Playing Devil’s Advocate

Following a terrible year for markets, is Wall Street’s mood too dire?

I don’t consider myself to be a contrary person, but I try to be the contrarian in the room when our Multi-Asset Strategy team meets. Playing the devil’s advocate helps sharpen the good arguments of our analysts and economists—even if I usually agree with them. Lately, this has put me in the frequently awkward position of arguing, “Come on, it isn’t all that bad!”

Okay, it’s pretty bad. Consider what 2022 has served up for investors so far:

• The worst stock market since the 2008 global financial crisis1
• The worst performance for a 60/40 stock/bond portfolio since 19292
• The worst performance of the government bond market in over a century, and the fourth-worst year in records going back to 1701.3

Don’t fight the Fed…

Moreover, there are good reasons to think the tide has yet to turn. After years of encouraging risk-taking and fostering a rise in asset prices, the Federal Reserve is now doing the opposite to tame the worst inflation in decades. As policymakers have acknowledged, falling asset prices do some of the work in slowing an overheated economy. The “Fed put” has become the “Fed call” in that any good news gets taken away by the Fed’s need to tighten.

Understandably, many investors are extrapolating from the past in guessing what the Fed’s aggressive stance will do to the economy and corporate earnings. The pessimists see a parallel in the rate hikes of the early 1980s, the last time inflation was this high. Under then-Fed Chair Paul Volcker, policymakers guided the effective federal funds rate to 19.1%. The result was back-to-back recessions as mortgage rates reached as high as 18.5% and the unemployment rate hit 10.8%.?

Even setting aside my devil’s advocate hat, I just don’t see something like that happening now. The economy is on much more solid footing than it was following the energy shocks of the 1970s, during which the United States was an importer of oil. Indeed, in some ways, it’s on better footing than it has been in years.

You need look no further than the labor market. The Fed has been hiking rates since March, and over that time the economy’s been creating an average of 366,000 jobs per month. Employers added 263,000 jobs in September, roughly twice the average number before the coronavirus hit, let alone typical of recession or pre-recession averages. Even as employers have grown more cautious recently, there are still 1.7 open positions waiting for every unemployed worker. Prior to the last recession starting in December 2007, that number was 0.6.?

If you’re bearish, you can argue that resilient employment will make the Fed’s job more difficult. But if you’re an optimist, you can argue that strong employment is an economic cushion against a deep recession. When people have jobs, they spend.

…but don’t assume the script will repeat

The unprecedented distortions of the COVID era make comparisons with past tightening-induced recessions difficult, at best. Supply chain problems are still with us, due largely to China’s sporadic COVID-zero shutdowns, as well as on Russia’s war in Ukraine, the resulting sanctions, and the looming energy crisis in Europe.

One of the reasons why inflation is sticky is that it’s contagious. When Russia invaded Ukraine, did you expect that the price of hamburgers in the United States would go up? Here’s one illustration of how supply stresses are working their way through the global economy and sparking inflation in surprising ways:

• To strike back at sanctions, Russia has cut natural gas exports to Europe, causing prices to go up.
• Natural gas is used in making fertilizer, which means prices for animal feed have gone up.
• This has led in turn to higher prices for meat at U.S. grocery stores.

That’s just one example but think about how energy and commodities are required as inputs to goods production, construction, and services. It’s the same for labor. Because you need labor to produce goods and deliver services (at least until the robots take over), former Treasury Secretary Larry Summers calls it the “super core” of inflation. Bottom line: Inflation is contagious. Our portfolio manager and inflation expert Chris Faulkner-MacDonagh warned us that this type of lagged inflation contagion was coming, but most of us underestimated these effects.

The Fed has no control over natural gas supplies, of course, so how much it can control inflation through rate hikes alone is yet to be seen. Conversely, easing supply strains—ocean shipping costs have come down dramatically, for example—mean the Fed may not have to do all the work in calming price pressures. We may well get a recession soon, but if we’re lucky, it may come with relatively little pain to workers.

The more direct question for investors is how much pain a recession will bring to corporate earnings. Here, I’ll admit it’s hard to find a silver lining. Historically, recessions have caused earnings to contract by an average of about 20%. As our strategist Tim Murray points out, however, analysts currently expect annual earnings growth for the S&P 500 Index to accelerate a bit in 2023, from 7.0% to 7.6%.? That would seem somewhat optimistic—and, of course, it was the duty of the real advocatus diaboli to question such things.

Devil if you do, devil if you don’t

Given that we perceive too much negativity about the economy and not enough about earnings, our Asset Allocation Committee has decided to strike the following balance:

• Stay underweight in equities but look for pockets where the negativity seems out of line with the fundamentals. For example, look for opportunities in small-caps, which historically have been more insulated from global economic turmoil.
• Seek opportunities in high yield, where I believe defaults are likely to remain low.
• Try to stay one step ahead of the positive shift in sentiment. As I remind myself and the team, no one has ever made much money by aligning with the consensus—whether that’s “times are good” or “times are horrible.”

References

1Stock market based on the S&P 500 Index; January 1, 2022 through September 30, 2022. The S&P 500 Index is a product of S&P Dow Jones Indices LLC, a division of S&P Global, or its affiliates (“SPDJI”), and has been licensed for use by T. Rowe Price. Standard & Poor’s? and S&P? are registered trademarks of Standard & Poor’s Financial Services LLC, a division of S&P Global (“S&P”); Dow Jones? is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”). T. Rowe Price's presentation is not sponsored, endorsed, sold, or promoted by SPDJI, Dow Jones, S&P, their respective affiliates, and none of such parties make any representation regarding the advisability of investing in such product(s) nor do they have any liability for any errors, omissions, or interruptions of the S&P 500 Index.

2BofA Global Research, “The Flow Show: The Bear Hug” October 13, 2022

3BofA Global Research, “The Flow Show: Infamy! Infamy! They’ve all got it in for QT!” October 6, 2022

?Sources: Federal Reserve Board, Bureau of Labor Statistics/Haver Analytics

?Source: Bureau of Labor Statistics/Haver Analytics; data analysis by T. Rowe Price

?There is no guarantee that any forecasts made will come to pass. Source: FactSet financial data and analytics www.factset.com; as of October 14, 2022

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The views contained herein are those of the author as of October 2022 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

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