Will April Showers Bring May Flowers?

Question:  With inflation and talk of a possible recession, can the Federal Reserve orchestrate a smooth landing? 

Answer:  With the level of interconnection between world economies, we can’t ignore what’s going on beyond and outside the United States borders. The Feds actions need to coordinate with international dynamics weighing on our markets. 

Russia-Ukraine Crisis Continues 

We’re in the third month of this conflict, and the longer it lasts, the worse the impact on the global economy and financial markets. Russia contributes 40% of the world’s palladium supply, 17% of natural gas, and 11% of oil so it’s no wonder the prices for these commodities have skyrocketed. This war continues to worsen the inflation outlook and dampen global growth. While Russia has ramped up its attacks, Ukraine, with the help of the West, continues to fight back. The unwillingness of Ukraine to give up any land to Russia could prolong the conflict. 

China’s COVID Contagion 

Zero-tolerance policies caused increased lockdowns across China in response to an upward trend in China’s COVID-19 cases, particularly in some of its largest cities such as Shenzhen and Shanghai. Chinese officials suggest that approximately 30% of the workforce is eligible to return to work. Although Shanghai only equals 3.8% of China’s GDP, it is the world’s busiest port and third-busiest cargo airport. Chinese authorities do not seem willing to deviate from their zero-COVID policy, going so far as to install metal barriers around cities to close off streets during lockdowns. Vehicle freight flows in Shanghai have already declined over 80% this month. The city has over 500 vessels (~20% of all vessels globally) waiting outside its port. Until the tangled supply chain is resolved, the global inflation outlook can only improve so much. 

Central Bank Conundrums 

Central banks around the world are attempting to fight inflation by raising interest rates. The problem is that raising rates doesn’t fix supply chain disruptions, or end war and pandemics. Raising interest rates too fast and too far could cause slowed economic growth and potentially cause a recession. While the U.S. economy is likely able to absorb several interest rate hikes this year because of its healthy economic growth backdrop, other parts of the world are less fortunate. Central banks can’t do much about supply, but they can raise rates to potentially reduce demand. Fed Chairman Powell has admitted that knowing what they know now, the Fed should have been raising short-term interest rates earlier to lower inflation and maintain a strong job market. 

There is discussion that the European Central Bank will raise rates above zero for the first time since 2012, regardless of growth concerns. Rising concerns of a recession in Europe and its potential impact on US corporate earnings weighs on U.S. equities.

The uncertainty surrounding these three developments adds to volatility although much of this negativity has been priced into the market. The percentage of bullish (positive) investors declined to the lowest level since 1992, suggesting that much of the bad news has been priced into the market. No one knows exactly when we’ll see peak inflation or peak long-term rates.

The good news is that corporate activity and corporate balance sheets are strong. These resources are being used for share buybacks and dividends to shareholders. Dividends remain healthy with S&P 500 dividends yield expected to rise 8% year-over-year for full-year 2022.

It may be that the prospect of a U.S. recession is exaggerated. We have a healthy labor market; strong consumer spending, and corporate capital expenditures strengthen the U.S. economy. In the near term, volatility will continue while dealing with inflation, bearish sentiment, interest rate increases, and geopolitical tensions. It’s subjective, yet economists generally put the odds of a recession in the next 12 months at around 25-30%. There are no good predictive models of recession looking a year or more out. Typically, declining short-term interest rates signal a recession, and that’s not the case right now.

According to The National Bureau of Economic Research’s Business Cycle Dating Committee (which is not a lonely-hearts club!) defines a recession as “a significant decline in economic activity that is spread across the economy and lasts more than a few months.” But based on assumptions of supply chains easing and the Fed getting monetary policy correct, much of the downside risk may already be priced into the market. Investors with a long-term approach may cautiously consider the current environment as a selective buying opportunity while understanding that stocks can be vulnerable in the short-term. Stay focused and plan accordingly as we navigate the tug of war between growth and inflation.