September 25, 2022

The Beatings Will Continue Until Inflation Improves

Boxer silhouette fighting in a dark foggy room

Bottom Line:


The Fed raised interest rates by .75% this week while sharply downgrading its outlook for the economy. This dissonance led to Pavlovian selling as rates spiked and earnings expectations fell. Nothing good came from the Fed’s September meeting. However, the lack of silver linings is, in itself, a silver lining. The Fed wants the economy to slow and for employers to lay off staff. This will happen, likely more than the Fed anticipates, leading to a policy downshift and/or reversal over the next six months. This timeline harmonizes with periods of extreme pessimism from the past which foretold robust returns. It is time to start playing the pain. Read on for our current assessment and our year end playbook.



The Full Story:


Last week, we discussed how Federal Reserve Chairman Jerome “Pow-Pow” Powell predicted pain for the markets from his podium at Jackson Hole. While undefined, we interpreted his pain prediction as a call for 2 million job losses as his chosen mechanism for dousing inflation. This week, the Fed not only raised interest rates by .75% to 3.25%, but also overtly raised predictions for unemployment (pain). Markets reacted violently as the Fed’s true recessionary policy stance became inked. This week, we will walk through the details of the Fed’s Summary of Economic Projections released September 21st and translate what they have signaled about the state of play and the policy on tap:


Economic Projections of Federal Reserve Board members and Federal Reserve Bank Presidents, September 2022


GDP and Inflation chart


GDP: Downgrade


The Fed still projects that it can engineer a “soft landing” where economic supply and demand reclaim a non-inflationary balance without inflicting recession. Note that the Fed expects the economy to run below potential (1.8%) for the next three years, with 2022 marking a near zero growth rate for real GDP. For 2023, average growth projections accelerate to a meager 1.2% within a range of -.3% to 1.9%. From there, 2024 and 2025 appear more in line with potential. Takeaway: The Fed projects the economy to fumble through 2022 and limp through 2023 before reaccelerating to a below-average pace in 2024.


Unemployment: Downgrade


Last week, we proposed that the Fed would like to see the economy shed anywhere between 2 million and 5 million jobs to stifle inflationary wage pressures. Within the summary of economic projections, they didn’t quite signal that much “pain” to come at 4.4%, but the range of forecasts did top out at 5%. This translates into 1.2 million job losses to hit the midpoint (4.4%) and 2.1 million to hit the high point (5%). These numbers unnerved the markets more than any others released on Wednesday. While the Fed may hope for a GDP soft landing with moderate job losses, history doesn’t usually play out this way. When unemployment levitates, it tends to rocket higher as seen in the unemployment rate chart below:


Unemployment rate


Even a mild recessionary period like we experienced in 2001 saw a spike in the unemployment rate from 3.8% to 6.3%. Since the Fed has now explicitly targeted “unemployment” as the prescription for inflation, and since unemployment historically overshoots, these projections will likely prove optimistic. This makes corporate earnings projections seem optimistic as well, leading to the cascade of sale orders to end the week.


PCE and Core PCE Inflation: Downgrade


The Fed slightly increased their inflation projections for headline inflation to 5.4% this year, 2.8% next year and 2.3% for 2024. They also increased their core projections to 4.5%, 3.1% and 2.3%, respectively, against their 2% target. While these numbers nudged up slightly, it’s the slope that matters. The Fed feels confident they will conquer inflation and that rates will only decline from here. The market agrees as inflation expectation gauges remain anchored near similar levels. While higher unemployment levels and lower corporate earnings may be bad news for equity investors, lower inflation levels are actually good news. As inflation falls, interest rates tend to fall, relieving pressure on valuations. Therefore, while these levels are high, they are declining. The pace of the decline will determine future Fed policy and the pace of the market’s recovery.


Fed Funds Rate: Downgrade


The Fed survey participants drastically increased their policy rate projections. The participants expect the Federal Funds rate to reach 4.4% by the end of 2022. This assumes another 1.25%-1.5% in rate hikes over the next three months! For 2023, the committee sees rates higher still at 4.6% before beginning their descent back to the 2.5% long-run target in 2024. Furthermore, examination of the dot plot (each survey respondents projection registers as a dot) suggests broad consensus around the heightened 2022 and 2023 rate levels as seen below:


FOMC participants assessment of the appropriate fed funds target rate


That is high conviction in a highly restrictive policy. This did not go unnoticed by the markets as stocks plunged and rates spiked. This will also not go unnoticed by CFOs and HR departments. Expect bulk layoff announcements to accelerate. This is precisely what the Fed wants, and since unemployment levels tend to leap as groupthink takes hold, overshooting projections, we expect rate realities will undershoot projections.


Sentiment: Upgrade


The dismal combination of the Fed’s projections did their job and has knocked the S&P 500 back toward its June lows. Consensus has turned decidedly and historically bearish. This week, 61% of individual investors (according to the American Association of Individual Investors) identified as “Bearish”. This has only happened a couple of times over the life of the survey as our friends at Bespoke investigated:


AAII Bearish Sentiment


In the two other clustered occurrences, sentiment levels and overall market levels deteriorated even further before putting in durable bottoms within two to six months:


SP 500 1990 2008


But…while readings of 60% could indicate more short-term pain for investors, the downfield results prove compelling for bargain hunters. Here are the forward returns from the full range of AAII Bearish sentiment readings:


SP 500 Historican Forward Performance Based on AAII Bearish Sentiment Ranges


Over the 5 similar periods of investor despondency, stocks returned 33% over the next 12 months, on average, with an 80% positive hit rate. This supports our base case that this is the bottoming phase for this cycle and should set us up within months for a positive 2023.


Here is the year end playbook:


  • Continue harvesting tax losses wherever possible
  • Reinvest proceeds to maintain market exposure
  • Add cash weekly, or bi-weekly and be fully allocated by Halloween
  • Should the market cascade lower between now and then, accelerate purchases
  • Wait for history to rhyme!


Have a great Sunday!


David S. Waddell  CEO, Chief Investment Strategist




Sources:  FRED, AAII, Federal Reserve, SEP
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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