“Some say the world will end in fire,” goes a famous Robert Frost line. “And some say in ice.”
If ever poetry could explain the stock market, this may come closest to capturing the sour mood that’s about to deliver a seventh consecutive week of stock-market losses.
With half the world’s investors apparently spooked by rising prices and the other half worried about growth, there are precious few buyers standing ready to balance out the general gloom.
But while there’s almost nowhere to hide when stagnation and inflation collide, this economic adjustment doesn’t feel like the start of a lingering illness. Rather it has the makings of a temporary shock that – soon enough — will restore the economy to balance.
That hardly mitigates the pain of the last six months of stock-market
declines, but it doesn’t justify the grim warnings of a looming U.S. recession. Recent price spikes in food and energy have already started to sour consumer sentiment, making the Fed’s task of price stabilization much easier to achieve. Growth will surely slow from here, but it’s hard to imagine a sharp collapse in demand given that consumers and companies have rarely been this flush.
These are clearly disorienting times. After nearly four decades of declining inflation and mostly solid growth, few active investors have ever grappled with markets feeling the heat of such sharp price hikes. Other than the 2008 financial crisis, which is already 14 years ago, the shivering prospects of recession have been relatively brief.
It has been a long time since analysts choosing assumptions for their valuation models have faced such a quandary. Should they use the Fed’s long-term inflation forecast of 2%, when they know their car just took $60 of gasoline? Can the Fed really ease growth to its projection 2.0%-2.9% for next year executing what Chair Jerome Powell now calls a “softish landing.”?
Stocks have been falling because in this environment no one gets through an investment committee with sunny assumptions about either inflation or growth. Meanwhile, uncertainty around both sets of numbers means it’s hard to tell what’s cheap. When rates were falling reliably and earnings were predictable, it was easy to talk yourself into price-to-earnings multiples in the high-20s. Today, investors aren’t sure stocks are bargains now that the S&P 500 multiples are now in the high teens.
But the case for America consumed by inflationary fires just doesn’t stand scrutiny. First, U.S. consumer price inflation seems to have peaked last week, even if wage pressures still need watching. Second, if higher prices don’t force many summer travel cancellations, they will calm this year’s Christmas shopping frenzy even if supply chains aren’t fully back to normal. Third, and most important, long-term rates are holding steady even as short rates rise, suggesting markets believe the Fed will succeed in stabilizing prices.
It’s technically possible the U.S. will tip into a recession within the next year, but a lot more would have to go wrong. Amid the dark headlines, it’s easy to forget that unemployment has reached near-historic lows and workers quitting their jobs in search of something better near historic highs. Corporate capital expenditure is up as well as firms invest in more advanced technology and more resilient supply chains.
Plenty of risks
Just how much damage is done as the economy “downshifts” is hard to predict. If the Fed is to fulfill one mandate to deliver “stable prices,” it will have to settle for a lower level for its other mandate of “maximum employment.” Loan defaults will have to rise from their own historically low levels. The housing market will have to stabilize.
Meanwhile, there are plenty of risks beyond American shores that could weigh on the U.S. economy. Europeans now face dramatically higher energy prices as they tighten sanctions on Russia. Food-importing countries face much higher prices for wheat and fertilizer, too. In China, COVID restrictions undermined seen industrial production declined a shocking 2.9% last month threatening further disruption to global supply chains.
Many of these risks have appeared suddenly and unexpectedly, creating stiff headwinds for U.S. stocks. The irony is that the relatively sharp price shocks from supply-chain disruptions and commodity price spikes make it more likely that red-hot demand will cool on its own. Inflation rates may find a new range above pre-pandemic levels, but they will be lower and more predictable than they are today.
There may be more fire and there may be more ice. But the world will not end.
Christopher Smart is chief global strategist and head of the Barings Investment Institute. Follow him on Twitter @csmart.