Thursday, December 1, 2022

Soft (ish) Landing Interpreted

Chairman Powell yesterday confirmed the Fed will slow the pace of its interest rate hikes from 75 bp to 50 bp.  Though it was expected, his statement created a strong relief rally in all markets, which chose to focus on that part of his statement, instead of these:

  • The Fed will keep hiking to a level higher than previously targeted
  • Inflation is expected to remain high for longer, necessitating a restrictive policy well into 2023 or further.  His reasons include structural shifts, such a demographics and changed employment patterns post COVID.
  • He expects a soft(ish) landing for the economy, rather than a deeper recession.
How do we interpret his pronouncements? For me, it's this: inflation will last for years and won't revert to 2% soon, or ever, and the economy will be weak(ish) for the foreseeable future.  In my book, that's called stagflation, though not the same as in the turgid 1980s.  Putting it in numbers, I expect inflation around 5-6% and real GDP growth around 0-1%.  

What does this mean for markets, assuming Mr. Powell is correct? For one, the yield curve inversion will soon reverse course and become more normal/flat around 5%.  For another, a period of near zero economic growth will hit equity valuations by lowering P/Es going forward.

Looking at real GDP growth for the last 70 years (chart below) we can observe a change in the nature of US economic activity. During 1950-80 the economy was highly cyclical, with frequent recessions and booms. During 1980-2000 there were fewer boom-bust cycles and a more consistent, albeit lower, level of economic growth.  Finally, from 2000 onward the economy was much more consistent, except for the Great Debt Crisis, though average growth was even lower. In percentages, average growth has declined stepwise from approx. 5% to 4% and now around 2.5%.

If our future is even mildly stagflationary, where should equity P/Es be? For perspective, here is a chart going back to the 1980s when they averaged around 12X.  Versus today's 17x, a reversion to 12x implies a 30% correction ON AVERAGE.  Of course, markets overshoot, and during long, drawn out bear markets they can also become despondent, so I would not be surprised to see multiples as low as 7-8X.

Chart: Yardeni Research

High inflation, high(er) positive real interest rates and near zero growth are very strong headwinds for equities, particularly "growth" stocks that do not pay consistent dividends. 


  1. sorry Hell... I keep butting in ... I can't help it eh... I just feel the need to contradict everyone all the time... zzzzzz...

    anyway, thinking through your writing, I think the implicit assumption in the estimates is that no more black swans appear... i.e. no covid, Ukraine, Trump, etc... It is a good place from which to start building a baseline prediction... and I really appreciate your providing a better baseline than I can for myself...

    but I think the assumption of no more black swans is not good... firstly, there are a few really big ones on the horizon... China property, crypto bubble, tech bubble... secondly, I think the black swans we are seeing are not really black swans... they are symptoms of system failure... and my suspicion is they will get more frequent and harder....

    also,.. since I am being contrarian here, I am not sure that the U.S. is politically stable at 1% growth and 5% inflation... I am not sure how much of the rest of the world is stable either... which means if the baseline prediction is 1% growth 5% inflation, the real scenario might be a lot worse...

  2. Dear AKOC.... I agree with you, it's a baseline, meaning that black swans are certainly not taken into consideration, ie its a projection that is not risk-adjusted. And, yes, there are lots and lots of risks out there. If you recall, in a previous post I touched on the US not being a safe haven any longer, but a risk factor in itself, likening it to a "powder keg". Seriously, I'm veeeery nervous about Uncle Sam.


    1. Haha good one! Oh boy, depressing, but good one. Informative.

    2. Honest Government, Military Intelligence, Free Lunch… 😂😂