It turns out, apparently, that Netflix was the canary in the coal mine. Recall that a few weeks ago the streaming giant stumbled after an earnings call revealed a decline in new subscribers for the first time in a decade. Netflix stock, one of the highest-flying names of the last decade, plummeted by almost 70 percent in a matter of hours. The concern was that as inflation picks up, consumers might finally be starting to make decisions that result in dropping some items from their monthly budgets, and streaming services might just be one such thing.

Not So Defensive

Fast forward to this week and the fate of some of the most redoubtable companies in the consumer goods space. Walmart and Target are nobody’s idea of a sexy high-octane growth engine; they are the venues that draw in the dead-center middle of Middle America every week for groceries, basic household goods and occasional splurges. These types of consumer goods companies have long been seen as defensive plays in times of trouble; bad economy or not, people still need to buy toothpaste and shower curtains and clothes for the kids.

Until this week, that maxim seemed to be working in the current market as well, with both Target and Walmart as well as basic consumer goods companies in general holding their values better than the broader market indexes. But then came the earnings reports, and this happened.

To be sure, the news was not all bad. Sales for both Walmart and Target grew slightly faster than expected, in low-mid single digits broadly reflective of US consumer spending overall (recall that the consumer spending component of Q1 GDP grew 2.7 percent). So far, anyway, sales are doing okay. The problem is with earnings and profit margins – both companies experienced an “earnings miss” where earnings per share came in below the consensus expectations of the securities analysts who cover them. Margins – profits expressed as a percentage of sales – are down due to the persistence of higher costs for key inputs (including labor and raw materials) and logistics (e.g. freight and other transportation costs). If companies are not able to raise prices by enough to compensate for the higher cost structure, then margins come down. Observers fear that this could be the beginning of a more sustained trend of margin erosion that will eventually show up in reduced consumer spending – conceivably enough so to push the economy into negative growth.

Confident, Or Not?

To repeat, the evidence of reduced consumer spending is not there yet, as reflected in the better-than-expected revenue growth numbers for Walmart and Target (among others). The old saying goes that economists and markets are famous for having predicted seven of the past three recessions, and there is plenty of prediction talk out there today without – yet – the evidence to back it up. In two weeks we will get another chance to assess the state of the consumer’s mind when the Conference Board’s consumer confidence numbers come out on the Tuesday after Memorial Day. As the chart below shows, the confidence number has held up pretty well recently, currently right around levels that suggest the middle of an economic growth cycle.

A poor reading for consumer confidence would not be a great way to end the already troubled month of May, while investors could take heart if the number doesn’t drop too much from the April reading. The mood of the market is clearly fragile as an “everything is bad” sentiment sets in for volatile intraday trading cycles. It will take a few more clear data points in favor of continued growth to get Mr. Market to back away from talking himself into the next recession.

A lot of things happened this week, and it has been a challenge to try and connect the moving parts. Stocks are on track to register their sixth straight week of declines, for the first time since the confluence of the Eurozone financial crisis, credit rating downgrade of US Treasuries and a debt crisis debacle in Congress sent equities reeling in the late summer of 2011. The cryptocurrency market appears to be in meltdown mode. And nominal junk bond yields have almost caught up with inflation (not quite, though, as the ICE BofA High Yield index is at 7.4 percent and headline CPI weighs in at 8.3 percent). The war in Ukraine slogs on, Shanghai is still stuck in lockdown and Fed watchers remain obsessively glued to every utterance from an Open Market Committee voting member who might drop hint of a 0.75 percent move next time (in vain, because the Fed really does seem to have circled the wagons around 0.5 percent).

The Clubber Lang Theory of Markets

The strand that weaves through all these moving parts is a fact of market life known as the pain trade. In the movie Rocky III the heavyweight challenger Clubber Lang, played to perfection by Mr. T, is asked what he predicts will happen in the upcoming fight against Stallone’s Rocky Balboa. “My prediction? My prediction is…pain!” snarls the fearsome Lang.

For investors who take the advantage of margin leverage to pile into hot markets, pain somewhat akin to a nasty left hook from Clubber Lang happens when their positions go far south and they need to come up liquid funds to cover margin calls. Selling begets more selling. When the S&P 500 fell below 4,000 earlier this week, a number of market analysts saw that as a pain threshold likely to unleash more near-term selling related to margin calls.

Looking at the above chart, it is not immediately clear why 4,000 should be a pain trade threshold, other than that it is a nice round number and sort of bifurcates the long rally in stocks that started when the Fed stepped into the pandemic crisis in late March 2020. You can look at that red dotted line on the chart connecting current stock prices to their levels in March ’21 and see that anyone who leveraged up somewhere between then and now would be feeling varying degrees of pain.

