Weekly View - 01.19.2022 Is a V-Shaped Recovery a Good Thing?
- The economy is experiencing a strong recovery with unusually high wage and inflation growth, in our view.
- We believe this makes the Fed’s job difficult and creates market uncertainty.
- For RiverFront, this underlines the importance of being agile.
In the December 6th Weekly View: Putting Things in Perspective, we discussed the remarkable recovery from the pandemic lows of both the economy and corporate earnings. This week we look at this ‘V-shaped’ profile of the current recovery and think about its implications. This recession was like no other and so it makes sense that the recovery is also unlike its predecessors. However, the remarkable pace of the recovery in gross domestic product (GDP) and the acceleration of inflation to a 30-year high makes the job of policymakers much more difficult in this early stage of a new economic cycle.
Although Main Street can get frustrated when a recovery is gradual, at Riverfront we have written many times about the typical advantages of a gradual recovery to financial markets.
- Inflation remains lower for longer
- Fed policy can remain supportive for longer
- Investor sentiment typically avoids excessive optimism
- Lack of excesses can prolong the economic and stock market cycle
Slow Recoveries Have Been Prolonged Recoveries
I remember the 1992, 2003 and 2010 recoveries well. Many, including sitting President George H.W. Bush were frustrated by how slow those recoveries were. The economy was beginning to recover in the 1992 election year, but voters didn’t feel it and he lost to the outsider Bill Clinton who capitalized on this frustration through one of his campaign slogans: “It’s the economy stupid”. It is purported that Bush always blamed, then Fed Chair Alan Greenspan, for not cutting interest rates quickly enough.
As you can see in Chart 1 below, although the end of the recession was determined to have been in 1991, unemployment continued to rise before gradually falling over the next decade. Since it took time for the unemployment rate to start falling, the 1992 and subsequent 2003 and 2010 recoveries were often referred to as ‘jobless’ recoveries (see red arrows on chart 1). The economic expansion that began in 1992 lasted throughout the decade as did the expansion that began in 2010. During this time, we witnessed the long bull markets of the 1990s and 2010s.
Chart 1: Rapid Rise, Remarkable Decline
This Cycle Is Different – A ‘V’ Shaped Recovery is Unfolding
The pandemic caused many parts of the economy to shut down and therefore the unemployment rate to skyrocket. Once the economy started to reopen, the unemployment level quickly dropped from over 14% to just 4% as of December 2021. The remarkable thing is not that it fell, but rather that it returned to almost pre-pandemic levels in just the last year (see blue arrow).
Another difference about this recovery has been the spike in inflation, only in part due to supply chain issues. Inflation is usually tame coming out of a recession as the fall in demand from the recession has put pressure on prices. This time is very different (see chart below). The challenge for the Fed is to determine which inflationary pressures are temporary and which more enduring. This will make their decisions about how much, and when to raise interest rates very difficult in our view, especially as their policies are designed to influence demand and they have no control over supply-chain issues. It will also mean that investors will have to deal with policymakers’ uncertainty, and financial markets typically don’t like uncertainty, hence the volatility we are expecting.
Coincident with the sharp fall in unemployment has been upward pressure on wages, at the fastest pace for a decade coinciding with a tight labor market – you have probably seen the ‘help wanted’ signs for months in your communities.
Chart 2. Rapid Acceleration in Wages and ‘Core’ Inflation
Be Careful What You Wish For
Just as the gradual recoveries put little upward pressure on inflation (the PCE was less that 2% for most of the 1995 to 2020 period), this recovery is leading to higher inflation pressures. While wages will rise, they may not rise much more than inflation and we think the stock market’s future will be greatly affected by the Fed’s actions in response to this data. As we wrote last week, there are risks that they don’t do enough and inflation gets somewhat out of hand – the pessimistic scenario in our outlook calls for 5% inflation leading to more Fed tightening which would hurt stocks, in our view. There is also the risk that they do too much and the recovery stalls, also not good for stocks. However, as the table below from our 2022 Outlook shows, we only give the pessimistic case a 25% probability.
A V-shaped economic recovery is creating a more volatile stock market where every action by policymakers is highly scrutinized. For our portfolios, this means that we recognize the importance of being agile and being alert to conditions which challenge our highest probability outcome, our base case. As you can see in the table above, in our base case CPI inflation falls to around 3.5%, growth stays strong at around 4% and long-term interest rates rise, but not enough to hurt stocks which have a positive year.