Our economic updates are written once weekly by nVest Advisors CEO Jeremy Torgerson for the general education of the public, and as a way to provide transparency for our clients and sponsored-plan participants as to how we create and modify our investment models over time.
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- All eyes are on the Federal Reserve this week.
- Energy supplies are dropping as we head into winter.
- Which parts of the economy are holding up?
All eyes are on the Federal Reserve this week.
Our Federal Reserve’s FOMC (Federal Open Market Committee, a group of regional Federal Reserve bank presidents and leaders who vote to set interest rate and Federal Reserve asset sales and purchases) meets tomorrow and Wednesday, as they do every six weeks. These meetings are crucial economic events, because the country’s interest rates and basic money supply are decided upon as the FOMC reviews the current data on the economy and the effects of its previous policy decisions.
So far in 2022, the FOMC has raised interest rates six times, the last four by .75% each time, which makes it the most aggressive rate hiking cycle since 1980:
This is impactful on all bank rates, loans, mortgages, and bonds in the economy, but this process of quantitative tightening is one of the major tools the Fed has to lower inflation. As we’ve discussed in previous Economic Updates, the Fed’s intention is to raise rates and reduce the available supply of money sufficiently to dampen economic activity enough that the upward spiral on wages and prices (inflation) is broken. In effect, the Fed needs to inflict damage on the economy in order to correct the “supercharge” to the economy that very low interest rates and all of the stimulus spending did during Covid-19.
The Fed has indicated that after this very aggressive rate hiking cycle so far in 2022, they will at some point begin to slow the rate of increases until they can pause and let the economic fallout happen. Each rate hike will have an economic impact but except for housing and short-term financing (like credit cards), there is a 6-9 month time lag before each hike really shows up in the actual economic output. Essentially, except for housing and finance and companies that were surviving on cheap loans, we are just now feeling the effects of the first one or two rate hikes on our businesses and family finances.
Most analysts believe the Fed may be ready to start slowing the pace of their increases. The consensus is that this week, the Fed will again raise rates but only by 0.50% (commonly described as 50 bps or “basis points”). If the Fed raises by more than 50bps, we should expect a very negative reaction in the stock markets, and if they raise by less than 50, you might see a significant market rally.
We tend to ignore the daily market reactions to news events because those can completely reverse in just a few days or even hours as new data arrives. The economic indicators are definitely giving us a group of mixed signals as to what the FOMC may be thinking, but we don’t believe we are what the Fed calls its “terminal rate” yet, and expect at least two more rate hikes (this week and in January) before the FOMC might even consider pausing for a while.
Labor demand remains (too) strong
One of the two major indicators that the FOMC is watching closely is, how strong is the demand for labor. As long as companies are still having to compete vigorously for the available workers, “upping the ante” to try to woo a worker to their company, the inflationary cycle will continue to feel upward pressure. The Fed must slow down the economy enough that there aren’t more job openings than there are workers (hopefully without going too far and causing too many jobs to be eliminated through layoffs and company closings).
So far, though, despite the economic headwinds all year, demand for labor remains very strong…
even though the nation is already considered fully employed:
Why are there so few workers out there? Part of it is indeed robust company growth due largely to all of the Covid-19 stimulus spending that happened during 2020 and 2021, but the other part is that since Covid, many people who used to work have voluntarily left the labor market and are no longer actively seeking employment. This is called the Labor Participation Rate, and as you can see from this graph, it shows that our workforce is substantially smaller than it was before the Covid pandemic:
Fewer people looking for work means companies have to aggressively compete for the ones that remain, offering ever-higher wages and better benefits in order to fill their job openings:
That sounds wonderful for the individual worker (and it is), but when your labor costs climb substantially, a company must then charge more for the products and services that labor will produce.
And there, in a nutshell, is why we have such persistent inflation.
The Fed will have to break this cycle, and the rate hikes are part of this strategy. Last week’s numbers (above) tell us that the Fed still has a ways to go with rate hikes before this cycle will finally be trending the other way.
Energy supplies drop as we head into winter.
Energy prices remained volatile last week as news of a leak of the Keystone Pipeline in Kansas forced the shutdown of that major domestic supply of crude oil while the pipe is repaired.
We also got the news that OPEC+ nations decided not to change their current supply quota, as we expected and predicted last week. The problem with OPEC+ production estimates is that they have routinely delivered less oil than they pledge, which causes some disruption in the market’s ability to accurately price future oil contracts. Currently, OPEC+ is pledging more oil production than in 2019, but delivering much less:
We do appear to be making the best use of the available supply as our refinery utilization is at years-long peaks. However, we are still refining well below our current capacity. The biggest issue is supply. With our government limiting the drilling and pumping of our own crude oil since the Biden Administration took over in 2021, we are forced to find much of our supply from outside the United States and wait on its transport before we can refine it.
It’s important to keep our own energy market in perspective with the broader picture of global energy demand and supply. The northern hemisphere, where most of the world’s population is located and where so much industry occurs, is entering winter. Winter is when energy demand will peak seasonally. When you factor in the current Russian / Ukrainian conflict and the resulting oil embargoes and price cap attempts for Russian oil, combined with the drain on many countries’ strategic energy reserves this year, you can see that the world’s demand for oil will not be abated for at least several more months, and supply is limited.