Stablecoins and Other Magical Things

Of course, investors loaded up on much more than the blue chip stocks on the S&P 500 during the good times. Now, many a prediction has been made many a time about the imminent demise of cryptocurrencies as they implausibly zoomed through the stratosphere over the last couple years. A couple things happened this week, though, to suggest that this asset class may be in for something more than a passing tempest this time around. Early in the week TerraUSA, a so-called stablecoin, became unmoored from its notional peg and started trading at levels typical of distressed debt – 25 or 30 cents on the dollar. The next day the largest of the stablecoin breed, Tether, plummeted five percent or so below the peg that is supposed to back each dollar of the token with a dollar’s worth of highly liquid cash equivalents.

Stablecoins are supposed to be a sort of gateway between the worlds of traditional financial products and the wild world of purely digital assets – cryptocurrencies like bitcoin and its ilk. For Tether to fall below its dollar-for-dollar peg is roughly analogous to a traditional money market fund “breaking the buck,” something last seen during the 2008 financial crisis. Financial regulators, central bankers and others who closely follow the market have long warned that stablecoins are nothing like the fully-backed assets they claim to be. Unsurprisingly, then, the tremors from Terra and Tether this week have been felt far and wide throughout cryptoland.

The crypto meltdown, then, feeds into the pain trade for the same reasons that highly leveraged positions in, say, the high-flying tech stocks of recent memory do. The good news is that there is likely to be nothing close to the kind of systemic risk that characterized the broader meltdown of the entire financial system in 2008. Back then all the major players were caught up in the highly leveraged asset-backed securities that initially brought down Lehman Brothers. Today many large financial institutions do have exposure to crypto, to be sure, but for the most part it’s more akin to toes dipped in the water than widespread systematic exposure. Bad for anyone who took a major punt on bitcoin at $60,000, not so bad for the so-called SIFIs, the systemically important financial institutions. As far as anyone knows, anyway.

Back To What Matters

So what does all of this mean for traditional portfolios of stocks and bonds? Conditions remain quite volatile, with multiple price swings of one percent or more throughout the day on many trading days. Credit risk spreads have started to widen – although, as observed earlier in this commentary, yields on high yield debt are still trailing present levels of headline inflation. Depending on how the stablecoin troubles play out, there could be plenty more damage in store for digital assets.

We would like to point out one feature of the above chart, though, to suggest that amid all the tumult there are some good reasons to keep a clear head about the underlying strength of the economy. In the chart we show the forward 12-months price-to-earnings (P/E) ratio, the green line. As you can see, the forward P/E has fallen fast over the past four months. Part of this, of course, is because the stock prices – the numerator in the P/E ratio – have come down. But at the same time analysts’ forward earnings estimates for these companies – the denominator of the ratio – have actually gone up, thus bringing the P/E even lower than it would be just from the stock price declines.

If the analysts’ consensus is correct (and we should note that such is not always the case) then at some point a company with a battered stock price and a strong growth outlook becomes a buying opportunity. That opportunity may not be today – like we said, there may be more pain trades to come and intraday markets are too frothy for implementing a rational trading strategy. But it’s the future cash flows that matter for a stock’s long-term return prospects. If those cash flows can be gotten at oversold levels, that makes it even better.

In our investment committee meeting this past Tuesday the discussion came, as one would expect, to the Fed and the likelihood that it would be raising the Fed funds target rate by 0.5 percent at the Federal Open Market Committee meeting this week. What effect would that have on the market? Oh, a few spasms in the immediate aftermath of the Wednesday afternoon press conference, as per usual, but in the end probably not much of a net move one way or the other.

The Intraday Cyclone

Our prognostication was in one sense not too far off the mark: by the closing bell on Thursday afternoon the S&P 500 was down about half a percent from where it was on Wednesday morning – nothing out of the ordinary! In another sense, though, the intraday market moves on Wednesday and Thursday were…um…a bit more than just “a few spasms.” The chart below illustrates the ride to nowhere that took place over these two days. The S&P 500 rose three percent on Wednesday and then promptly fell 3.5 percent on Thursday.

What on earth happened to unleash a stampede of bulls in one frenzied hour of trading on Wednesday afternoon, only to have a sleuth of bears chase them far away on Thursday? It’s not as if anything unexpected happened at the FOMC meeting. The prevailing wisdom was that the Fed would raise rates by 0.5 percent. That’s what they did. The same wisdom of the crowds expected a formal announcement about the Fed beginning to reduce its balance sheet – quantitative tightening – in the very near future. So it was: the balance sheet runoff will commence on June 1 with explicit targets for monthly reductions of Treasuries and mortgage-backed securities. All of this was widely telegraphed ahead of the meeting via the usual communication channels fondly referred to as “Fedspeak,” where this or that FOMC voting member shares his or her views at some luncheon event at some gathering of economists, business types and financial journalists. So why all the intraday drama?

