Investment Strategy

Can the Fed rein in inflation without causing a recession?

Jun 21, 2022

We think so. But acknowledging risks and making a few portfolio tune-ups may help you manage whatever comes.

The U.S. economy came into 2022 on solid footing.

Consumer and corporate balance sheets were bolstered by cash savings and the lowest debt burdens in decades. Earnings looked solid thanks to strong revenue growth and margins. Companies’ business investment plans promised continued innovation. At the same time, though, rampant inflation and a Federal Reserve (Fed) resolved to snuff it out cast a shadow over an otherwise healthy economy.

Additional risks to the investment outlook have since emerged.

Russia’s invasion of Ukraine has disrupted the global supply of energy, agricultural commodities and metals. Chinese policymakers seem committed to Zero-COVID policies that increase risks to the global growth outlook by curtailing consumer activity and the production of goods critical to global supply chains, complicating central banks’ fight against inflation.

We unpack these risks in our global Mid-Year Outlook 2022. But in our view, the path for inflation—and how the Fed responds to it—will be the defining dynamic for the U.S. economy and markets for the remainder of the year. Here, we sketch out three potential scenarios of how that dynamic, and other macro factors, might play out. We also explain how that assessment influences the investment decisions we’re making today.

Our expected scenario: Inflation moderates, no recession

To date, two key factors—pandemic-era disruptions and an “extremely tight” labor market (as described by Fed Chair Jerome Powell)—have spurred most of the rise in inflation. Now both forces are moving naturally in a more favorable direction.

As demand for goods wanes in favor of services (or, for lower-income consumers, food and energy), inventories are being replenished. This diminishes the inflationary risks of supply-chain snarls.

Spread between inventories and wholesale sales is back to pre-pandemic levels

This chart shows the spread between inventories and wholesale sales, from February 2004 until March 2022. The first data point came in at 50.4. From here, it maintained rangebound until it skyrocketed to 128.8 by January 2009. Then, it declined to 45 by April 2010. From there, it gradually rose to 161.2 by March 2016, before declining to 129.8 by May 2018. Here, it rose to an all-time high of 268.2 by April 2020, before dropping back to 116.2 by July 2021. From there until recently, it rose to 154.2.
Labor supply has been increasing at an impressive clip so far this year, slowing the pace of wage increases across income cohorts.

Wage gains are starting to moderate

Source: Bureau of Labor Statistics, J.P. Morgan Private Bank as of April 2022. Past performance is no guarantee of future results. You may not invest directly in an index.
This chart shows the average hourly earnings (AHE) by income in year-over-year terms fro 2002 to 2022. The low bracket began around 3% and dipped to around 1.2% by February 2004. It rose to around 4% by November 2007 then fell again. In February 2011, it began rising to 3.5% by January 2015 and 4.9% in March 2019. By January 2022, it skyrocketed to 11.2% before ticking lower. Meanwhile, the medium bracket began around the same point and also fell towards 2% by January 2004. It rose to 4.2% in February 2008, then dipped to around 1% in November 2012. It then rose steadily to 6.9% by February 2022 before ticking lower. Finally, the high bracket followed a similar. It rose to 5.7% in November 2006 and 6.2% in December 2008 before falling to a low of 7.5% in June 2012. It then rose steadily to 6.4% in April 2020, dipped then rallied to around 5.5% by April 2022.
In addition to these “natural” forces, there are already signs that the fastest Fed policy normalization since the early 1990s is having its intended effect: slowing economic growth to rein in inflation. The housing sector is one of the first segments of the economy to reflect the implications of higher interest rates. As average 30-year fixed mortgage rates have increased from 3.3% to ~6% year-to-date pending home sales have declined for six consecutive months.

Home sales heading lower

This chart shows the 52-week average and year-over-year change of Redfin home sales from 2018 to May 2022. The 52-week average began at 45193 and rose to 47184 by February 2020. It then dipped to 45066 in June 2020 before climbing to a high of 65776 in January 2022. By May, it dipped to 64740. Meanwhile, the year-over-year change began at 2.9% and remained relatively steady until November 2019 when it spiked to 58.1%. One month later, it fell to -18.3%. It rose and then fell to a low of -40% by April 2020. It then rose to 68.3% in September and 101.1% in April 2021. It began falling to 3.5% in July 2021 and -22% in May 2022.

