Late Economic Cycle Commentary

INVESTMENT COMMITTEE COMMENTARY August 2022

Inflation remains high and the Federal Reserve (Fed) knows U.S. money supply growth, which surged a historic 25% between 2020-2021, must be curbed further if inflation is to moderate.

Fed Chair Jerome Powell announced an increase in short-term interest rates of 0.75% in July and commented the Fed was committed to reducing the high level of inflation.  Investors were positive on Powell’s comments at that time and both equities and fixed income investments rallied.

However, speaking from a central bank symposium on August 26th,  Powell presented a more hawkish tone saying the Fed must continue raising interest rates and keep at it until the job is done.  This could “require a sustained period of below-trend growth”.  Investors had been hoping the Fed would slow its rate tightening sooner and Powell’s comments squashed any hopes of a near-term Fed pivot.  As a result, equities and fixed income investments fell sharply, reversing much of the July gains.

Of note, some emerging markets (EM) central banks which had been preemptively raising interest rates earlier than developed countries were able to slow rate increases.  China and Turkey cut rates.  As a result, EM equities performed better than developed countries.

In August, the S&P 500 and foreign developed equities dropped 4.1% and 4.5%, respectively.  Emerging market (EM) equities gained 1.2%.   For the month, the yield on 10-year Treasuries rose from 2.64% to 3.13%.  As a result, intermediate investment grade bonds fell 2.8%.

Late Economic Cycle Commentary

Inflation has been and continues to be a key driver of Fed policy, fiscal policy, investor uncertainty and short-term investment performance.  The following are recent months’ year-over-year, non-seasonally adjusted inflation rates.

Of note, the inflation rates of the selected components are still high and trending higher, particularly housing and food.  The data shows inflation is stubbornly problematic leading to Chair Powell’s most recent comments.

The Inflation Reduction Act of 2022 was signed into law by President Biden on August 16th.  Despite the name, the Congressional Budget Office estimates the law will have “a negligible effect” on curbing inflation in 2022 and 2023.  With a key focus on policies related to climate, tax, semiconductor and technology research, the law includes a 15% corporate minimum tax rate on corporations with income of at least $1 billion. Additionally, corporate stock buybacks will face a 1% excise tax.  JP Morgan estimates the additional taxes will reduce S&P 500 earnings growth by 3% in 2023.

Other late cycle economic reports have shown both negative and positive trends.  Monthly single family housing permits and starts have fallen since February by about 25%.  The National Federation of Independent Business Optimism Index has also trended lower over 2022.  However, employment numbers remain sound.  Nonfarm payrolls are now above pre-pandemic levels.  Unemployment ticked up slightly to 3.7% in August which was due, in part, to the largest increase in the U.S. labor force in 2022.

Late-stage economic cycles, by their nature, exhibit greater market volatility. Current uncertainties may dissipate as we get more reports showing the economy is normalizing and as more companies are calling workers back to the office.  Thereafter, the recession does not have to be deep, but that will depend on how quickly inflation can drop and how much earnings and employment can hold up.  With current uncertainties, now is not the time to be adding risk to investment portfolios. However, strategic neutral equity weightings are appropriate.  Investors are encouraged to maintain discipline while avoiding urges to react to short-term market noise.

If you have any questions, you should consult with your JMG Advisor.

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