Guy:   Let’s begin with the mixed signals, I mentioned. What is the state of the economy?

Tani: 

• The phrase I’m using for where we are now is “residual strength.” What I mean by that is that indicators showing strength, but most of those are showing some softening. We are seeing that among both households and companies.
• Let me point out a few areas where households have strength.
• Households saved enormous amounts during the pandemic. Balance sheets have been extremely strong. This occurred from sitting at home and not spending money, and from the stimulus packages. Households are still sitting on a lot of cash.
  • But: they are now spending down their savings. By some very rough calculations, I’m seeing if households keep spending at this rate, they will run down their excess savings by around mid-year 2023.
• The job market is still quite strong – openings, hirings, all that – and some people are still getting big wage increases. 
  • But: There is some softening of the jobs data. I would characterize it going from abnormally, historically tight labor market to a more conventionally tight labor market. That is, you can’t call it a soft job market, but it isn’t as strong as it’s been. Job openings have declined, although are still extraordinarily high, average weekly hours are coming down, payrolls are below 300k now two months in a row, labor force participation looks like it’s done for this cycle, and we’ve been stuck at a 3.5 to 3.7% unemployment rate for several months.

Guy:  And companies?  How are they fairing generally?

Tani: 

• Right, corporate margins have been very strong. We look at both publicly traded companies in aggregate and a much broader measure which takes total reported profits of all corporations into account, and both show that profit margins have been strong. Companies have been able to pass on a lot of price increases on to customers. 
  • But: Corporate margins have come down from their peak. In Q3, our macro credit analyst is expecting a decrease in corporate margins. The last few quarters are showing some wobbles. I assume this has to do with the fact that households are finally reining back spending, meaning less pricing power for corporations.

Guy: You have confirmed my assessment that the data is mixed. So after all this shakes out a bit, where do you think the economy is headed?

Tani:       

• In a word: fishtailing. Just like a car that’s trying to stay on the road after hitting a patch of ice, and the driver’s frantically turning the wheel this way and that to try to keep on the road.
• That’s the analogy. But what do I mean by that? 
  • In short, I mean that first you have the external shock, which is the pandemic. That caused a lot of volatility. On top of that, you have everyone’s reaction to that volatility. Consumers switched up their spending patterns, companies laid everyone off and then rehired them. Prices are moving all over the place. 
  • And there’s still a lack of clarity about where we will wind up with spending patterns and labor patterns. Just one example: our in-house automotive analyst noted that car dealers love the current situation. They would probably be fine with having an inventory shortage going forward, because their pricing power is through the roof. Car companies, on the other hand, are looking more at market share and wanting to increase inventory. So, how does that particular tension get resolved? And that’s just one example of thousands of new situations and questions that have been raised by the upheaval from the pandemic. 
  • The real question is where are we headed? We don’t know whether we are in a brave new world, or whether we just move back to something like the pre-pandemic world. Where do inventories wind up, where do employment levels wind up, where does inflation wind up? Our responses to all these questions feel much less certain than it was before the pandemic.

Guy: A post pandemic world has its own unique characteristics and yet it is further complicated by China’s Zero-COVID policy and the supply chain issues stemming from the Ukraine war.  Let’s talk about the Fed and how they are dealing with all this.

Tani:   

• Right, the Fed is possibly the primary culprit of the fishtailing problem.
• They were clearly caught off-sides at the start of the high-inflation period. They were possibly looking at the wrong things. Ben Bernanke, in a speech in October, noted that it seemed Fed officials thought the job market was much looser than it actually was – they expected all of those people that left the labor market during the pandemic to come running back, and they just haven’t.
• Instead, the Fed let the economy get red hot. Then they slammed on the brakes with all of the hiking they are doing now. I feel they may wind up over-tightening because the markets are being too impatient to let the lagged effects of the current hikes take shape.
• They will try to stop hiking and hold rates steady for some time next year, but historically this has been very difficult. On average, the Fed is able to hold rates at tight levels for only six months. The outlier really was right before the financial crisis, when the Fed was able to hold rates high for about a year. But other times it’s been much quicker.
• Even during the famed Volcker period at the start of the 1980s, when Volcker rightfully got credit for crushing inflation, he started cutting rates when inflation was at 1 percent per month. He didn’t wait for inflation to descend that far down. He saw economic weakness and started cutting.