Bots Don’t Think, Bots Just Do

To even begin to come to terms with such a seemingly irrational two-day whirlwind it is helpful to remember what types of investors are actively trading off these types of events (hint: not portfolio managers with a long-term time horizon for the assets under their management). This short-term market is dominated by mechanized trading strategies – models powered by algorithms set to respond to outcomes of specific events. From a technological standpoint these are highly sophisticated programs incorporating leading-edge artificial intelligence and machine learning. They can process human communication modes – Twitter posts, FOMC press conferences, what have you – and distill the verbiage into zeroes and ones leading to crisp buy/sell triggers. But these aren’t human traders absorbing a piece of news, going through some cognitive gymnastics and then deciding what to do. They are machines, programmed not to think but just to do. Do, or do not, there is no try (one of the two days in question was May the Fourth, hence the egregious Yoda reference).

IF (not 75) THEN (buy, buy, buy)

At the press conference on Wednesday Fed chair Powell spoke at length, forcefully and comprehensively, about the importance of bringing inflation under control. He emphasized the underlying strength of the economy as providing a context in which rates can rise in a programmatic way without sending the economy into recession (while noting the importance of getting it right and the thin margin for error). He spoke warmly of Paul Volcker, the last Fed chair who had to battle rampant inflation, as having the courage to do the right thing when it was needed. He was specific about what sources of inflation monetary policy can address (the demand side) and what it is not equipped to do (solve supply chain problems like the lockdowns in China).

All well and good, but those trading programs apparently ignored around 59 minutes and 30 seconds of the hour-long discussion and focused like so many heat-seeking missiles on one single comment. In response to a question about whether the Fed planned to raise rates by 0.75 percent at one of its upcoming meetings, Powell replied something to the effect of “at the moment the Committee is not countenancing a 0.75 percent increase.” That’s when the buying started, because apparently the only thing the short-term trading programs wanted to know was whether rates would go up by three-quarters of a percent in June or July. If not, then Katy bar the door and let a thousand bulls run.

Wait, What?

So what about Thursday’s reversal? Well, a good night’s sleep is probably enough for the market’s collective cognitive functions to work. What exactly did we just do? it might have asked reflexively. The “not 75” outcome was supposed to signify a dovish Fed, hence the immediate buy trigger. But nothing else in Powell’s comments or the post-meeting press release suggested that the Fed is dovish. Or is it? Was that “not 75” a slip of the mask, a revealing of a more timid Fed that will lack the will to fight inflation (which would potentially be bad)? Or was that encomium to Paul Volcker, whom Jay Powell clearly holds in high esteem, a sign that, if inflation gets measurably worse, the Fed would be ready to bring out those bigger guns, including a 75 basis points hike?

On Thursday morning the Bureau of Economic Analysis reported that first quarter GDP fell by 1.4 percent (on a quarter-to-quarter, annualized basis). The S&P 500 rose by 2.5 percent on the same day. That may sound odd, but in fact the market largely ignored the GDP story and focused instead on a crop of earnings reports from large tech companies that, on balance, came in better than expected. This tells us a couple things: first, how the market responds to macroeconomic data often has little to do with whether you might think the number in question is “good” or “bad” (we’ll get to this in regard to yesterday’s GDP number here below); second, what driving forces actually move stocks on any given day tends to be capricious and fortuitous; finally, and most importantly, correlation does not equal causation. Intraday stock market movements are less the necessary result of determinative Great Forces, and more like corks bobbing on the surface of the ocean, buffeted this way and that by the multiple natural phenomena of ever-shifting winds and tides and currents.

Below the Bad Headline

Nonetheless, the GDP number does merit some attention. Two consecutive quarters of negative growth may be all that’s required for a group of boffins at the National Bureau of Economic Research known as the Business Cycle Dating Committee to pronounce a recession. Since we at MV Financial have been maintaining for quite some time that we do not believe a recession is imminent, we feel we should discuss our own take on the Q1 number.

Going into Thursday morning’s release, the consensus expectation among economists was that the economy would grow by 1.1 percent from the previous quarter. The negative result relative to expectations came largely from two components. First, private business inventory growth was lackluster. This was more of a seasonal phenomenon than anything else: in the last quarter of 2021 businesses, fearing supply chain disruptions, stockpiled lots of inventory so as not to be caught short during the holiday season. That meant less need for restocking inventory in the first three months of this year.

Second, Americans imported a whole lot more than we exported during the quarter. This is actually a sign of economic strength relative to other parts of the world: consumers continued to buy foreign made goods even when those goods came with higher price tags on account of inflation. Other countries bought less stuff from us. From the standpoint of GDP math, negative net exports (i.e. when the total value of exports is less than the total value of imports) subtracts from growth.

The good news below the headline is that consumer spending and nonresidential fixed investment, which are arguably the two most important GDP categories for signifying economic health, were both positive and in line with recent trends. Consumer spending alone accounts for about 70 percent of total GDP, and grew 2.7 percent for the quarter. Taking all this into account, our often-expressed view that a near-term recession is not likely has not meaningfully changed.

