Notes on the Week Ahead

Every August, for more than 40 years now, the Federal Reserve has held a retreat in Jackson Hole, Wyoming. It has become an important venue for Fed communications and investors this week will be focused on Jerome Powell’s speech, to be delivered at 10:00AM eastern time (or 8:00AM Wyoming time) on Friday. The topic of this year’s conference is “Reassessing the Effectiveness and Transmission of Monetary Policy”, a subject that is well worth careful reconsideration. This, no doubt, will be the focus of Chairman Powell’s remarks.

The last two weeks have provided a vivid reminder of how sensitive markets can be to small changes in the macro-economic outlook. With a nudge down in oil prices, the Fed’s 2% inflation goal suddenly seems achievable within a matter of months. With a slight weakening in the labor market, the unemployment rate has shifted to a trajectory that has foreshadowed recession in the past. In response, the 10-year Treasury yield fell from 4.29% on July 24th, to 3.78% on August 5th while the VIX index, a measure of stock market volatility, more than doubled over the same period, with stock prices falling sharply by the close of business last Monday.

We live at a time when extreme voices get the most attention and so it is tempting, following a string of weak economic numbers, to yell the word “recession”. However, a balanced assessment of demand and supply suggests that we are, thus far, merely transitioning to slower growth. A slower growth path is a more vulnerable one, particularly because excessive monetary ease is more likely to weaken than strengthen the economy in the short run. Nevertheless, barring some outside shock, the baseline scenario should be a slowdown scenario, even as volatile markets remind investors of the importance of diversifying and paying attention to valuations.   The mood on the economy has changed quite quickly. The economic headline from just 12 days ago was that real GDP growth had, yet again, surprised to the upside, coming in at a robust 2.8% for second quarter, well above the 2.1% consensus expectation. Since then, however, we have seen higher-than-expected weekly unemployment claims and weak readings on construction, durable goods orders, home sales and manufacturing activity. This was topped off, on Friday, by a softer-than-expected employment report, both in terms of payroll job gains and the unemployment rate.

My wife, Sari, and I love old movies and one of our favorites is the Long, Long Trailer, staring Lucille Ball and Desi Arnaz.  Desi and Lucy are newly-weds who decide, instead of buying a house, to purchase a trailer home which they hitch onto the back of their car and set off on their adventures.  Soon, without any idea of how to drive such a contraption, they find themselves ascending into the Sierra Nevada mountains, driving up steep, narrow and twisty mountain roads.  Unbeknownst to Desi, Lucy decided to collect rocks as souvenirs along the way which she hid all over the trailer, adding extra weight to an already dangerously unwieldy vehicle.  The funniest part is watching them making small talk, pretending nothing is going on, as their car engine roars, gears squeal and little rocks spit out from their tires, over the cliffs and out into the abyss below.  The contrast between the nonchalance of their conversation and the terror in their eyes is priceless and it only increases as they head over the peak and begin to descend. The most dangerous time, both for oversized trailers and central bankers, is when you begin to descend from a peak.  Recent data suggest the Fed should, finally, begin to cut rates in September.  This operation could work out OK.  However, it is a delicate one and, particularly, when both markets and portfolios appear to be overconcentrated, it is important that investors take what steps they can to maintain or regain balance in their portfolios. 

The podcast discusses the rise in unemployment rate as a potential recession warning, analyzing factors like higher payroll gains, drop in temporary employment, and modest wage increases. It explores different recession predictors and the SAM rule as an indicator. Shifts in the labor market and economic outlook are also examined, with focus on long-term unemployment and Federal Reserve actions.

The play, entitled “Steadily She Slows”, has, from a dramatic perspective, turned out to be a dud. It started with such a promising prologue of pandemic, recession, recovery, political upheaval, war and inflation. However, it has since settled into a drawn-out, repetitious script, wherein the lead actor, consumption, hogs the center stage and the supporting cast, in the form of investment spending, government spending and trade, has very little impact on the plot. The promoters, on cable news shows and social media feeds, do their very best to gin up public interest by prophesying catastrophic collapse into recession or reignited and blazing inflation. But still the play drones on, unloved by all, except, of course, the investors, who are profiting handsomely from its extended run.

As a young lad growing up in South Dublin, I received certain geography lessons on where I could, or could not, safely roam.  In particular, I was warned not to stray north of O’Connell Street.  I remember debating my mother on the issue, once when I wanted to go to a movie at a theatre near Parnell Square.  I can’t remember exactly what I said, but I probably claimed that bad things didn’t happen on the North Side quite as frequently as South Side mothers thought they did.  But my mother held her ground on this occasion…someone might or might not get beaten up in Parnell Square that afternoon.  But if her son wasn’t there, it wouldn’t be him. After almost every speech, someone asks me about risks – what keeps me up at night.  And today, with a soft-landing economy and the stock market near record highs, it does seem like a good time to review risks.  But it’s important to recognize the most obvious point about market risk.  The risk to you, as an investor, isn’t simply the danger of some negative event – it is the product of the probability of that event and your exposure to it.  How you are positioned says a great deal about how worried you should be about any risk. 

Every three months, the 19 members of the Federal Reserve’s Federal Open Market Committee, of FOMC for short, aided, no doubt, by an army of econometric minions, work up new forecasts for key economic variables and their assessment of appropriate monetary policy.  In recent days, as they have huddled in their offices engaged on this task, they’ve had much to be thankful for.  The economic roller coaster triggered by the pandemic and the policy response, which manifested itself in wild swings in output, unemployment and inflation, has subsided.  Moreover, the very narrow road by which they thought inflation could be subdued without triggering a recession, turned out to be not so narrow after all.  The U.S. economy has maintained solid economic growth and a very tight labor market even as inflation has fallen towards their 2% objective.  

For centuries, economists have extolled the almost magical properties of competitive markets.  In the 1770s, Adam Smith wrote about an “invisible hand” by which individuals end up promoting the common good even though they only ever intended to do themselves a bit of good.  In the 1970s, Milton Friedman spoke passionately of the virtues of a free-enterprise system in boosting innovation and productive activity.  Such voices are quieter now and much of modern economic commentary is devoted to how to fix an economy when markets fail or how governments and central banks should seek to manipulate it.  However, the U.S. economy in the wake of the pandemic should serve as a reminder of the power of simple economics.  No matter how abnormal the starting point, an economy will, if sufficiently neglected by the government, tend towards balanced growth.

One of the most common plotlines in all of literature is when a protagonist, overestimating the gravity of a situation, responds with a series of unfortunate decisions. Perhaps the classic example of this is Romeo, not appreciating the difference between a sleeping Juliet and a dead Juliet, but the pattern has played out in innumerable stories. When it comes to the state of the economy, it seems clear that Americans are harboring too negative a view. In the short run, this misapprehension may not lead to disaster. However, it could still imperil investment returns if it leads to political decisions that make a relatively healthy economy sick.