June 15, 2022
With the recent confirmation of a Bear Market finally taking hold, I’ve gotten some requests to comment on the situation: Are we going to have a recession? What’s my inflation outlook? What to expect from the Federal Reserve? What does this all mean for us in the FIRE community?
Let’s take a look…
Just to be sure, the Bear Market started in January, not on June 13!
I made this point in a post two years ago pointing out the challenges of pinning down the stock market (and also economic) turning points: If we define a bear market as a drop of 20+% then the bear market is confirmed once we hit the 20% drawdown. But the bear market started on the day after the previous all-time high. So, we’ve been in a down market since January 4, when the S&P 500 dropped from its all-time high. By only 3 points to 4,793.54. We just didn’t know it back then. Sometimes ignorance is bliss! Why is this important? It’s good news, of sorts, because if go by the average length of bear markets of maybe 1.5-2 years, we’ve already lived through about 5.5 months of it. Yay!
Of course, I always like to issue the warning that the length of the bear market is meaningless. What matters is how long it takes for the market to recover and reach the next all-time high again, which could take many more years. And when adjusting the portfolio for inflation the recovery can sometimes take a decade or more, as I outlined in my old post “Who’s Afraid of a Bear Market?” in 2019.
Will we have a recession as well?
Not every bear market is accompanied by a recession. All of the prominent ones were, but we’ve had a few without a recession, for example in 1987. And a few “close calls” like the fourth quarter of 2018.
In any case, what’s the economic outlook? Am I worried about a recession? I’m no longer a full-time economist. Even the short consulting gig as a “Chief Economist” for a startup only lasted for only a year in 2021. So, not willing to run a big forecasting model, which is at least a part-time maybe even a full-time job, I like to keep things simple. As I introduced in a 2018 post, here are the three indicators that I like to follow as a hobby-economists to monitor the health of the economy and the prospect of an economic slowdown:
1: The slope of the yield curve is one of the most reliable recession indicators. At some point before the start of the recession, all those smart folks working as fixed-income traders apparently sense that the Federal Reserve will first yank up rates and then lower rates again 1-2 years down the road, in response to the slowdown. This will push short-term rates higher and long-term rates lower. And apparently, those fixed-income folks were so smart that they even predicted the 2020 pandemic recession with a very brief yield curve inversion in August 2019. Some of them must be virologists, who knew?! Joking aside, financial markets probably didn’t have any inside knowledge and even without the pandemic, there might have been an economic slowdown around the corner.
In any case, that yield curve signal again flashed (slightly) red in early April of 2022. It’s a slightly worrisome signal, but the brief and very shallow YC inversion isn’t that concerning. For example, in 1998 we had a similarly meek inversion and the recession took another 3 years to take hold.
2: Weekly Unemployment Claims have been a pretty neat signal in the past. Every past recession was preceded by a sharp rise in the weekly unemployment insurance claims. Even though the NBER business cycle timing committee uses the monthly payroll employment numbers in determining the business cycle turning points, I like this series better because it’s at a higher frequency and doesn’t have to deal with those pesky benchmark revisions like the payroll series. In any case, according to this series, we’re still looking great. Unemployment claims are close to their post-pandemic lows, around 200k. Neither level nor direction indicates an imminent recession risk.
3: The Purchasing Managers Index (PMI) is another important economic health indicator. During or even before recessions, we’d normally observe a marked fall in the PMI index, usually below 45. Of course, anything below 50 is already looking shaky. In fact, the level of 50 is the +/-0 line between contraction and expansion, but there have been a few “false alarms” when the PMI fell to a level between 45 and 50. Below 45 seems to be a clear sign of the economy doing poorly. Right now, we’re still above 55. In fact, in May the PMI even edged up slightly to 56.1 from 55.4 in April. While the PMI readings have certainly come down from their 60+ levels in the Spring of 2021, we’re still looking pretty solid. No recession warning signals are flashing red here!
So, with my recession indicators, we’re 1 for 3. Hey, maybe only 0.5 for 3, if we factor in how brief and shallow the YC inversion was. So, the economy still seems to chug along. Everybody should be happy about that, right? Right? Uhm, maybe not. You see, in a perfect world, the Federal Reserve will slowly tighten the policy rate to about 4% by next year, inflation pressures will slowly abate, and we avoid a recession as well. The perfect soft landing. In a blog post five months ago, that was my personal prediction. While I still hope for this scenario, I’m almost sure that the path of the economy will be bumpier. The big gorilla in the room: Inflation! Notably, there are two unpleasant observations:
1: Inflation doesn’t seem to go down on its own. Thankfully, we’ve now retired the “transitory” moniker. The year-on-year CPI just posted a 40-year high. How is that possible? True, we’re now phasing out the strong inflation readings from the Spring of 2021. But we’re now replacing them with even worse monthly CPI numbers. And thus, the nasty CPI surprise on June 10 set off the whole equity selloff.
And the June 2022 CPI reading (released on July 13) will probably be another bummer, looking at the energy price surge in June month-to-date. What’s worse, it’s not just food and energy prices. A slow-moving train wreck is coming our way, in the form of shelter (i.e., rental) inflation, both for actual rental units but also for owner-equivalent rent (essentially derived by extrapolating the market rent to the owner-occupied market). Rental inflation factors in rises in real estate prices as well as interest rates but with a delay. In the chart below, notice how the shelter CPI trough lagged the overall CPI trough by about a year. In other words, rental inflation stayed relatively benign during the early part of the inflation shock. But the rental inflation train is now gathering steam. Housing is the largest component of the Core-CPI! A quick decline in year-on-year CPI numbers is certainly off the table. And we might even see further acceleration. Buckle up, everyone!
