Another week, another dismal set of returns. For stock and bond investors, 2022 is off to a terrible start. Now stresses are beginning to emerge in credit fixed income markets. Large Chinese real estate developers are teetering on the edge of default and US high-yield spreads are beginning to gap wider. Growth and speculative stocks (those with little or no earnings) remain under intense selling pressure.
The deeper global equity and bond markets sink, the more contrarian investors begin to ask when is it enough? At what point have financial markets appropriately discounted weaker future growth, including plausible worst-case scenarios, paving the way for markets to bottom and subsequently recover?
That assessment is, to put it mildly, non-trivial. Economies and asset prices are interconnected in complex fashion, and relationships between them are forever shifting. That’s why even the most sophisticated fundamental models or pattern-recognition algorithms are incapable of reliable forecasts.
But humans are decision-makers. And decisions invariably demand probabilistic assessments, however uncertain, of future outcomes. So, try we must.
What, then, can we say about prevailing asset prices and their implications for future economic and investment outcomes?
To begin, the expected future path of short-term interest rates—the forward curve—offers some guidance. According to the Federal Reserve Bank of Atlanta’s Fed Funds probability tracker, investors anticipate that the Fed will hike short-term interest rates above 3% by early 2023. The peak in the expected path of Fed rate hikes comes shortly thereafter, around 3.5% in mid-2023. Rising short-term interest rates reflect the Fed’s intention to bring inflation down to its target level of 2%.
But is the market’s expectation for short rates already high enough to achieve the Fed’s aim? The answer depends, in part, on the point where monetary policy shifts from accommodative to restrictive.
According to various studies, the real (inflation-adjusted) ‘natural rate of interest’—the rate that is consistent with a fully employed economy accompanied by non-accelerating inflation—is about 0.5%. Meanwhile, equilibrium long-term expected inflation is about 2.5% (consistent with the Fed’s definition of core personal consumption expenditures inflation of 2.0%). Hence, the neutral nominal short-term interest rate is also around 3.0%.
In other words, in one year’s time, investors believe the Fed will have arrived at a neutral, but not yet restrictive, level of short-term interest rates.
That might not seem sufficient for the Fed to achieve its objective of bringing down inflation. But it could be if other factors help to bring the economy back into balance.
If, for example, global production and distribution bottlenecks ease and if the US labor force participation rate rises, some of the desired reduction in inflation will be achieved without the need for overly restrictive monetary policy. For now, however, Covid lockdowns in China and the latest dip in the US labor force participation rate are not encouraging signs for those hoping the supply side will come to the rescue.
Much depends, therefore, on other demand transmission channels, including the impact of broader asset price movements on household and business spending, as well as the impacts of higher long-term interest rates on housing markets. We can omit the impact of a stronger US dollar because, historically, it only has a minor impact on US growth or inflation outcomes.
We begin with business spending. Anecdotal evidence suggests that some businesses are slowing hiring and overall spending. Among information technology companies, belt tightening follows the need to demonstrate ‘free cash flow generation’, resulting from the drubbing that speculative growth stocks have taken this year. That suggests that investors will focus on indicators of labor market softness, such as rising jobless claims, in the weeks to come. Thus far, the labor market is not softening.
Another focal point will be housing. Courtesy of rising Treasury yields, conventional 30-year mortgage rates have jumped to over 5.5%, their highest levels since the global financial crisis. Investors are also apt to increasingly scrutinize mortgage applications, homebuilder sentiment, and similar evidence for a slowdown in housing demand and construction. So far, however, housing is holding up.
Consumer spending is, however, the big fish. The US is a consumer-driven economy, after all. Consumers presently enjoy good job prospects and strong nominal wage gains. If cracks are to emerge in their spending, therefore, it may be due to negative wealth effects from falling stock and bond prices.
According to various studies, the marginal propensity to consume from a given change in stock market wealth is between 2.5-5.0%. Thus far in 2022, US equity market capitalization has tumbled about $7 trillion. Not all of that will impact households directly—many hold their portfolio wealth in retirement accounts. Accordingly, the negative wealth effect is likely to be small—perhaps $100-200 billion in 2022. That’s 1% (or less) of US GDP.
The best way to pull all this together is to consider the impacts on the US output gap, which today is roughly minus 1-2% of GDP (actual GDP exceeds potential GDP as one would expect when inflation has risen). Based on observed outcomes in labor and housing markets, as well as the likely impacts of negative wealth effects, the overall impact on output appears small—too small to reverse the sign of the output gap over the remainder of 2022.
The conclusion that follows is that while markets have shifted dramatically thus far in 2022, they do not yet appear to reflect more plausible outcomes of weaker demand (and weaker profits) that will be required to bring US inflation down in line with the Fed’s aims. That conclusion also mirrors recent comments from Fed Chairman Powell that a harder landing may be unavoidable.
Finally, prevailing market pricing has not yet been tested by the realization of rising unemployment, weaker housing activity, and slowing consumer spending—none of which has yet materialized. Equally, investors have yet to endure genuine credit stress, which typically accompanies a period of monetary policy tightening.
Knowing when ‘enough is enough’ is frustratingly difficult to determine. But in macroeconomic and financial terms, it appears that investors still have not discounted the full extent of the challenges that are yet likely to surface in this cycle.