If you were wondering what a “soft landing” looks like, current US economic data is about as close as you are likely to see. The big jump in inflation in 2021-22 was primarily driven by massive supply disruptions caused by COVID and then the Russian invasion of Ukraine. Those supply disruptions have largely been mitigated (though the Middle East or China could be a new source of supply disruptions), so the rate of inflation (not the absolute price level) has come down rapidly back toward its pre-COVID range (top section, chart below) and the Fed’s 2% target. Inflation was indeed “transitory” but has not shown up in the data quite as fast as some might have liked (in large part due to the shelter-related lags in the data).
This relatively rapid return to more “normal” inflation has occurred without the recession and widespread unemployment that so many economists, including those at the Fed, thought would be required. Essentially, the “Phillips Curve” economic model that assumes a trade-off between inflation and unemployment (for inflation to go down, unemployment must go up) has not really worked for years and is more clearly broken now.
Our favorite employment measure is the “prime age” (25-54 year old) employment/population ratio (middle section of chart below), which avoids compositional issues caused by changing demographics. It is marginally off its latest peak but remains near its highest readings in almost 25 years and not far from the all-time peak in 2000. So the Fed’s official dual mandate of “low inflation and high employment” looks to be largely achieved.
Along with historically strong employment, real economic activity has also avoided recession and has in fact been improving in recent months. The year-on-year change in real final sales to domestic purchasers captures inflation-adjusted GDP growth excluding the effects of changes in inventories, trade, and government spending (bottom section of chart). The latest data show it at 2.7%, right in line with the average over 2011-2019, though lower than the growth rate in the late 1990s and mid-2000s when inflation was also low.
Source: Mill Street Research, Factset, Bloomberg
It’s been a while: last soft landing scenario was mid-1990s
The most recent historical analog to the soft landing scenario we see now is arguably the mid-1990s period. That was the last time the Fed cut rates without any associated recession (2001, 2008) or crisis concern (1998, 2019-20). In that case, real economic growth and earnings growth remained solidly positive and inflation declined steadily, while bond yields were higher than they are today.
After a difficult year for both stocks and bonds in 1994, both assets did very well in 1995, and stocks continued to perform well in 1996-97 as well. This is because earnings for the S&P 500 continued to grow rapidly in those years. Importantly, the strong earnings and markets occurred even though the Fed only cut rates three times from the 6% peak by a total of 75 basis points between July 1995 and January 1996 (and raised once in March 1997). So neither stock markets nor earnings required aggressive rate cuts to perform well since underlying economic growth remained solid. Some investors may be looking back at the mid-1990s and seeing further gains for equities this year.
Reviewing some of the mid-1990s indicators:
Source: Mill Street Research, Factset, Bloomberg
As shown in the chart above, in 1993-94, after weaker growth following the 1990-91 recession, US economic growth picked up and the Fed became preemptively concerned about inflation pressures. So they embarked on a fairly aggressive rate hike cycle in 1994, raising rates from 3% to 6% between February 1994 and February 1995.
But inflation continued to decline despite the solid economic growth, so after bond yields peaked around 8% in late 1994 and growth had begun to slow, the Fed cut rates three times between July 1995 and January 1996 (25bps each time for 75bps of total cuts).
The growth rate of real GDP did slow, but remained solidly positive (3%+, i.e., higher rate than today and most of the 2000s) through the entire period, and inflation continued its downward trend: evidence that growth by itself does not cause inflation.
Thanks to the solid underlying growth, S&P 500 earnings continued to rise steadily, doubling in the four years between mid-1993 and mid-1997. The rise in earnings and mostly stable rates allowed stock prices to continue rising, with the S&P 500 returning 125% (31% annualized) in the three years 1995-97.
It may or may not be the 1990s all over again, but they remind us what can happen
To be clear, we do not rely on direct historical analogs to make market forecasts, we follow the current readings of our indicators as they evolve and take into account the current mosaic of information.
The key point, though, is that many investors I talk to and what I read and see in the media (including Fed officials in some cases) suggests that few even think (or thought until very recently) it possible to 1) have solid growth and low inflation, and 2) that stocks do not require very low interest rates or aggressive monetary support to go up.
The experience of the mid/late 1990s shows us that such conditions can occur, and it is not all about monetary policy, if underlying productivity and economic growth are strong enough. It remains to be seen if the recent signs of stronger productivity growth will be sustained, but we should at least be open to the idea.
At the moment, our indicators tell us that the near-term equity market outlook remains positive, with the risk this year being that investors now have higher expectations, which makes “upside surprises” potentially harder to come by, but certainly not impossible.
Sam Burns, CFA