- A Recession May Be Delayed, Not Avoided
- 2023-03-06 10:24
The U.S. stock market rallied sharply in January and into early February, with the S&P 500 Index registering a year-to-date total return of 9% through February 2. The rally was driven by a series of encouraging reports about the health of the U.S. economy, alongside positive developments abroad—including the reopening of the Chinese economy and falling energy prices in Europe.
The two most notable positives for the U.S. came from:
- Employment: where new jobs reported rose to 517,000 in January after marching steadily lower over the previous five months.
- Consumer spending: where credit card spending increased sharply after dipping to concerning levels in the latter part of 2022.
These positive developments, combined with the ongoing decrease in inflation, meant that many investors began to believe that both a U.S. and global recession could be avoided.
Rates Higher for Longer
Unfortunately, a more somber outlook took hold in the middle of February as investors began to recognize that these positive developments were likely to lead to a more hawkish Fed—as evidenced by the 10-year U.S. Treasury yield rising from 3.39% on February 2 to 3.96% by February 21.
This happened because futures markets shifted their predictions for the path of the federal funds rate notably higher. In the beginning of February, futures markets projected the fed funds rate to peak at 4.89%. But by February 21, that projection had shifted to a peak of 5.37%. More notably, the futures market also raised its expectation for rates over the long run from 2.87% to 3.63%.
Because Inflation is Not Falling Fast Enough
So why would the market expect the Fed to be more hawkish, given that the recent CPI report confirmed that inflation is falling? It’s because the portion of inflation that the Fed is most worried about falls into the category of “services excluding shelter.” And, unfortunately, this portion of inflation has not yet shown signs of falling—and it also happens to be the portion of inflation that is most sensitive to wages.
The Fed recognizes that, while strong employment and consumer data are a signal that the U.S. economy is on healthy footing, they are also a signal that wage inflation is likely to remain stubbornly high. This means that the Fed probably needs to tighten policy even further in order to get wage inflation under control.
The bottom line is that the Fed is stuck between a rock and a hard place. They want the economy to avoid recession, but they also know that they need to weaken the labor market in order to get inflation under control.
In conclusion, while there certainly are reasons to be optimistic about the near-term path of the U.S. economy, these encouraging signs may be short-lived because they could force the Fed into a more hawkish stance.
As a result, we remain cautious about the medium-term path for the U.S. economy. At least for now, any positive economic news could ultimately just mean a recession is delayed rather than avoided. So, despite a somewhat rosy near-term outlook, T. Rowe Price’s Asset Allocation Committee is maintaining an underweight position in stocks relative to bonds.
- Key Insights
- Equity markets started the year on a positive note, boosted by economic surprises in the U.S. and improved outlooks in China and Europe.
- In our view, favorable economic news in the near term could mean a more hawkish Federal Reserve, which would be a headwind for the economy and equity markets.
Equity markets rallied from the beginning of the year into early February, driven by encouraging data regarding the health of the U.S. economy and improved economic outlooks in China and Europe that were supported by the reopening of the Chinese economy and falling energy prices in Europe.
Positive Economic Data Could Mean Rates Stay Higher for Longer
(Fig. 1) 10-year U.S. Treasury yield and Fed rate hike expectations rose in February
Past performance is not a reliable indicator of future performance. Actual outcomes may differ materially from estimates. Estimates are subject to change.
Source: Bloomberg Finance L.P.
In the U.S., positive economic surprises—including an unexpectedly strong jobs report in January, an uptick in consumer spending, and a slowing trend in inflation—boosted optimism that a U.S. and global recession could be avoided. However, investor sentiment shifted by mid-February amid concerns that these positive developments could lead the Federal Reserve (Fed) to take a more hawkish policy stance. From February 2 through February 21, the 10-year U.S. Treasury yield rose, and futures markets shifted their predictions for both the federal funds rate and the 10-year Treasury yield meaningfully higher (Figure 1).
Notably, the Fed has signaled that it remains committed to fighting inflation. Although aggregated data show that inflation is slowing overall, the “services excluding shelter” category—which is very sensitive to wages—is still problematic (Figure 2). Typically, strong economic indicators suggest a healthy economy, but to the Fed, they also indicate that labor costs are likely to remain stubbornly high and that additional rate hikes may be needed to moderate elevated wage inflation.
In our view, positive economic news may be short-lived as the Fed could be forced to keep raising rates—a headwind for the economy and equity markets. This could mean that, for now, a recession may be delayed, but not avoided. Therefore, we remain cautious, and the T. Rowe Price Asset Allocation Committee is maintaining an underweight position in stocks relative to bonds.
Inflation Is Not Falling Fast Enough
(Fig. 2) Contribution to the consumer price index (CPI) in percentage points
January 2019 to January 2023.
Source: Bloomberg Finance L.P.
*CPI = year-over-year percent change. CPI measures the monthly change in prices paid by consumers and is a widely used measure of inflation.
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