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Fed Policy, the Stock Market and Recessions

When we wrote our Leader Board piece “Time to Pivot from Equities” in March 2021, inflation was increasing at an annual rate of 1.7%. How times have changed!

At the time, though, we could see the handwriting on the wall. Historically, high money supply (M2) growth of 25% would lead to a sharp rise in inflation followed by a sharp drop in the stock market. We wrote in a Leader Board published March 8, 2021:

“The historical record documented here shows that rapid M2 growth inevitably leads to higher inflation. We shouldn’t be surprised, therefore, that when inflation begins to rear its head, the stock market bubble will burst.”

All of that has come to pass. But where do we go from here? Although the stock market has declined 15% from its high, will it continue its slide?

Just as the explosive M2 growth gave us an early indication of what was coming down the pike in terms of inflation and interest rates, our economic future will now depend, in large part, on whether the Fed succeeds or fails in its attempt to bring inflation under control while orchestrating a soft landing.

The historical record on that doesn’t hold much promise.

As shown in Chart 1, every time the Fed began a cycle of increasing interest rates to fight strong inflationary cycles (shown with arrows), the economy inevitably slipped into recession.

While admitting that bringing a soft landing will be a tough challenge, Fed Chair Jerome Powell believes that the Fed has more tools at its disposal than it’s had in the past. As a result, he holds out hope that the current inflationary cycle can be brought under control and that a recession can be avoided.

That’s certainly possible, but we believe it’s highly unlikely. And it’s unlikely not because the Fed is inept. Quite the contrary. Because prices are rising sharply, the focus of the Fed has changed from preserving full employment to that of fighting inflation. That fight, however, has inherent risks.

Inflation is largely the result of excessive monetary growth leading to a situation where too much money is chasing too few goods. Recall Milton Friedman’s dictum: “Inflation is always and everywhere a monetary phenomenon.”

So for the Fed to reduce inflationary pressure, it needs to decrease monetary growth and increase interest rates. And it needs to do those things by enough to reduce consumer and investment spending to the point where inflation subsides. But if spending drops, then real GDP drops, and if real GDP drops, that’s a recession.

While some believe declines in real GDP over the last two quarters signal that a recession has, in fact, already begun, we don’t agree with that view. Not only have the back-to-back declines in real GDP been mild, but the spending declines have not been pervasive enough for the National Bureau of Economic Research, the most reliable arbiter of recessions, to define the current slowdown as recessionary.

If, however, economic conditions continue to deteriorate and negatively affect more sectors of the economy, the prospects for a recession will increase.

If a recession occurs—and we believe it is likely—it will have wide-ranging economic impacts on virtually every sector of the economy.

One of those sectors is the stock market. Chart 2 presents a typical pattern between recessions and the stock market. The S&P 500 index peaked at 108 about a year before the start of the 1970 recession. By the time it bottomed out in the middle of the recession, the market had declined 33%.

Virtually the same pattern occurred during the 1973-75 recession (see Chart 3). The S&P peaked about a year before the recession hit and reached a trough near the middle of a recession.

All four bear markets and recessions after the above two recessions (1980-82; 1990; 2001; and 2007) followed similar patterns.

What is of critical importance here is the fact that all six of the bear markets didn’t end until about the middle of the recessionary periods. The average decline in the S&P 500 for all seven of the recessions we analyzed was 33%. That suggests the current stock market, which has already declined 15% (see Chart 4), is likely to continue its downward trajectory.

Finally, it should be noted that in all six of the recessions we analyzed, new bull markets didn’t begin until after the Fed reversed course and began reducing interest rates, something it didn’t do until near the end of every recession.

What’s the financial lesson here? Equities are expected to remain unattractive to most investors until the Fed changes its tune.

Editor’s Note: Jim Doti and the Chapman Anderson Center have been one of the nation’s most prescient forecasters, including last year’s spot-on 5.7% growth in GDP. For more information regarding Chapman’s Update Forecast presented in June, here is the link: https://economicforecast.chapman.edu/2022-update.

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