September 18, 2022

Prediction? Pain

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Bottom Line:


While companies like FedEx have heralded recession, employee layoffs have not risen in aggregate across the economy. This keeps the Fed restrictive and guarantees at least a .75% increase in the Fed Funds rate on September 21st. Unfortunately, for the Fed to hit its 2% inflation target near term, the reanimated Phillips-curve chorus calls for unemployment levels to rise well above 5%, up from 3.7% today. This is the “pain” Powell prescribed for the economy in his August 26th speech from Jackson Hole. But how much pain is this really? And how much pain will American voters tolerate? The answers to these questions must now inform your investment strategy as they will certainly define 2023.



The Full Story:


As FedEx detailed on Thursday, the lockdowns in China, the war in Europe and policy tightening in the U.S. have upended shipping volumes. Fewer goods circling the globe in boxes translates into less global GDP. Less global GDP means less corporate revenues and less corporate profits to share. Less corporate profits mean less employees. Less employees means less wage pressure. Less wage pressure means less inflation. The Fed believes layoffs will cure inflation. Unfortunately, we haven’t seen any. Note the chart below which chronicles unemployment claims:


Picture1 1


Initial unemployment claims have shown little uptick as of late and continue to plumb the record lows seen earlier this year. The Fed clearly still has work to do. But how many layoffs does the Fed need? This has become a hot topic of debate and has reanimated the long-forgotten Philips curve. For those who slept through macro-economics, the Phillips curve posits that inflation and unemployment are inversely correlated; i.e., more employment means more inflation, and more unemployment means less inflation. According to Phillips-curve adherents, dousing inflation by the end of next year would require the Fed to engineer a recession to drive the unemployment rate up between 4.5% and 7%. The increase in unemployment would depend on how aggressively the Fed wants to decrease inflation. If the Fed can stomach 3% inflation, it needs to destroy 2 million jobs. If the Fed wants to hit its 2% target, it needs to destroy 5 million jobs. But before the job reductions occur, the job openings must evaporate:


Picture2 1


And while the pace of job openings has slowed, there are still two job openings for every one job seeker. Therefore, the Fed needs millions of “Looking for Work” signs tomorrow to replace the millions of “Help Wanted” signs today. That’s what Powell meant when he prescribed “pain” as the cure for inflation.


How Much Pain, Mr. Powell?


Of course, there are degrees of pain. During the COVID lockdown, 22 million jobs were shed which amounted to 14% of working Americans. During the Great Financial Crisis, 9 million jobs were shed or 6% of working Americans. During the 2002 recession, 2.6 million jobs were shed or 2% of working Americans. During the Volker recessions, 1 million jobs in 1980 and 2.8 million jobs in 1982 were shed, or 1% and 3% loss of working Americans, respectively. If the Fed must press unemployment up by 2 million to hit its Phillips-curve derived inflation target of 3% by the end of 2023, that is 1.3% of today’s working Americans. While “painful”, this reduction registers on the lighter side of the historical range. In fact, an increase to 5% unemployment, from 3.7% today, would still lie below the long-term average unemployment rate of 5.7% going back to 1948:


Picture3 1


Unfortunately, the economy responds to infinite variables in addition to Fed policy. So, while the Fed might neatly land the economy at 5% unemployment and 3% inflation “ceteris paribus” (a nod to those of you who didn’t sleep through class), it is easy to see from the chart above that movements in rates tend to overshoot and undershoot their tidy targets. And while the Fed might like to see somewhere between 2 and 5 million Americans unemployed to fight inflation, those Americans vote. Note the speed with which the Fed has historically cut rates when unemployment rates begin to rise (I started this series in 1989 to reduce eye strain):




This relationship between rising unemployment and rate cuts held true even during the “unflappable” Volker era. Remember that the U.S. had only come off the gold standard a decade earlier, so the clumsiness of the rates reflects the inexperience of the Fed. Today’s Fed has more experience and more tools which reduce the wild rate volatility of yore. Nonetheless, look at the speed with which Volker cut rates as unemployment rose:




While the Fed may prescribe “pain” to stimulate layoffs, the historical record suggests they may get more than they bargain for, forcing them to reverse rates quickly in 2023. That is not the base case in the market right now, but that is mine for 2023.


WIFM (What’s In It For Me?)


On average, markets rallied 16% over the following year after the first-rate hike. Without a recession during the year, returns jump to 24%. With a recession during the year, they fall to +11%. Therefore, should the Fed overdo austerity (likely) and need to reverse course in 2023, history bodes well for intrepid investors.




Have a great Sunday!


David S. Waddell 
CEO, Chief Investment Strategist




Sources:  FRED, Bureau of Labor Statistics, Ned Davis





David Waddell
Author: CEO Chief Investment StrategistAfter graduating from the University of the South with a BA in Economics, David began his career with Charles Schwab & Co., Inc. in Phoenix, AZ. Having been recognized for his outstanding business development record, David was promoted to the San Francisco- based Institutional Strategic Accounts Team, which interfaced with the Big 5 accounting firms and Schwab’s largest customers. David left Schwab to continue his education at the graduate level in Boston. While earning his MBA degree with a concentration in finance and investments at the F.W. Olin School at Babson College, he was appointed by the college Trustees to manage a team of seven portfolio managers overseeing the student-managed portion of Babson’s endowment fund. David also founded the Babson Investment Management Association to assist undergraduate and graduate students with training and career path planning in the investment management field. As the firm’s Chief Investment Officer, David chairs the W&A investment committee and combines macro economic forecasting, macro market analysis and macro risk assessments to design portfolio strategies utilizing public market securities worldwide. A civic leader in Memphis, David currently acts as Chairman of Epicenter Memphis, and Co-Chair of the Memphis Chamber Chairman’s Circle while also serving as a board member for LaunchTN and the New Memphis Institute. David previously served as chairman for The Leadership Academy, the RISE Foundation, and the Economic Club of Memphis. He also chaired the capital campaign to build the “Live” stage at the Memphis Botanic Garden. David was a member of the 2004 Leadership Memphis class and has been recognized as one of Memphis’ “Top 40 under 40” by the Memphis Business Journal, and as a finalist for “Executive of the Year” in 2007. In addition to weekly columns in the Memphis Daily News and the Nashville Ledger, David has appeared in the Wall Street Journal, USA Today, Forbes, Business Week, Investment News, Institutional Investor News, The Tennessean and Memphis Business Journal. He has also made appearances on Fox Business News, Yahoo Finance, Bloomberg TV, CNBC, and CBS News and ABC News Channels. Read some of David's articles on his author page in Inside Memphis Business. David has two wonderful children, Easton and Saylor, an obedient Labradoodle named NASDAQ, and a devoted Goldendoodle named Ripley.


David S. Waddell


Chief Investment Strategist

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