Guy:  Do you think the Fed will achieve 2% inflation anytime soon? 

Tani: 

• I’m not so sure. One more point about the Volcker period, it took years for inflation to settle down toward 2%. Inflation was up in the mid-single digits for a number of years before it really settled down. 
• I expect the Fed will get us to under 3% at least on PCE inflation.
• But I do think that at some point their communication will have to change so that they acknowledge 2% will have to be more of a medium-term goal, and that they’ll have to cut before they achieve 2%. 

Guy:  If you think the Fed cuts before inflation falls below 2%, is that because you believe we will have a recession and the Fed will react by cutting rate?

Tani: 

• Yes, I think so. 
• Our base case is for a recession in 2023. It’s of course very difficult to know, but there are multiple signs pointing in that direction, including all of the signs of weakness I noted above, the Fed’s determination to squash inflation, and the market signals including yield curve inversion. 
• Financial conditions are tightening, as we can see with widening spreads and higher rates. The Fed wants markets tighter, so I’m not sure they would react to anything in markets per se – except of course specific liquidity problems. This could mean a stoppage or reversal of quantitative tightening at some point.
• There are ways we could escape a recession. possibly involving continued strength of the services sector, which is still growing at a rapid rate, and which is a much larger share of the economy. If we are able to maintain that spending, and that in turn manages to keep enough people employed and spending, then we could actually avoid a recession.

Guy:  Would that scenario require fiscal support like what’s happened in the EU? A sort of hand-off from Monetary to Fiscal levers? 

Tani: 

• I’m not so sure. There are already some automatic stabilizers built into the economy. Assuming that the House flips Republican, we are unlikely to see any kind of stimulus. If Democrats manage to get both the House and Senate – which would be a pretty big upset at this point – there could be some additional assistance, but even that would probably not be very large. In our analysis, we’d expect this recession to be quite a bit less disruptive than the last two recessions – which admittedly is a low bar.

Guy:  The recession that you are forecasting next year….what will that look like in terms of magnitude? 

Tani:

• Historically, recessions that follow periods of inflation tend to be more volatile than other recessions. That is, growth tends to fall more sharply when the Fed is actively trying to halt inflation, because the Fed is stomping on the brakes.
• And where you see a real difference is in the rebound. The recovery from an inflation-recession tends to be quite a bit sharper than from other types of recessions. And this makes sense. The Fed is trying to artificially suppress demand with restrictive monetary policy, and when they have to start cutting, they are permitting demand to spring back to where it wanted to originally.

Guy:  Do you have any advice for how investors should play this?  The Fed has been hiking relentlessly all year and look to hike again in December. Yet, the forward market is pricing in small rate cut in 2023^[i]. Does the market have this right or what should investors do in your opinion to prepare for 2023?

Tani:   

• Risk assets are likely to bottom at some point before the recession. Once the markets have a pretty shrewd idea that the recession is starting and can start looking to the other side, spreads can start to compress. Treasury yields on the long end also start to come down at that point. We’re not there yet but we may be close.
• I think the markets have it right directionally. The Fed’s latest summary of economic projections indicates that they won’t cut rates between 2022 and 2023. I think it will be difficult for them to stick to that. The Fed has a present-ism bias. They are just trying to signal that they are serious about controlling inflation, not that they have any prescience about their hiking pattern. They know that if they put in any kind of cuts for 2023, the markets will have an allergic reaction and think they’re not serious about getting rid of inflation.

Guy:  I think that gives us an excellent picture of what we might expect in 2023 and a good place to end.  Thank you for sharing your thoughts and insights.

Tani: Thank you.

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ⁱAccording to 2023 Fed Fund Futures.