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This is an excerpt from our 2023 Mid-year Investment Outlook, in which specialists from across our investment platform share insights on the economic and market forces that we expect to influence portfolios in the second half of the year. This is a chapter in the Bond Market Outlook section.
“Mere inflation — that is, the mere issuance of more money, with the consequence of higher wages and prices — may look like the creation of more demand. But in terms of the actual production and exchange of real things, it is not.” – Henry Hazlitt
Over the past few decades, many market participants and the US Federal Reserve (Fed) alike have become conditioned to believe the financial markets do a superior job of predicting the economic cycle versus their own forecasts. Indeed, Fed Chair Jerome Powell said as much in an October 2018 speech:
“Whatever the cause, in the run-up to the past two recessions, destabilizing excesses appeared mainly in financial markets rather than in inflation. Thus, risk management suggests looking beyond inflation for signs of excess.” – Jerome Powell
Fast forward to 2023: I believe it is this faith in the market’s ability to forecast recessions that has emboldened the Fed to continue its current interest-rate-hiking campaign to tame inflation — because, simply put, the equity and credit markets have not yet “broken” in the face of rising rates. In my view, however, the Fed is pursuing a dangerous strategy: The financial markets are not always reliable prognosticators of the next economic cycle, particularly with the US economy in a state of “money illusion” these days.
Money illusion is an economic concept whereby most consumers tend to view their income in nominal terms instead of in real (inflation-adjusted) terms. In other words, when their wages rise, their knee-jerk inclination is to buy more goods and services — without realizing that, despite the upward bump in their paychecks, they are actually worse off on a net basis than they were before, when adjusting for the increased prices.
For example, consider that real average hourly earnings in the US are virtually unchanged from pre-pandemic levels, even though real consumption is materially higher. Similarly, stock prices have been supported by corporate revenues that are higher now than they were pre-pandemic driven by this post-COVID surge in consumer spending. It is largely because of this relationship that equities can serve as a potential inflation hedge in investor portfolios.
Eventually, however, money illusion fades as consumers wake up to the reality that real incomes do matter, and that’s when the economic cycle typically begins to deteriorate. This is already starting to happen with real US retail sales adjusted for core CPI now declining year over year, which is often consistent with the onset of a recession (Figure 1).
I believe the next phase of the economic cycle (both in the US and globally) is likely to be one in which companies will initially try to maintain current consumer price levels by restricting the available supply of goods and services. Many companies today sport elevated equity multiples because they have been able to demonstrate the “stickiness” of high profit margins post-pandemic, and they will probably do their best to keep prices more or less where they are now.
However, this sought-after equilibrium does not usually last long as consumers, many suffering from declining real incomes, adapt by trading down in quality to lower-priced goods to save money. In addition, there is also often an incentive for companies competing with one another to reduce their prices in an effort to attract consumers, drive sales, and ultimately grow their market share. As a result, consumer prices eventually come down, leaving many companies with lower unit volume and, thus, shrinking revenues and profit margins.
So, what can companies eager to protect their profit margins do? Well, those that made sound, productivity-enhancing capital investments during the preceding upcycle will likely be better positioned to preserve their margins. However, unfortunately for the global economy, most of the new capital investment since the pandemic has been residential rather than nonresidential expenditures. The former is really just another form of consumption, while the latter has historically led to productivity gains.
By contrast, companies that did not make prudent, productivity-boosting investments when times were good (and again, that includes a lot of today’s companies) are all too often forced to lay off workers, causing the unemployment rate to rise. The Fed keeps citing the currently tight labor market as one reason to maintain its restrictive monetary policy stance, but the jobs market will lag other economic indicators in an environment of money illusion like we’re in now. That is to say, it won’t stay tight indefinitely.
Henry Hazlitt’s quote above perfectly encapsulates the present state of the US economy as the policies enacted during the pandemic have created the illusion of wealth and prosperity. The government fiscal spending may have temporarily subsidized consumption but it did little for productivity growth, which has remained stagnant and is most correlated with rising real wages in the long term. In fact, overconsumption today likely means lower real incomes in the future. That’s why I would argue that real (inflation-adjusted) yields should be lower on average than they were pre-pandemic.
In the economic process described above, the financial markets do not lead the economic cycle and typically only respond negatively during the disinflationary part of it. I think we will soon be entering that phase of the cycle, and in my next piece, I will discuss why liquidity issues may exacerbate that next phase as the US debt ceiling has been raised.
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