The Persistence of Stagflation Fears

Our relatively benign view towards the likelihood of a near-term recession does not mean we are dismissive of the longer-term picture. The outcome nobody wants to see is anything that even rhymes with, let alone repeats, the stagflation of the 1970s. The combination of high consumer prices and low growth is a bad formula for most core equity and fixed income asset classes. So where are we on that basis today? The chart below shows real GDP growth along with headline and core (ex-food and energy) inflation going back to 1960.

In the above chart the stagflation period stands out, most notably the inability to bring inflation down below five percent for any sustained time until the draconian action on interest rates taken by the Volcker Fed in the early 1980s. The good news today is that we are not yet anywhere near the point where expectations about wages and prices are as embedded as they were throughout the 1970s. In a sense, the persistence of inflation today is due more to a string of bad luck than anything else. The ongoing Covid lockdown in China has prolonged supply chain problems, while the war in Ukraine has thrown a further wrench in energy and food prices (30 percent of the world’s total grain supply comes from Russia and Ukraine, and this year’s harvest in the latter country this year will be close to nonexistent).

So while we have not crossed the red-flag horizon for stagflation – and while the ex-food and energy numbers look like they are starting to stabilize – we cannot simply dismiss this outcome as a scenario. It will very much be in focus next week when the Fed meets and, if market expectations bear out, raises interest rates by another 0.5 percent. We will be very interested to hear Jay Powell’s views on current inflation and GDP trends when he speaks to reporters after the meeting. Much is riding on the Fed’s ability to make the right calls in an increasingly complex environment.

There have been a couple different stories about corporate earnings out there in the mediasphere this week. You probably know one of them, especially if you yourself happen to own shares of Netflix, which are worth quite a bit less at the end of the week than they were on Monday morning. You may not have heard the other story, though, which is that with a little over 100 S&P 500 companies having reported so far their first quarter results, the consensus estimate for earnings per share growth for the quarter is now 6.6 percent, up from 4.5 percent just three weeks ago.

In other words, conditions seem to be improving for companies’ financial performance despite all the headwinds out there – inflation, rising interest rates, the war in Ukraine, Covid lockdown in China and so on ad nauseum. And yet there is an asterisk to that improved performance trend, and this week the asterisk came in the form of a 63 percent freefall in the price of one of the most high-flying stocks of the last 12 years. Let’s look more closely at both these stories.

Maintaining the Margins

The big question for analysts covering US publicly traded companies has been whether they would be able to sustain their recent strength in operating profitability given the higher cost of many inputs – raw materials and labor chief among them – as well as the supply chain problems resulting in backlogs and sky-high transportation costs. The answer, so far anyway, seems to be yes. The chart below shows the trend in operating margins (operating income as a percentage of sales), along with trailing and forward earnings per share, for the past ten years.

Operating margins (the crimson line) remain at a ten-year high, which in turn means that companies are able to pass on cost increases to their customers, which in turn also helps their bottom line earnings grow (the blue line in the above chart represents earnings per share for the last twelve months, while the green line indicates earnings estimates for the next twelve months). The key driver sustaining this profitability is the ongoing level of above-average demand from American consumers, who continue in the aggregate to be spending ferociously.

The improved profitability outlook would seem to be good news for anyone worried about an impending recession; after all, if companies are selling, people are spending and jobs are there for the taking, that would seem to put the likelihood of negative GDP growth to be very low indeed. This brings us to Netflix, to ask whether this is the figurative canary in the coal mine warning of danger ahead.

Streaming to a Trickle

The Netflix earnings call this past Tuesday was one of the all-time lulus of a surprise. Analysts had been expecting the company to report somewhere in the neighborhood of 2.5 million new subscribers; instead, the streaming giant announced an outright decline of 200,000 subs, the first quarterly decline in a decade. Management was pretty forthright about the key reasons for this performance, including increased competition, password sharing among households and new ways content consumers are configuring their viewing experiences. These are fundamental forces that will be affecting anyone competing in the already-crowded streaming space (fittingly, this was also the week when Warner Bros. Discovery announced it would be shutting down the new CNN+ streaming service after just one dismal month).

Left unsaid was a bigger question: are the lower subscriber numbers at Netflix a sign that households are starting to pare back on discretionary spending choices, as a result of the pressure inflation is putting on their monthly budgets? We don’t have a definitive answer to this yet; this is just one data point representing one quarter’s worth of activity. But it may be a preview of what we start to see if inflationary expectations become more entrenched into real-world behavior. We think the market probably overreacted to the actual news from the Tuesday Netflix call. But it’s what we don’t know that could be the thornier issue down the road.

If you were following the flow of economic data releases this week you probably took note of the Consumer Price Index release on Tuesday, from the Bureau of Labor Statistics. The CPI, of course, has been the talk of the town within the last year as inflation has soared to levels not seen since the early 1980s. And this month was no exception; the March headline CPI, including those volatile categories of energy and food items, jumped by 8.6 percent compared to March 2021 – a new 40-year record.

