The 1994 Fed hiking cycle is often mentioned as a very unusual period, but in 2022 the FOMC has increased interest rates faster and more than during the 1994 episode, and the FOMC expects this to be the biggest percentage point increase in the Fed funds rate in recent history, see chart below. Inflation is 8.3% and the FOMC’s inflation target is 2%. The Fed is trying to cool down the economy by tightening financial conditions, i.e. by pushing rates higher, credit spreads wider, and stocks lower. Investors should be positioned accordingly.
If you had entered 2022 with a portfolio of 60% stocks and 40% fixed income, you would be down 20% so far, see chart below. With inflation still at more than 8% in the US, EU, and the UK, central banks will continue to push rates higher and stocks lower to cool down the economy and slow down earnings growth until inflation moves closer to the central banks’ 2% inflation target.
Monetary theory points to a sharp decline in inflation over the coming months, see chart below.
The FedEx results don’t tell us much about the broader economy because goods only make up 18% of GDP, and consumer services such as air travel, hotels, restaurants, sporting events, and concerts are not slowing down. The bottom line is that the goods sector in the economy continues to cool down, and consumer services continue to overheat, see chart below. For markets, the implication is that the Fed will continue to slow down the interest-rate sensitive goods sector, including housing and autos, while we wait for the service sector to show signs of cooling down.
Last week, the S&P500 continued to follow the pattern seen in 2008, see chart below.
At last week’s FOMC meeting, the Federal Reserve announced that they were raising interest rates by 75 basis points. They also reinforced the message that we can expect additional rate hikes until inflation starts to come closer in line with their 2% target. In a relatively short amount of time, the Fed has significantly changed their expectations on interest rates and the economic outlook. FOMC forecasts are now predicting that the Fed funds rate will hit 4.5% by the end of next year. Not so long ago, they had forecasted that the same rate would be zero at that point in time. Given this dramatic shift, it’s not surprising that assets like equities and credit continue to see spreads widening.
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In March 2021, the FOMC thought the Fed funds rate would be zero at the end of 2023. Now they think the Fed funds rate at the end of next year will be 4.5%, see chart below.
Our attached Slowdown Watch PDF shows that the US economy is still overheating, with unemployment at 3.7% and inflation at 8.3%.
The consensus is now expecting a recession in Germany in 2023, see chart below.
Although services make up 80% of GDP, fluctuations in the goods sector are still important. Inventory levels are normalizing as a result of the supply chain improving and the goods sector of the economy slowing down, see chart below. Inventories for wholesalers are back to pre-pandemic levels, but inventories for retailers are still substantially below 2019 levels.