Updated: Oct 10
Q3 2022 Market Recap
People have been feeling the effects of inflation in nearly every aspect of their lives. Everything from food to gas to home repair products seems to be increasing with each day. So, what caused this inflation to occur and what is it affecting most? Major spending shifts and production constraints are driving inflation. Those constraints find their roots in the pandemic and worsened after Russia’s invasion of Ukraine and China’s lockdowns to combat Covid-19. And, in the U.S., the strength of the job market has boosted wages, creating more inflationary pressure.
Rising Interest Rates
The Federal Reserve is on its fastest rate hiking cycle since the early 1980s. The Fed increased rates by 0.75% for a third-straight time in September and revised higher its projection for rate rises with the aim to rein in inflation.
The Fed now sees the fed funds rate rising to 4.6% by the end of 2023, a significant bump from prior views. The Fed still sees growth this year and sees it picking up next year. But it also wants to see evidence core inflation is on a decisive 2% trajectory beyond 2023 before it stops hiking. Only time will tell if the Fed is correct in their assessment
Possible Recession in 2023.
The main uncertainty is the outlook for the U.S. economy. The pace and magnitude of U.S. Federal Reserve (Fed) tightening create the risk of a recession by the second half of 2023. A deep recession could trigger a larger equity bear market. We think a slowdown or mild recession are the two most likely outcomes. U.S. household and business balance sheets are in good shape, and these should protect against a more severe downturn.
Why would a recession be needed to reduce core inflation? Unusually low supply can’t meet demand. That’s driving inflation. There are two reasons why. First, a labor shortage – people who left the workforce during the pandemic haven’t returned yet. Second, the economy wasn’t set up to match consumer spending’s massive shift from services to goods which hasn’t fully reversed even as the world moves on from the pandemic
Continued Market Volatility
In the U.S., we expect volatile growth and persistent inflation. Overtighten policy first, expect significant economic damage second and then look for signs of inflation easing only many months later.
Central banks can’t fix these constraints, in our view, hence a brutal trade-off: trigger a deep recession by hiking rates or live with more persistent inflation. This assumes production constraints will rapidly dissolve, causing inflation to fall quickly. The implications of all of this: We think central banks will keep raising rates until it’s clear that core inflation is coming down. That means economic activity is set to fall. The Fed’s current policy may drag down U.S. growth far more than it realizes. We’re tactically underweight DM equities as stocks aren’t fully pricing in recession risks.
The bottom line is that rising inflation, slowing growth and the potential for an aggressive Fed can cause a severe recession. We think U.S. core inflation can trend lower over the remainder of the year, but the key question is by how much. A sustained move lower would ease fears around excessive Fed tightening and a deep recession. Until this becomes apparent, however, markets are likely to remain volatile.