happen. He also said Aegon sees a recession looming. While the Fed has suggested it is looking for modest economic growth in 2023, Grills noted that there has never been a period when the unemployment rate has gone up more than 40 basis points without a recession. Meanwhile, the strong US dollar is creating difficult business conditions in the rest of the world, Grill said, which will have negative ripple effects on the U.S. economy.
To watch for evidence that the Fed’s plan to reduce inflation is working, Grills advised monitoring private domestic demand, which accounts for about 86% of the nation’s gross domestic product. The key to its movement will be how prices behave on the services side of economy, which accounts for two-thirds of consumer demand. Services inflation is just beginning, Grills said, and tends to be sticky—once service companies have boosted prices, they tend to be slow to reverse them. Although spending on services is in an upward trend, Grills noted, services as percent of consumption is still near all-time lows, meaning there’s no easy peak from which to pull back.
To some extent, the Fed’s anti-inflation strategy has been working. Mortgage rates, which reached a 20-year high in mid-October, have made it more expensive for the average consumer to afford a house, eliminated marginal buyers, and contributed to a sharp decline in existing home sales.
On the other hand, a low labor participation rate is working against the Fed’s inflation-fighting strategy, Grills said, as older workers with decades of on-the-job knowledge continue to leave the workforce, holding down productivity.
While consensus forecasts are for corporate earnings to grow 7% in 2023, Grills cautioned that the outlook for the stock market isn’t particularly favorable right now. For starters, he said, there has been no recession in history where earnings grew. In fact, they typically decline about 10%.
What’s more, he said, equity values are still high despite the worst sentiment for equity investing since the financial crisis of 2007-2008, with stocks trading on average at 16 times consensus forward earnings, or higher than they were during the crisis. He said the equity market should be on stronger footing by 2024.
On a more positive note, Grills said, much of the bad news is already priced into the fixed income market. If economic growth slows, he said, U.S. Treasury yields could actually be lower next year than they are now. “If so,” he added, “that would hopefully set investors up for a better fixed income market at some point in 2023 or 2024.”
For now, Aegon expects the Treasury yield curve to remain inverted for most of 2023, with the front end of the curve anchored by the Fed around 4.25% to 4.5%, two-year and five-year Treasury notes yielding above 4%, and 10-year and 30-year Treasuries yielding below 4%. This, he said, will make it difficult for any person or entity with adjustable-rate loans and will negatively impact bank earnings. Under that scenario, he said, money center banks should fare better than regional banks.