You may have also noticed that stocks rose quite briskly on Tuesday, and if you tuned into what the talking heads were chattering about on CNBC you would have heard the phrase “peak inflation” over and over again. Financial news groupthink being what it is, it didn’t take too long for “peak inflation” to morph into “peak Fed” and suddenly it might have seemed like all the problems we’ve been dealing with so far this year are about to go away. Right? Or is it not that simple?

Points of Comparison

The chart below shows the change in the Consume Price Index over the last three years. We present two ways of looking at inflation: how much it has changed from twelve months ago to today (called year-on-year or YoY), and how much it changes from one month to the next (month-on-month or, quaintly, MoM).

The first thing we want to focus on here is the year-on-year number (in blue), because that is what all the pundits are looking at when they talk about “peak inflation.” As you can see from the chart, year-on-year inflation started to really pick up about a year ago, and it’s been mostly a straight line up since then. Why is that important? Because when we say that the headline YoY CPI number in March 2022 is 8.56 percent, what we mean is that is how much prices have gone up since March 2021. When the BLS reports the April number next month (May 11, if you want to make a note on your calendar) the point of comparison will be April 2021, and so on. The point of comparison, in other words, will increasingly be reflecting that accelerating inflation trend from the prior year – so the percentage gain should be more modest. “Year-on-year headline inflation should not be trending above 8.6 percent in the coming months” is, therefore, what the big story was on Tuesday and why it seemed to have a positive effect on investor sentiment.

MoM Has a Say

But that’s not the entire story. For that matter, it’s not even the most important story from the standpoint of consumers dealing with the practical effects of inflation in their own lives. For that story let’s look at the other number on the above chart – the month-on-month price change (the green line). What that line shows is that prices in March, on average, were 1.24 percent higher than they were in February. That, in turn, is the most that prices have risen in one single month over the last three years. Now, this being the headline inflation number, the big drivers of the MoM increase were food and energy. March, you will recall, was the first month to feel the added shock on energy prices coming from the war in Ukraine.

This number is likely to fluctuate in the months ahead, because food and energy prices in general are more volatile than other categories of consumer goods (which in turn is why many economists prefer to look at the core inflation number, which excludes these categories, for analyzing longer-term inflation trends). But it is much less likely for anyone to confidently assert that the MoM trend has peaked. We simply don’t know. There are likely to be ongoing pressures on both food and energy as long as the war continues (which, sadly, is likely to be for a while). The Covid lockdown in Shanghai has closed one of the world’s busiest ports and thus thrown yet another wrench in the troubled global supply chain network. Consumer demand in the US still appears to be strong, though expectations of higher prices may be starting to have a more pronounced effect on household budgets.

The point is that, while it is certainly good to have one measure of inflation looking like it has peaked, that does not give any kind of “all-clear” signal. Nor does it mean that the Fed can relax, kick back and buy more bonds to goose asset prices (which at the end of the day is what investors want more than anything). Expectations remain that the Fed will be raising rates by 0.5 percent when the FOMC meets next month. Yes, the supply chain problems and the other forces driving prices higher will eventually work themselves out. But there is still a ways to go.

You have probably noticed that prices at the grocery store are higher than they were a year ago, but some, like cereal and sunflower oil, are a whole lot higher. For most of us in developed Western countries that is an annoyance, but a more or less bearable one. Not so in other parts of the world. On average, food costs account for around seventeen percent of consumer spending in the developed world, but in sub-Saharan Africa, for example, around 40 percent of household spending goes towards food products. That’s a big problem when you see a chart like the one below, showing the price trend for wheat over the past five years.

Fallow Fields

Russia’s invasion of Ukraine, as shown in the above chart, caused a near-doubling of the price of wheat from where it was in late 2021. Together, Russia and Ukraine account for around 30 percent of the total global wheat market, and are major exporters of grains and sunflower oil. With the war in Ukraine showing no signs of abating, it is estimated that somewhere between 20 to 30 percent of the arable land in the country producing its agricultural bounty – Ukraine after all has been called the “breadbasket of Europe” — will not be planted this year, meaning no harvests later in the summer and no exports to the many countries around the globe that depend on these exports for their own food sufficiency.

This impending food crisis has been somewhat overlooked in developed-world analysis about the economic effects of the crisis in Ukraine, with the focus being more on energy prices, Europe’s dependence on Russian gas and related issues. But the food shortages that threaten much of the developing world, from sub-Saharan Africa to the Middle East and Asia-Pacific, could potentially reverse much of the gains achieved in recent years in lifting people out of poverty. The World Bank recently warned that a prolonged war in Ukraine could push millions of people back below the poverty line and engender a national debt crisis for potentially dozens of countries. This, in turn, will have a negative effect on global growth and is a major reason why the World Bank and the IMF, among others, have been recently lowering their estimates for world GDP growth. And this comes at a time, of course, when much of the world is still struggling to come out of the economic blow from the pandemic.

