From Allegro to Adagio: Growth, Inflation and the tune it plays
Published on July 25, 2022
David Kelly
Chief Global Strategist at J.P. Morgan Asset Management
When engaged in the more mundane tasks of my job, I often have classical music playing in the background. A piano concerto, in the hands of a great orchestra and soloist, is a delight to the ears as the rush and energy of the first movement gives way to the softer pace of the second. And when the conductor downshifts the tempo, the musicians follow with effortless precision.
If only the American economy were so easy to conduct.
This week, the Federal Reserve’s Federal Open Market Committee (FOMC) is widely expected to raise the federal funds rate by 0.75%. As they do so, they will likely send stern messages about how the current rate of inflation remains unacceptably high. However, they must be equally aware that economic growth is in the midst of a sharp slowdown and inflation readings look set to follow suit. This is, of course, something they have been trying to orchestrate all year using the blunt instruments of monetary tightening. However, whether the economy can smoothly transition from allegro to adagio is very much in doubt and depends both on the current state of the economy and how the Fed conducts policy from here.
So as the FOMC meets for the fifth time this year, what is the economic backdrop, how is the Fed likely to react to it and what does all of this mean for investors?
The current economic situation can be summarized in terms of growth, jobs, inflation, profits, overseas activity and the position of the dollar.
Growth: On economic growth, there are plenty of signs of both a current slowdown and future drags. Real GDP fell by 1.6% annualized in the first quarter and the Atlanta Fed’s tracking model is currently forecasting another 1.6% decline in the second quarter release which is due out on Thursday. Our own forecasts are a little more optimistic, at 0.9% positive, while consensus is currently looking for a 0.5% gain. Wednesday’s numbers on International Trade in Goods and Retail and Wholesale Inventories should narrow the range of these forecasts.
However, it is worth emphasizing that, under any of these projections, real GDP will have declined in the first half of the year. Unfortunately, prospects for growth in the second half also look bleak. In particular:
The federal budget deficit continues to decline, down a whopping 77% year-over-year for the first nine months of the fiscal year. This reflects the end of a wide variety of pandemic assistance that is squeezing the budgets of low and middle income consumers, and likely contributing to a second consecutive decline in real retail sales in June. This is likely to continue later this year with real consumer spending growing by between 1% and 2% annualized, at best.
Home-building and home-buying will also likely slow, given a surge in 30-year fixed-rate mortgage rates from 3.11% at the end of 2021 to 5.54% last week and a sharp decline in the National Association of Homebuilders index in July.
Exports will also be slow, due to weak economic growth in China and Europe and a much higher dollar which has risen 11%, year-to-date, and is close to its highest level since the mid-1980s in real terms.
Overall, we estimate that economic growth will average just 0.5% annualized over the second half of the year. This puts real GDP up just 0.1% year-over-year by 4Q2022 and 2.3% year-over-year by 4Q2023 compared to the Fed’s June forecast of 1.7% year-over-year for both periods.
Jobs: Employment growth and, in particular, the unemployment rate, tend to be lagging indicators in the economic cycle. This is likely to be even more the case this time around, due to the massive excess demand for labor entering the current slowdown. That being said, initial unemployment claims have been rising steadily since mid-March while continuing claims have been climbing since mid-May.
We expect that slower economic growth will eventually translate into weaker job gains, with payroll employment growing by less than 100,000 per month in 2023. The unemployment rate, currently at 3.6% could still edge down to 3.5% by the fourth quarter, due to very weak labor supply and the lagged impact of excess labor demand, before slowly climbing in 2023. However, there is a growing risk that unemployment could begin to rise more quickly.
Incidentally, the persistence of job growth in 2022, even as GDP growth has slowed to a crawl, removes the last of the pandemic productivity bump. We now estimate that real GDP per worker will have increased at a 1.0% annualized rate from 4Q2019 to 4Q2022, slightly lower than the 1.2% pace observed over the prior 20 years.
Inflation: After a US inflation heatwave, we believe a cold front is now moving through. According to AAA, the national average price for a gallon of gasoline fell to $4.37 on July 24th, down 65 cents from a peak of $5.02 on June 14th. We are also seeing declines in broad commodity prices, with the Bloomberg Commodity Index down 15% from its peak on June 9th. In addition, airline fares appear to have fallen in July while recent declines in wholesale used vehicle prices could translate to a decline in retail prices in July.