By year-end, we believe the combination of natural dynamics and Fed policy tightening will bring inflation down to more palatable levels. If that’s the case, the Fed will not need to tighten monetary policy more than markets already expect.

In this scenario, economic growth slows, but it doesn’t stop. There is likely no significant rise in unemployment. In markets, bond yields could hold steady (or fall slightly), and corporate earnings may grow modestly, as investors currently expect. That combination could warrant a recovery in equity valuations that fuels a modest upside from today’s levels.

Alternate scenario: Inflation moderates, but the Fed triggers a recession

The Fed has signaled its willingness to combat inflation at any cost—even if that means triggering a recession. It has already tightened financial conditions considerably, perhaps to such an extent that the economy will begin to contract. But by the time the broad-based growth impact shows up in the data, it may be too late for the Fed to pivot and stave off recession.

As economic activity weakens, companies may lay off workers and put investment plans on hold. Weaker than expected demand may force earnings expectations lower, fueling further stock price declines. As the economic outlook deteriorates, investors start to anticipate future Fed rate cuts. Treasury yields will likely fall and core bonds will prove their worth as portfolio ballast. The high yield bond complex is a different story: Higher default risks could cause spreads to widen, fueling losses.

Least likely scenario: Stagflation hits

In what we deem to be the least likely scenario, inflation stays stubbornly high despite slowing growth, forcing the Fed to push interest rates even higher than current projections. This scenario likely reflects an unwelcome environment in which rising food and energy costs depress consumer demand, crushing corporate revenues while expenses increase. To cut costs, companies announce sweeping layoffs, causing a spike in unemployment.

In this scenario, both stocks and bonds suffer, while commodities remain the only shelter from the storm. Downside protection strategies such as derivatives and defensive hedge funds earn their keep.

Investing through the uncertainty

History proves that staying invested, even in times of significant uncertainty, generates the best outcomes for investors over the long run. To feel confident in sticking to that tried-and-true approach, we encourage you to consider a few portfolio tune-ups.

Lean into core bonds

Year-to-date performance has been painful, but there’s a much greater chance that rates move lower, not higher, from here. The recent rise in rates means that investment-grade corporate and/or municipal bonds now offer attractive absolute levels of yield and portfolio protection should a recession spark a further selloff in equities.

Core fixed income offers downside protection

Source: Bloomberg Finance L.P., J.P. Morgan Private Bank. Data as of May 4, 2022
This chart shows the potential returns for U.S. Aggregate Bonds and Municipal bonds in different scenarios: What if 10Y rises to 3.5%? : U.S. Aggregate Bonds (-2%) and U.S. Municipal Bonds (0%) Base Case + 25bps: 2.75% 10Y: U.S. Aggregate Bonds (3%) and U.S. Municipal Bonds (5%) Base Case: 2.50% 10Y: U.S. Aggregate Bonds (5%) and U.S. Municipal Bonds (6%) Base Case -25bps: 2.25% 10Y: U.S. Aggregate Bonds (7%) and U.S. Municipal Bonds (6%) Recession: 0.75% 10Y: U.S. Aggregate Bonds (14%) and U.S. Municipal Bonds (11%)

Prioritize quality in equities

This year’s equity declines have brought valuations lower, making for a more compelling entry point. We advocate for staying invested in stocks, but we believe it’s prudent to tilt the allocation toward higher-quality market segments. Healthcare, for example, has attractive defensive characteristics: It is the only S&P 500 sector to deliver consecutive annual earnings growth over the past 25 years.

Further, you might choose to participate in the stock market with protection. Elevated volatility creates attractive pricing for derivatives and structured notes that offer downside protection.

Beyond stocks and bonds

Acknowledging the risks that may lead to one of the less favorable scenarios we have described, you may consider other complements to the basic mix of stocks and bonds. Exposure to commodities, or companies involved in their supply chains, could prove beneficial. Alternative real asset exposure, such as diversified real estate or infrastructure, can offer portfolio diversification and a hedge against the potential for persistent inflation.

We can help

J.P. Morgan is here to help you make the tactical tweaks to your portfolio to help navigate and endure the ongoing volatility. By designing and maintaining a bespoke investment portfolio tailored to you, we aim to bolster your confidence in staying invested and staying on track to achieve your financial goals. To explore our thoughts about the current investment environment in more detail, see our Mid-Year Outlook 2022.

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