We believe oil prices have upward momentum globally because supply remains limited and demand is increasing. This may be offset partially by the imminent economic slowdowns in many parts of the northern hemisphere, and certainly, a positive outcome of the war in Ukraine will help ease supply constraints, but without either a steep recession or a sudden surge in global supply, we believe energy prices have bottomed and will trend upward again for several months. The data agree with our assessment. First, our own supply of crude oil is at multi-decade lows, with only 25 days of supply in the United States:
And the situation is just as dire, if not worse, in much of Europe. For example, here is the current amount of natural gas that Europe must import. It’s at all-time highs with no end in sight:
Another bit of evidence that these recently lower oil prices are not pairing with reality is that they have widely diverged from the revenue reports of actual energy companies. Remember that oil is a commodity that is purchased months in advance using contracts to set the future price of a barrel of oil, but energy companies report their revenue and profit after each quarter is completed.
So oil futures are speculative, and energy company revenues are actual results. Oil has been down significantly as a commodity, but oil company profits are doing very well. This disconnect is literally in unprecedented territory, and will likely mean a sharp uptick in oil prices is soon coming, in what we call in economics, “reversion to the mean”:
In short, we believe energy prices have upward pressure and will likely not continue to follow the recent downward trends from the summer and mainly fair and warm autumn months in the northern hemisphere. Our Macro models for all of our account custodians continue to be invested in both energy and broad-basket commodities for now (in appropriate amounts).
Are some sectors of the economy already in recession?
When the GDP figures are released each quarter, we often hear of the “headline” number (the TOTAL GDP), but often the news skips over the break-downs of the individual sectors of the economy and doesn’t look at them one by one.
All the parts of an economy don’t fall into recession at the same time and to equal degrees. Each industry has unique factors that will respond differently to economic conditions. For instance, some sectors of the economy are far more sensitive to interest rate hikes (like housing and bank lending), while others need low energy prices in order to thrive (like shipping, on-land transportation of products to stores, and airlines).
So as the economy slides toward a recession, which we firmly believe is imminent and unavoidable for much of the developed world, we will see some sectors impacted first (and to a greater degree) before we see the others. Data released last week seems to show that while some parts of the economy are still doing okay, there are others that are sliding quickly into recession:
Some of this makes perfect sense if you think it through logically. Health care, for instance, is seeing a climb in business as we enter the winter months, and respiratory virus transmissions are higher. And after a year of significant turmoil, the technology sector seems to be improving again. However, as the consumer is “tapped out” (has no more surplus cash to spend after paying for basic necessities), we can see consumer services reporting declines, as well as basic materials (housing), and especially in financials (loans).
At nVest, we watch not just the broad economic indicators, but the activity of each of the major sectors of the economy, too, and invest our clients’ accounts appropriately based on where the world is trending and which sectors of the economy (and which parts of the world) are responding favorably to the actual, real-time conditions. Currently, our Macro model is invested mostly in the United States and only in the four sectors of the economy that have the strongest history of weathering recessions and inflation well. This is not typical of most financial advisory firms, which tend to do what is called “strategic investing” based on a client’s generalized risk preferences and time horizons. All of our models incorporate some element of the macroeconomy into the investment selections, and our nVest Macro Model is 100% driven by real-time, real-world conditions.
We said last week that the incoming data continue to confirm our analysis that many of the world’s economies, including our own, will face a recession in 2023. No one knows exactly when a recession will occur, or how long and painful one may be, but we do have most of the indications that we are very close. Our firm’s opinion has not changed. A surprise Fed announcement this week (positive or negative) may be the catalyst for the markets for the rest of 2022, but the economy itself has not changed course and is still trending toward a recession in 2023. What will precipitate a more broad and sustained downward trend in the markets will be, in our opinion, either a 75bps or higher Fed rate hike this week, or short of that, we will see some sudden data changes (most likely corporate earnings and some surprise bankruptcies) that will “jolt” the stock markets into accepting the economic reality, and these short-term rallies will cease.
Whether you are our client or not, you need to consider the broader economy (and much less so the daily market fluctuations) when making investment decisions. The economy is telling us clearly what is coming soon, and you need to have your investment accounts prepared before that happens.
Use these economic reports, and those of others working in this space, to prepare. You can not only avoid much of the pain that is coming, but you might actually profit from it, if your investments are properly positioned, and you’ve done what you can to shore up your business’ and family’s financial situation. If you need help with this, nVest Advisors has amazingly affordable personal financial planning and fiduciary investment management services to help you.
This is what we do for a living, and we’re very happy to partner with you on that endeavor.
Reach out to us for a totally free financial and portfolio checkup today if you’re concerned about where your finances sit for the coming few years, particularly if you are at or approaching retirement age. We’re delighted to offer you our thoughts. You can schedule that time with us below:
Watching This Week:
- Retail sales will be reporting on Black Friday, Small Business Saturday, and Cyber Monday.
- Federal Reserve Interest Rate reaction
- Labor Market Update
- Real Estate Market Update