Is Bad News Bad News Again?

Wednesday was an interesting day in the stock market. There was a broad sell-off despite the release of some economic data that suggested the economy, and therefore, inflation continues to cool. The Producer Price Index for December came in well below expectations, Retail Sales were down much more than expected in December, and Industrial Production contracted by 0.7% in December after falling 0.6% in November. The negative stock reaction to this weak economic data breaks a pattern that had been firmly in place for many months. Up until yesterday, it seems, stock investors had cheered softer economic data because it meant that the Fed would not have to raise interest rates much more to contain stubbornly high inflation. Since high inflation and rising interest rates are bad for stocks, the weak economic data was therefore an encouraging development. At least up until Wednesday, when the S&P fell 1.5%. What gives? 

I believe that the preponderance of evidence is beginning to suggest that recession fears are replacing inflation fears as investors’ primary concern. It seems to me that rationale for this fear rotation is two-fold. First, investors are opting to place more faith in the bond market – which continues to suggest that inflation has been defeated and therefore the Fed will reverse course and start cutting interest rates in the not-too-distant future – rather than the Fed itself. The Fed has made repeated and emphatic public comments promising that rate hikes will continue until much more progress is made in bringing inflation back down to its target of 2%. But nobody believes that. Bond yields have dropped across the yield curve, which is not something that happens when investors are worried about inflation and aggressive Fed rate hikes. Perhaps just as telling, market-based gauges of inflation expectations continue to fall as well. For example, the 5-year inflation breakeven rate, which can be computed using the yields on a plain-vanilla 5-year Treasury bond and a Treasury Inflation-Protected (TIPs) bond of the same maturity, suggest that investors believe inflation will average just 2.16% over the next five years. That is fairly remarkable given the fact that we know inflation will remain elevated for at least the next year. In fact, if we assume that inflation comes in right in line with the Fed’s forecast of 3.1% for 2023, then inflation will average just 1.9% in years two through five. Clearly the bond market isn’t worried about inflation.   

The second cause for the rotation is the economic data itself. First, the data now clearly show that inflation has peaked and should continue to come down. Readings on the various price indices are all saying the same thing. Even average hourly earnings has slowed to a year-over-year rate of 4.6% from a high of 5.6% in March. At the same time, other economic data increasingly show that the economy is undergoing a dramatic deceleration. The effects are most pronounced in the housing data which, no surprise, is most heavily dependent on low interest rates. In housing, we are seeing a rapid cooling from heights we can only describe as “bubbly.” But the economic deceleration has spread well beyond housing. Surveys of manufacturing and services activity are now in contractionary territory; factory orders and industrial production are falling; consumer and business sentiment are very weak; the consumer savings rate is near all-time lows and consumer credit is now surging (especially credit cards); retail sales are weak; and the list goes on.

Is it likely that inflation will remain a big problem with the economy slowing such as it is? Investors are screaming an emphatic “NO” even as the Fed tells us its work isn’t done. Yes, the labor market remains very strong, which appears to be the one big remaining concern for the Fed. But all the other data are beginning to back our long-held belief that the economy cannot withstand meaningfully higher interest rates. The economy had become heavily dependent on low borrowing costs during the decade-plus period during which the Fed held interest rates very close to zero. We borrowed demand from the future, and investment returns were likely pulled forward as well. Now comes the inevitable reckoning for that largesse, and investors seem to understand this better than the Fed does.

Hang in there. These periods of adjustment are painful but necessary. The mythical “soft landing” is unlikely to become a reality from where I sit, but that doesn’t mean we are doomed. A mild recession is preferrable to uncontrolled inflation, and much of the damage may already be incorporated in stock prices following a nasty 2022.