By Randy Myers
Inflation changes everything.
In October 2021, the Multi-Asset Strategy team at New York Life Investments had a “constructive” or positive outlook on the U.S. economy. Six months later, economist Lauren Goodwin, director of portfolio strategy for the Multi-Asset Solutions team, said the outlook had shifted to “cautious but constructive” for the rest of this year.
What changed? Mostly, inflation. The economy dipped abruptly in early 2020 following the onset of the COVID-19 pandemic, but heading into 2022 the recovery from that downturn was on pace to be the fastest in the post-World War II period, Goodwin told participants in the 2022 SVIA Spring Seminar. The labor market also had staged a strong recovery. But over the course of the first quarter of this year inflation rose dramatically, reaching a rate of 8.5% for the month ending March 31, 2022. (Goodwin’s appearance before the SVIA preceded, by one day, news that the U.S. economy contracted at a 1.4% annual rate in the first quarter.)
Goodwin attributed the uptick in inflation largely to continued pent-up demand for goods and services, exacerbated by the Russian war in Ukraine, which has disrupted global supplies of energy, wheat and other food inputs. Over time, Goodwin noted, higher prices for base goods like food and gasoline can dampen demand for other goods and services, further crimping the economy.
One positive development, Goodwin said, is that the U.S. today is in a better position to navigate oil price shocks than it was in decades past because the country now produces about as much oil as it consumes.
The latest economic challenges facing the U.S. come at a time when the Federal Reserve is tightening monetary policy in a bid to bring down inflation. As had been anticipated by Goodwin and many other economists, the Fed on May 4 raised its target for the federal funds rate by 50 basis points to a range of 0.75% to 1.0%, its highest level since the pandemic struck. The Fed also is planning to start reducing its balance sheet, mostly by selling some of its Treasury and mortgage bond holdings.
More Fed rate increases are likely. At the beginning of this year, Goodwin said, financial markets were pricing in three 25-basis-point rate hikes this year. Now the markets are expecting many more, envisioning the federal funds rate reaching about 3% by the end of the year.
Goodwin cautioned that higher short-term rates won’t necessarily translate into significantly higher long-term interest rates given other factors at play at that end of the yield curve. Her team’s view, she said, is that the 10-year Treasury note is unlikely to see sustained levels in the 4 % to 8% range that we saw from the 1980s to the 2010s.
As to how the challenges facing the economy might impact the financial markets, Goodwin noted that “companies are still printing reliable revenue” and said it’s hard to envision a lasting drawdown in the equity markets while that’s happening. Nonetheless, she said her team expects to see continued volatility not only in equities but also in fixed income and alternative asset classes, including commodities.
That volatility, Goodwin stressed, simply emphasizes the importance of stable value as an asset class, especially given that bonds and stocks have both been under pressure this year. And while any rapid uptick in short-term rates might make money market funds look more attractive, Goodwin warned that it can be difficult for investors to time the market even on short-term instruments like those.
Responding to audience questions following her formal presentation, Goodwin said her personal view was that inflation has likely peaked for now but will be a problem for the rest of this year. Most estimates put inflation in the 4% to 5% range by the end of the year, which would still be well above the Fed’s target. She also estimated that it will be difficult for the Fed to hike rates as much as the markets are predicting, because it would put the federal funds rate above the so-called “neutral rate” where it neither helps nor hurts the economy. But she cautioned that if it did go as high as the markets are expecting it would increase the risk of a recession. Goodwin also pointed to three factors that are helping to support the case for further economic growth over the next few quarters. One is the reopening phenomenon following the pandemic. While much of the country is back to shopping, spending and vacationing as it had pre-pandemic, there’s “probably a little bit more reopening juice left to squeeze into the economy,” she said. Another is the fact that the strongest wage increases of the past year or so have gone to the lowest-quartile earners, who have the strongest tendency to spend every incremental dollar they earn. Consumer spending supports economic growth. Finally, she pointed again to strong corporate earnings, which make it more likely that companies will invest some of their profits in growing their businesses and so add to the economy’s momentum.