Can Powell Slow the Economy Without Stopping It?
US stocks finally pushed back during the second half of March, turning a 1st Quarter correction into a more palatable decline. The recovery is a significant sign of resilience given it was in the face of a steady drumbeat of bad news: war in Ukraine, continuing high inflation, a Fed ready to fight it, and a consumer starting to feel the effects of all the above.
As of the 2nd Quarter of 2022 there are growing signs that the US and global stocks could be facing some serious headwinds. But as with most things in life, timing will be key.
Most of the media play surrounded the Russian invasion of Ukraine on February 24. The war in eastern Europe has had a significant effect on the markets, but as we pointed out last month Wall Street appears to be more concerned with Fed Chair Jerome Powell than they are with Russian President Vladimir Putin. With no clear sign that inflation pressures are peaking, the Fed was forced to change expectations for interest rates considerably over the course of the quarter. It now looks like seven hikes are likely in 2022, rather than the four or five that were expected as the year began. In addition, some of the upcoming hikes could be 50 basis points, whereas all were expected to be 25 basis points previously.
Investors, at this point, are impressed with the continued strength in the labor markets and realize interest rates are still low. This should provide support in the near term for stocks barring any unforeseen news. And if we get a cessation of war in the Ukraine and energy prices ease, we could see a continuation of the late March rally.
Taking a step back, however, there’s good reason for the extreme volatility we witnessed in the 1st Quarter. For the market to make another bull run the Fed will have to engineer a “soft landing” for the US economy. This means they’ll have to battle the persistently high inflation we have now without tipping the economy into a recession.
It’s a small window for the Fed to squeeze through to avoid stagflation. Recessions typically mean higher unemployment, reduced consumption and falling corporate profits. Historically, recessions have been a proven killer for stock prices.
An economic slowdown, if it is created by a Fed policy mistake, is probably still several quarters away (i.e., it will take quite a few Fed meetings and corresponding interest rate hikes to put a serious dent in growth). And when it does, what is the depth of the slowdown? Is the pullback to trend or slightly below (say -1.5% to -2.0%) or will it result in a recession? We think the former is likely.