In 1971, David Bowie urged us to “Turn and face the strange” — a warning we might do well to embrace today as many nations and consumers grapple with the highest inflation in 40 years, as well as the economic and humanitarian costs of their energy needs. All of this occurs while market volatility continues to spike and the Federal Reserve walks a narrow policy path in subduing persistent inflation without sacrificing economic growth.
Supply chain disruptions that were the root cause of inflation in 2021are slowly being resolved in spots. Business inventories are back above their pre-COVID trend while manufacturing activity and new orders point to still-strong, but slowing, growth in the U.S.1 However, the nature of supply chain disruptions is changing due to the geopolitical uncertainty unleashed by the situation in Ukraine. European automakers have cut production this year as industrial parts became harder to source; major global cargo carriers suspended shipments out of fear of regulatory backlash.2 And there is potential for a structural change as well: it’s possible that efficiencies built into global supply chains over decades may now be viewed as vulnerabilities, not least because of recent Covid lockdown measures in China, complicating exports. Should reshoring and the localization of supply chains follow, the cost could result in higher prices for the long term.
After spending the last two decades in the benign 1.5-2% range, U.S. core and headline CPI are currently running at levels not seen since the 1980s.3 To combat this, the Fed raised the Fed funds rate by .25% in March, .50% in May, and signaled they could potentially raise rates to ~2.8% by the end of 2023, and announced plans to steadily reduce the size of its near $9 trillion balance sheet. This has led to a sharp increase in yields across the U.S. Treasury curve, led by the very front end of the yield curve. While we believe the longer end of the curve has the potential to move modestly higher in yield, market pricing of Fed hikes in the front end is likely overdone. Though the Fed is talking tough now by signaling sharply hawkish policy shifts and an openness to more rate hikes, in the current environment we think the Fed may not be able to hike as much as the current market is pricing or as much as the Fed implies in their Statement of Economic Projections without crimping growth.4
As rate hiking cycles unfold, they are often met with sharp yield curve flattening and inversions in the 2/10s curve (in which the yield on 2-year Treasuries is higher than that of the 10-year). Markets tend to view this as a harbinger of an economic recession, and growth fears were ignited once an inversion occurred this spring (although the curve has since steepened, which we think should continue). Yet our analysis shows that while yield inversions are often followed by recessions, the timing of the recession after an inversion can be difficult to pinpoint, ranging anywhere from six to 24 months. Even more importantly, equity markets have tended to remain resilient for the first 12 months following an inversion, and in most cases, have delivered positive returns.5
