My least favorite subject in high school was earth science. For some reason, I found the subject matter very dry and mundane. However, as I grew older and started to travel more extensively, I found much to like about the planet. In particular, rocks and rock formations drew my interest. During my travels, I would marvel at strange and weird rock formations known as precariously balanced rocks. How did these formations come to be? And more importantly, how do these formations remain standing? In surveying the current U.S. economic environment, a precariously balanced rock formation comes to mind. While the manufacturing sector of the economy has been contracting as evidenced by the declining ISM Manufacturing PMI, the service sector appears to be holding up fairly well. While the federal funds rate has increased by 4.5% to a range of 4.5% – 4.75%, the labor market remains strong. The January employment report showed a payroll increase of 517,000 and an unemployment rate of 3.4%.1 And just like a precariously balanced rock formation, the U.S. economy in the aggregate remains standing. After declining by 1.6% and .6% in Q1 and Q2, respectively, real GDP increased by 3.2% in Q3 and 2.9% in Q4 based on the advanced estimate.2 Moreover, the estimate of Q1 2023 real GDP provided by the Atlanta Fed (GDPNow) is 2.4% as of February 15, 2023.3 While the strength in the U.S. economy is encouraging, caution is warranted. Inflation has been moderating, as expected, but the data does not yet appear to meet the “clear and convincing evidence” criteria set forth by the Federal Reserve. This is underscored by the most recent CPI report. The CPI increased .5% in January 2023 and 6.4% year-over-year (Core CPI increase of .4% and 5.6% year-over-year).4 These data points are difficult to reconcile with a 2% inflation target. A precariously balanced rock formation will remain standing provided its balance is not offset by a greater seismic force. For the U.S. economy, the Federal Reserve is that seismic force. With each increase in the federal funds rate, the seismic force becomes greater and greater with adverse effects on the U.S. economy.
Reviewing the major U.S. stock market indexes, 2023 is off to a good start. Shown below are the year-to-date returns as of February 15, 2023 (price performance, dividends not included).
| U.S. Stock Market Index | Year-To-Date Return |
|---|---|
| Dow Jones Industrial Average | 2.96% |
| Nasdaq Composite | 15.33% |
| Nasdaq 100 | 15.98% |
| S&P 500 | 8.02% |
| S&P 400 | 10.62% |
| S&P 600 | 11.40% |
Shown below is a chart of the S&P 500. The index is down about 14% from its all-time high set in January 2022. Over the last eight months, the S&P 500 has been flat with choppy up and down price action.
Reviewing the S&P 500 sectors via the SPDRs, the consumer discretionary, technology, and communication services sectors are performing well. Shown below are the year-to-date returns as of February 15, 2023 (price performance, dividends not included).
| S&P 500 Sector SPDR | Year-To-Date Return |
|---|---|
| Consumer Discretionary | 19.15% |
| Consumer Staples | -1.72% |
| Energy | 1.15% |
| Financials | 7.46% |
| Health Care | -2.73% |
| Industrials | 5.32% |
| Materials | 6.86% |
| Real Estate | 8.80% |
| Technology | 15.79% |
| Communication Services | 17.25% |
| Utilities | -3.16% |
On several occasions, Federal Reserve Chairman Powell has mentioned the inflation experience of the 1970s. In many ways, the inflation of the 1970s was a unique experience. While politics played a role, as it always does, the inflation witnessed at the time was a new and unique phenomenon. The “stop and go” monetary policies enacted in the 1970s exacerbated the inflation problem but may have been reasonable given limited historical precedent. It may not have been understood at the time that failing to control inflation would result in a resurgence in inflation and entrenched inflationary expectations. But today, there is historical precedent and the risks are clearly understood. And this is one of the key factors to keep in mind when assessing monetary policy going forward. The inflation we have witnessed post-COVID-19 is understandable given the circumstances, but a failure to control inflation at this point would present serious problems for the Federal Reserve. And it is this risk that the Federal Reserve needs to guard against. While the trends in the inflation data have been positive over the last several months, it is far from certain that inflation is under control. It is highly debatable whether the current data meets the “clear and convincing evidence” criteria. As such, barring unforeseen events, ongoing increases in the federal funds rate are likely. Another .25% increase in the federal funds rate in March appears to be a given. As for May and June, the economic data between now and then will determine the course of action. The U.S. economy is in a precarious position and the probability of a recession is high. An additional risk factor is the U.S. debt ceiling, which needs to be increased in the coming months.
Thanks for reading.
Phillip B. Kaiser, CFA, CFP®, CMT®
Notes
1. U.S. Bureau of Labor Statistics, The Employment Situation – January 2023. Accessed on Monday, February 13, 2023 from https://www.bls.gov/news.release/empsit.nr0.htm.
2. U.S. Bureau of Economic Analysis, Gross Domestic Product Fourth Quarter and Year 2022 (Advance Estimate). Accessed on Monday February 13, 2023 from https://www.bea.gov/news/2023/gross-domestic-product-fourth-quarter-and-year-2022-advance-estimate.
3. Federal Reserve Bank of Atlanta, GDPNow Model. Accessed on Wednesday, February 15, 2023 from https://www.atlantafed.org/cqer/research/gdpnow.
4. U.S. Bureau of Labor Statistics, Consumer Price Index – January 2023. Accessed on Tuesday, February 14, 2023 from https://www.bls.gov/news.release/cpi.nr0.htm.