Inflation and Its Discontents

Back in the developed world the situation, while less lethal, is creating problems of its own. The food price index from the UN Food and Agriculture Organization is at a record high, 34 percent up from its level one year ago. For most people, the most visceral direct impact of inflation is felt in the supermarket aisles and at the gas pump. Persistently rising prices creates discontent, and that discontent tends to get expressed whenever possible at the ballot box. This weekend, for example, French citizens will go to the polls in the first round of national elections that will determine whether Emmanuel Macron gets to keep his job as president for another term. Even a couple weeks ago this was seen by most political observers as a yawner, with Macron expected to cruise to victory. But polls have tightened considerably. Now the most likely scenario is that Macron and perennial far-right candidate Marine Le Pen will each receive enough votes to force a second round runoff, and the current polling suggests that Macron’s lead in that head-to-head matchup could be within a statistical margin of error.

In the US, the Consumer Price Index will come out next Tuesday and economists expect to see year-on-year growth in the headline CPI register 8.5 percent, which would be the highest level since 1982. Now, simply based on the period of comparison, the year-on-year number is likely to start going down after the April release. But that is not going to mean very much to people who – given those food price trends we described above – are still going to be shelling out more every time they go to the local Giant or Kroger’s. If this is still a problem come November, the results are likely to be catastrophic for Democrats in the US midterm elections.

Globalization has been the organizing principle of the world economy for the past four decades. It has brought efficiency and convenience to developed countries, and pulled a plurality of the developing world into something approximating a middle class existence. Of course, it has brought about less savory outcomes as well, including growing wealth inequality and a fraying social safety net. For better or worse, though, if this organizing principle truly is going into reverse, as BlackRock’s Larry Fink opined in a recent letter to his firm’s shareholders, then there will be many unknowns ahead. Unknowns will beget more unknowns, and we will have to be  ready to figure them out.

It’s the first Friday of the new month, which means it’s time for another jobs report from the Bureau of Labor Statistics. This month, unlike some in recent memory, was fairly uneventful. The headline unemployment rate ticked down to 3.6 percent, just a tad higher than the 3.5 percent rate in February 2020, right before the pandemic hit. That 3.5 percent, in turn, was the lowest level in more than 50 years. The payroll gains number, which economists tend to focus on more closely than the unemployment rate, was 431,000, a bit lower than expected but still healthy in relation to historical norms.

The labor market has been something of a mystery to economists recently. Anecdotal stories abound of positions going unfilled, with would-be employers devising all manner of carrots to entice new hires. Headlines like “The Great Resignation” suggest that a not insignificant percentage of the US population is finding better things to do with it’s time than showing up for a 9 to 5 stint. If these headlines are true (as opposed to the default assumption for everything these days of “just trying to generate more clicks”) then what are the implications for wage growth, and thus inflation more broadly?

Hot Market? No Worries!

That question about the implications of a hot jobs market for inflation is important, because it is perhaps the biggest question mark in the Fed’s fairly benign assessment of the short-term environment. In the press conference following the FOMC meeting a couple weeks ago, Fed chair Powell opined that the unemployment rate would probably trend down to that pre-pandemic level of 3.5 percent, stay there for two to three years, and meanwhile inflation would trickle down from the current near-eight percent to the Fed’s two percent target. Is that a reasonable assessment of things or Panglossian wishful thinking? Let’s look at the long-term relationship between jobs and inflation, going back to 1960.

Looking at the above chart, it is perhaps not hard to see from where the Fed might draw its optimism that a hot labor market can coincide with subdued inflation. During the 1990s growth cycle that is, in fact, what happened: core inflation (the green trend line in the chart) fell from about five percent to two percent while unemployment (the blue line) also went down from around eight percent after the 1990-91 recession to four percent. In the next two growth cycles, inflation stayed reasonably well-contained; this was most noticeable in the period following the Great Recession when unemployment fell from a peak of ten percent to that 50-year low of 3.5 percent. Contrary to all those economics textbooks from the 1970s and 1980s with their Phillips Curve dogma of low unemployment = high inflation, the more recent cycles suggest that the two variables do not, in fact, have to be at odds with each other.

Structurally, Things Have Changed

There are some other considerations that should give one pause, however, from banking too confidently on the recent growth cycle trends, and these have to do with longer-term structural issues in the jobs market. The chart below shows the same unemployment rate as the previous chart, this time compared to the labor participation rate.

This long-term view of the labor market tells three important stories, all of which were extremely favorable to the relationship between labor, wages and prices in the US. First, the initial wave of workers from the baby boom generation started coming in to the labor force in the 1970s. You can see from the above chart how this caused the labor force participation rate to rise. Alongside this massive inflow of new workers came a second trend; the rise of the two-income household as more women entered the market as full-time employees. This trend accelerated in the 1980s before levelling out in the 1990s.