Given all of this, we expect headline CPI to grow by roughly 0.1% in both July and August compared to mammoth increases of 1.0% and 1.3% in May and June. We estimate that year-over-year headline consumption deflator inflation will peak at 6.8% in the June reading, due out on Friday, and fall to 5.1% by the fourth quarter of 2022 and 2.1% in the fourth quarter of 2023 compared to the Federal Reserve’s forecast of 5.2% and 2.6% over the same periods.
Profits: All of this suggests a challenging environment for profits. Early results for the second-quarter earnings season are mediocre in terms of positive and negative surprises but still suggest a 4.5% year-over-year gain for the quarter. However, in the balance of 2022, slower nominal GDP growth, higher wage costs and higher interest rates should be a significant drag on earnings and 2022 as a whole could see a small decline in operating earnings. Modest earnings growth should resume in 2023 as wage growth and interest rates stabilize.
Global Trends: The Federal Reserve should also be acutely aware of the slowdown emerging around the world. Last week’s flash PMI readings for the U.S., the U.K., the Eurozone and Japan made dismal reading and suggests that the final global composite PMI index for July, due out in early August, could fall to its lowest level since the early months of the pandemic. Chinese PMI data helped boost the index in June and might do so again in July. However, it is clear that just as the Ukraine war and commodity price shocks are hurting Europe, attempts to control the spread of COVID-19 are continuing to drag on growth in China and elsewhere in East Asia.
The Dollar: Finally, the Fed should be aware of the impact of its newly hawkish policy on the U.S. dollar, which, as mentioned earlier, is up 11% year to date and close to its highest levels in real terms, in almost 40 years. Some of this strength could abate in the months ahead, partly reflecting more hawkish monetary policy overseas. The European Central Bank raised its deposit rate by 0.5% last week, in a more aggressive move than widely expected and the Bank of England appears set to raise its Bank Rate by 0.5% also in early August in a sixth consecutive hiking move. However, both the Bank of Japan and the People’s Bank of China are maintaining a much more dovish policy, likely limiting any significant dollar slide until the Federal Reserve relents on its currently hawkish plans.
This change of heart and change in messaging is unlikely to emerge from the FOMC meeting on Wednesday. While both the FOMC statement and Chairman Powell’s press conference will likely acknowledge a recent weakening in economic momentum, the Fed will likely feel the need to appear resolute in battling inflation until there are clear signs that it is abating. Having raised rates by 0.25%, 0.50% and 0.75% over the past three meetings, we expect them to raise rates by 0.75% in late July.
However, by their next meeting in September, they should have seen a weak second quarter GDP report along with two moderate reports on CPI inflation for July and August. This along with further signs of cooler inflation and slowing growth could cause them to moderate their path, hiking the federal funds rate by just 0.50% in September and 0.25% in November. This would boost the federal funds rate to a range of 3.00%-3.25%, exactly 3.00% higher than at the start of the year and the Fed could hold rates at this level throughout 2023, provided the economy does not fall into actual recession. We expect them to continue to reduce their balance sheet by up to $95 billion per month from September 2022 on.
It is clear that there is now only a narrow economic path that will both keep the economy growing and allow for a gradual downshift in inflation at a pace that is acceptable to the Federal Reserve. However, for investors, despite this uncertainty and significant losses in both stock and bond markets this year, this can be a time of opportunity.
Valuations on U.S. growth stocks now look much more reasonable than at the start of the year while both U.S. value stocks and international equities look relatively cheap from a historical perspective. If we assume that the Federal Reserve will eventually have to pivot to a less hawkish stance, long-duration fixed income looks more attractive that it has for some time and offers protection if the economy does stumble into recession. In addition, a less aggressive Federal Reserve could lead to a decline in the dollar from its currently very high level, boosting both U.S. corporate profits from overseas and the dollar value of international securities.
Even if the U.S. economy doesn’t exactly follow the Federal Reserve’s wishes in the short run, and it stumbles into recession, such a recession should be relatively short and mild and could firmly squash remaining inflation pressures. In its aftermath, the U.S. and global economies could re-emerge into an environment of slow growth, low inflation and, once again, low interest rates, benefiting both stocks and bonds. At a time when investors, like consumers, are in an exceedingly sour mood, it is important to position portfolios not just to weather short-term turmoil but to benefit from more favorable conditions in the long run.
For more of my insights, listen to my Insights Now podcast for a breakdown on big ideas, future trends and their investment implications.
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