2: Contrary to the public’s perception, U.S. monetary policy isn’t tight at all. Quite the opposite, the Federal Reserve effectively continues to pour gasoline on the inflation fire. How is that possible? Isn’t the Fed raising rates already? 75bps at the meeting today, on June 15! That sounds like monetary tightening, right?
Well not really. What matters for real economic outcomes is the real, inflation-adjusted policy rate. Right now, that real FFR is still close to its all-time low. Consequently, in response to a worsening inflation shock, our current monetary policy is actually more accommodative than at the bottom of either the Global Financial Crisis or the Pandemic Crash when the central bank accommodated with a real FFR in the -3% to -1% range. In other words, the real FFR is now lower than when everyone ran around with their hair on fire, worried about deflation. The Fed raised the real FFR to around 3% above trailing inflation during the 2000 and pre-GFC tightening cycles. Even in 2018, we at least reached a (slightly) positive real short-term rate.
Let’s face it, we won’t see any true monetary tightening until short-term rates exceed the inflation rate! By that measure, the Fed is about 6-7 percentage points behind the curve. It would take many more rate hikes to correct that. Ouch!
How did this happen? Very simple, my former colleagues at the Federal Reserve apparently forgot about a very simple monetary economics doctrine: the Taylor Principle, named after famed Stanford economics professor John Taylor. I would summarize the principle as follows:
Taylor Principle: The central bank should move the nominal policy interest rate by more than one-for-one in relation to inflation shocks. This produces a tightening effect in the form of a real interest rate hike, slowing down demand and reducing inflation pressures.
But I don’t want to ding the Fed too badly. It was easy to get complacent. During the entire post-GFC era, even the post-2001 era, economists were puzzled that despite massive and prolonged monetary and fiscal stimulus, inflation didn’t rise much. What a conundrum! It was easy to forget basic economic lessons.
The image that comes to my mind is that of someone trying to start a BBQ, pouring copious amounts of lighter fluid on the grill. The thing still doesn’t start. Let’s empty another bottle! We need more stimulus! And then it does start and almost sets the whole neighborhood on fire. That person with the singed hair and eyebrows: that’s how the Federal Reserve is feeling now.
What would be the easy way out of this mess? A mild recession right around the corner could be a blessing in disguise! It would likely break the self-fulfilling prophecy inflation spiral. It would take pressure off of energy prices. New and used car prices could return to normal levels. You might be able able to get a rental car again at reasonable prices! That’s because during recessions, even mild recessions, consumers like to tighten their belts. Spending less on durable goods and discretionary items always does the trick.
If we don’t have that marked slowdown soon and prices don’t come down on their own? Expect rate hikes at 50-75bps every meeting. At least we don’t get a 200bps hike in one meeting, as proposed by Jeffery Gundlach! Either way, the Fed will raise rates until inflation subsides. In all likelihood, that will eventually trigger a recession if the Fed has to go into a full Paul-Volcker mode.
Again, I don’t want to sound like a doomsday preacher. I certainly prefer the scenario where we can thread the needle and everything still works out all right. But absent that optimistic scenario, I prefer the near-term mild recession. Let’s just get it over with! Let Paul Volcker rest!
Conclusions: What does this all mean for the FIRE community?
The usual disclaimers apply: it depends on where you are on your FIRE journey. If you’re still years away from (early) retirement, you probably should not stress out over this. Automate your savings and investments. There is no point in trying to time the market. Remember the old advice “time in the market is more important than timing the market.” My retirement plan contributions during 2001-2003 and then again in 2007-2009 were some of the best investments I ever made, thanks to dollar-cost-averaging. This bear market will turn around again. In fact, following a painful inflation episode and the Fed sinking the economy in 1982, we had one of the longest and most robust equity bull markets. Stay the course, everyone!
If you are close to retirement or even in retirement, you have more reasons to worry. Going through a bear market is more damaging to your finances when you are taking withdrawals already. It’s called Sequence Risk and I have written about it extensively. Readers of my blog and my Safe Withdrawal Rate Series will likely start with a conservative enough withdrawal strategy that would have withstood even the Great Depression. A 20% drop in the stock market is nothing compared to that. Also, check out Part 37 of the SWR Series, with my recommendations during the 2020 bear market. For example…
After we’ve already fallen by 20+% we can be a lot more generous with our safe withdrawal rates. Historically, you can use withdrawal rates well in excess of 4% if the stock market is down as much as today!SWR Series, Part 37.
Yup, you’ve heard it here first: The 4% Rule probably works again in today’s environment, after the market dropped by 20%+!
Another question I frequently get: Now that the stock market is down, should retirees shift to 100% equities again? If the bear market stays relatively shallow and rebounds quickly you might look really smart. But again, in Part 37 of the series, I point out that during the really catastrophic equity bear markets, going all-in too soon would have backfired spectacularly.
Update 6/15/2022, 6PM:
Since someone asked: with the recent drop in the S&P index, how does the valuation look like now:
- With the 6/15 close of 3789.99, my CAPE now stands at 28.6. We can’t use the Shiller numbers because the index and earnings data are outdated. That CAPE is still 80% higher than the historical median.
- I also compute an adjusted CAPE that accounts for different corporate taxes and earnings payout ratios. The adjustment lowers the CAPE to 22.9. Still elevated but not that bad. 45% higher than the median.
- PE ratio using 12-month trailing earnings: 18.9. Only 27% higher than the historical median.
- PE ratio using 12-month forward earnings estimates: 17.2. 20% higher than the historical median.
So much for today! Stay invested, stay safe and enjoy the ride, everyone! Looking forward to your comments and suggestions!
Title picture source: pixabay.com