Then, in the 1990s a third trend emerged which, while not having a direct impact on the US labor force participation rate did have the effect of allowing the unemployment rate to stay low without overheating and pushing up prices. This was the “Great Migration” of young Chinese job-seekers from their rural provinces to the cities where massive manufacturing infrastructure was being created to produce the Chinese economic miracle of the late 1990s and first decade of the 21^st century. In the US and elsewhere in the developed world companies decamped from their domestic production sites to tap into this new supply of labor.

In total, then, three major global demographic phenomena all worked to the benefit of both the labor market and low inflation. All of those three trends have come and gone; there are virtually no more incremental benefits to be gained by any of them. From a global perspective the change in the supply and demand dynamics of the labor market will, all else being equal, contribute to more pressure on wage growth, which in turn can feed into more demand-side upside pressure on prices.

This does not necessarily mean that stagflation is the only plausible economic scenario. It is entirely possible that some of the major technology innovations that have been bubbling up over the past twenty year or so will show up in the form of productivity gains. This happened in the 1990s, when technology that had been around since at least the 1970s started to visibly manifest in productivity numbers. Productivity is the key to long-term growth. If Jay Powell’s optimistic assessment of the relationship between labor and inflation is to play out, it would be nice to have that productivity show up sooner rather than later.

If you want to know what’s in store for stocks, pay attention to the bond market. That’s something we tell our clients repeatedly. Interest rates have an outsize effect on equity valuations. The shape of the Treasury yield curve contains all sorts of information about economic expectations. Credit risk spreads signal how much investors are demanding for taking on credits with a higher risk of default. In effect, the bond market is supposed to be the sober, thoughtful repository of market intelligence while the stock market’s day-to-day mood swings reflect a bundle of flighty emotions and mindless groupthink.

Dangerous Curves Ahead

That’s how it’s supposed to work. But the bond market today seems to be sending out mixed messages. The Treasury yield curve has inverted slightly in the so-called “belly” – between the 5-year and 10-year Treasury notes. It is ever so close to doing the same in the wider expanse between the 2-year and 10-year maturities. A 2-10 inversion strikes fear into the heart of investors because of its historical prescience as a predictor of an approaching recession. The chart below shows this track record for the four recessions we have had since 1990.

A word about this chart is in order, though. The 2-10 curve inverted very briefly in the fall of 2019, and then we had a recession in 2020. But that recession had absolutely nothing to do with the economy of September 2019 or, for that matter, the economy of February 2020. The recession happened because we shut the economy down when the pandemic hit. Absent the pandemic, and given every other piece of data we have about the economy at the time, it seems highly unlikely that we would have gone into recession then. So the 2019 2-10 inversion would seem to need an asterisk, at best.

Nonetheless, the fact that the short end of the curve is rising while longer maturities stay put (or don’t rise by the same magnitude) would suggest that fears of an economic reversal are higher than they were several months ago. Last week, after the Federal Open Market Committee meeting, Fed chair Powell made the case that a series of methodical increases to the Fed funds rate would gradually bring down inflation while the unemployment rate would drop to 3.5 percent and stay there, with GDP growth continuing at a slightly above-trend cadence. The bond market, at least according to the flat yield curve, doesn’t seem to be fully on board with that assessment and thinks a harder landing may be in store.

Credit Risk Complacency

Then we come to another important bond market dynamic – credit risk spreads between benchmark Treasuries and corporate bonds. In particular, the spread between the 10-year Treasury and the riskiest investment grade corporates (Moody’s Baa) is just about two percent today. That is tighter than the three year average of about 2.3 percent, and comfortably within the normal range of the spread during economic growth periods, as shown in the chart below.

In other words, credit risk spreads are not telling us that we should be hunkering down for an oncoming recession. We would expect these spreads to widen in advance of a downturn, because the risk of default would be higher. Remember that the only way a bondholder loses money, assuming that she holds the bond to maturity, is for the company to default. Otherwise it’s a predictable stream of cash flows from timely interest and principal payments.

So which one of these messages is right? We have been on record for much of this year saying that the likelihood of a recession in the next twelve months is quite low, given current levels of consumer demand and a tight labor market. So in this sense we are more or less in line with the view Powell expressed at the FOMC press conference last week. That being said, we are not completely on board with the idea that inflation can come down from its current levels to the Fed’s two percent target without more pain than the soft landing of Powell’s worldview. We will be talking more in upcoming commentaries about some of the things going on in the world that may be beyond the Fed’s ability to fix with a benign, measured series of Fed funds rate hikes. Meanwhile, we think there might be a little truth in both those bond market signals, from the yield curve and from risk spreads.

Believe it or not, we’re only a couple weeks away from the end of the first quarter. And what a quarter it has been, the lowlight of course being the unthinkable devastation and human misery resulting from an unprovoked war of aggression by Russia on Ukraine. In addition to what is arguably the single most significant geopolitical development since the fall of the Soviet Union, though, this quarter has also witnessed the highest levels of inflation in the world economy in more than forty years. Not to mention the persistence of the Covid-19 pandemic past the Year 2 milestone. That’s a lot for people – and markets – to process. And those are just the threats that are active, clear and present.

