Any reading of the financial media focuses on all the problems confronted by the markets. Inflation ravages purchasing power and the Federal Reserve (Fed) responds by raising interest rates. Russia’s invasion of Ukraine crimps food and energy supplies and destabilizes the world order.
It’s not all bad news though – there is strength in our current economy. The April jobs report showed an increase of 428,000 jobs and an unemployment rate of 3.6%. Job openings of 11.5 million are at record highs. We’ve almost fully recovered from the pandemic job losses and all indications are the job market is strong. The unemployment rate of 3.6% is lower than the rate was going into the Great Financial Crisis (about 4.5%) and in early 1980 (about 6%), the last time the Fed was aggressively increasing rates.
Additionally, the rate of inflation may be starting to slow. Hourly wages were up less than expected in April, a 0.3% month over month increase, and less than March’s 0.5% increase. Rising interest rates may dampen housing and auto demand. Increasing vehicle prices have been one of the drivers of inflation and housing is the largest component.
The first quarter’s GDP report had a negative headline number driven by a trade imbalance. Conversely, the significant driver of the economy, spending by households and businesses, was up 3.7%. This is coming off the 4th quarter GDP growth which was above trend.
The changing environment has created equity market volatility. Rising interest rates increase the pain because as rates increase, bond prices go down (an investor that can get a newly issued bond with a coupon of 3% is going to pay less for the bond issued last year paying 2%). The result is that both stocks and bonds lose money. It’s important to note that fixed income valuations are falling due to rising rates, not increasing defaults or a freezing of the credit market as happened early in the pandemic.
The Fed has messaged the expected future rate increases and the market has already discounted future earnings accordingly. The market selloff has already signaled that a recession is much more likely than it was a week ago. However, it’s also possible the Fed engineers a soft landing or that a market recovery in the near future discounts a mild recession and strong recovery.