Labor Market, Productivity Gains Can Fuel Expansion for Some Time

The American Stock Exchange
Markets appear to be pricing in an economy that's in the later innings of the cycle, but we think this is premature. Getty Images

In our Q1 market commentary, “Descending from the ‘Easy Policy’ Mountain Summit,” we forecasted increasing market volatility as investors assessed the Federal Reserve’s reaction to inflationary pressures. Would rising prices lead to a less accommodative Fed in the coming quarters? At the time, we said:

“The same leading indicators of rising economic growth we previously referenced are also pointing nearly unanimously to rising inflationary pressures in the coming months as rapid demand, low inventories and continued supply chain interruptions collide and lead to rising prices.”

In Q2, these projections played out as we predicted; and core measures of inflation — both the Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE), the Fed’s preferred metric — rose to levels not witnessed since the early 1990s. At the heart of this ongoing debate is whether a spike in inflation will prove transitory or will stick around and force the Fed to act, potentially creating a recessionary environment. Following the Fed’s June meeting, inflation chatter reached a fevered pitch: Fed Chairman Jerome Powell indicated members are “beginning to talk about talking about tapering,” and Fed members, on balance, moved up their forecasted date for the first rate hike from 2024 to 2023 (keep in mind this is a forecast, not a policy).

Equity markets pushed higher in the second quarter, but leadership shifted as investors seemingly positioned for the later innings of an economic cycle. After a strong first quarter for cyclicals, value and small-cap stocks (early cycle beneficiaries), in Q2 investors shifted their equity market preferences toward sectors that typically perform better later in the economic cycle: large-cap stocks and growth. The Nasdaq led markets higher in the quarter, while the 10-year Treasury yield declined from a post-pandemic high of 1.74 percent on March 31 (its high) to 1.46 percent at quarter’s end.

We view inflation as temporary, and importantly, we don’t believe the Fed harbors any desire to tighten this economy into a recession. Instead, the Fed is likely to drag its feet with rate hikes for as long as possible.