The Damage to Date

Given all that’s happened, it is perhaps somewhat reassuring that as of today the damage to broad-based US stock indexes can still be measured in single digits: the S&P 500 is down around 7.5 percent for the year to date as we write this, and the Dow is off by around five percent. The Nasdaq, home to the tech stocks that with their heightened sensitivity to rising interest rates have borne a greater share of the reversal, has meanwhile managed to claw its way out of bear market territory in recent days and sits around 12.5 percent off its level at the beginning of the year (markets are slightly higher in early trading on this Friday, but of course that could change between now and the end of the day).

How does this environment look compared to other pullbacks in recent and not-so-recent times? Every situation has its own unique factors, of course, but we always find it useful to put current events into a larger context. With that in mind let’s consider all the times the S&P 500 reversed by ten percent or more, going all the way back to the tech sector crash in 2000.

Two Long, Five Short

As the above chart shows (which presumably is not news to you) there were two major bear markets in this period: the one that started with the dot-com crash in 2000 and then the 2008 financial crisis that really fell apart with the bankruptcy of Lehman Brothers. Apart from these two seminal events there were five instances where the market fell by more than 10 percent but also recovered relatively quickly. These were the financial crisis in the Eurozone (2010 and 2011), a sharp economic slowdown in China (2015), fallout from the Fed’s interest rate hikes in 2018 and, of course, the pandemic in 2020 (technically, the 34 percent peak-trough fall during March 2020 constituted a bear market, but the lightning-speed bounceback after the Fed’s intervention makes this materially different from 2000-02 and 2007-09).

Now, if you look to the far right side of the above chart you will see the current pullback. At the March 8 close, the S&P 500’s low point thus far, the index was off about 13 percent from its January 3 high. A peak – trough duration of two months is pretty comfortably within the range of those previous five events from 2010 – 2020 that didn’t extend into a longer, more painful experience. But, of course, we don’t know with any level of assurance that the March 8 close will wind up being the definitive bottom for this event.

A Closer Look at 2000

It is customary market shorthand to refer to the 2000-02 bear market as the “tech crash” because of the outsize impact of the meltdown in Internet stocks that occurred early in this event. But while the dot-com implosion gobbled up the likes of Pets.com very quickly, the trend in the broader market is actually a lot more complex. Below we show the S&P 500 from January 2000 to December 2002.

After peaking in March 2000, the S&P 500 did fall sharply in the initial downdraft from the tech crunch. On April 14 the index fell by nearly six percent in a single day (by contrast, the worst single day for the index in the present-day environment was a 2.95 percent slide on March 7). But then, as you can see, things stabilized and the S&P 500 actually flirted with the March 24 high several times later on in the year (this all taking place while the wheels continued to come off anything tainted by the dot-com association). Things didn’t start going really south for the S&P 500 until February 2001. By then it was becoming evident that the economy was headed for a recession. The Fed started a rapid series of interest rate cuts in January 2001 to try and head off the building evidence of economic weakness, but that seemed to only unsettle the market even more (yes, interest rate cuts don’t always bail out falling stock prices).

A further hit came with the terrorist attacks of September 11, 2001, which in the end was probably more damaging at a psychological level on market sentiment than in terms of an actual economic effect. In any event, the combination of these factors – tech’s woes, the recession and 9/11 along with no doubt other evanescae that have faded from memory but that were probably seen as important at the time – was enough to keep stock prices depressed until the S&P 500 bottomed out in October 2002.

Lessons for Today

Does the 2000-02 experience have any implications for today? Let’s fast-forward to the FOMC meeting this week in which the Fed raised interest rates for the first time in more than three years. Because the question about whether the market pullback of January – March 2022 turns into something more persistent hinges a great deal on whether what Fed chair Powell said about the economy in the press conference following the meeting on Wednesday actually comes to pass.

The interest rate hike and those slated to follow are necessary to tame inflation – which, says Powell, is job number one for the Fed. Not only necessary but, in his view, sufficient. The supply chain problems and the added uncertainty brought about by the war in Ukraine will, in time, work themselves out according to this view. Meanwhile the labor market is strong, consumer demand remains healthy and thus the likelihood of a recession in the next twelve months is low. This is the world according to Jerome Powell, and if he is correct in his assessment then (absent some other threat that has not yet manifested) the likelihood of a repeat of the 2000-02 market environment is commensurately low.

That is still a big “if” though, and what bears particularly close scrutiny is whether the labor market can continue to add jobs and keep unemployment around the 3.5 percent level (like the Fed expects) without triggering the kind of endemic wage growth that would in turn make it less likely for inflation to subside back down towards the Fed’s two percent target. That’s the potential wrench in what is otherwise a fairly compelling case for the continuation of solid real economic growth. It will require close attention as we head into the second quarter and beyond – because nobody wants to see a repeat, or even a rhyme, with the history of 2000-02.