U.S. economy moving from ‘COVID inflation’ to ‘conflict inflation’: Economist

Manulife Investment Management Global Chief Economist & Strategist Frances Donald joins Yahoo Finance Live to discuss the UMich consumer sentiment report, market reactions, inflation, and the outlook for consumers and the U.S. economy.

Video Transcript

JARED BLIKRE: Frances, great to see you here today. Just your quick take on the numbers that we've seen here. Retail sales and consumer sentiment, retail sales actually coming in a little bit light, half a percent. Consumer sentiment coming in a little bit heavy here.

FRANCES DONALD: This is, as always, a devil in the details. What we're witnessing in the US economy right now is a transition away from COVID inflation and COVID themes, towards conflict inflation and conflict themes. And by that, I mean, we're still seeing evidence of reopening activity, restaurants getting more activity. But we're also seeing some of that pressure coming from higher gasoline spending.

Remember that our retail sales numbers are in nominal terms. They're not adjusted for inflation. We actually look at volumes of retail sales. People are paying more out of pocket, but they're taking home a lot less. So it's no wonder that our consumers are not particularly happy. And yes, we did get a little bit of an increase in consumer sentiment, but look at the long-term trend of consumer sentiment.

We are at recession level consumer sentiment when you look at the actual level of the activity, even with the month over month improvement. And we've never had a Fed that hiked in to this level of consumer sentiment weakness before. So I don't see a picture of a roaringly strong consumer. I see a consumer that's moving from, yeah, we had high prices in used cars, to, high prices in food and energy that's going to crowd out other spending at a time when income is coming down. That's not a great consumer outlook.

BRIAN SOZZI: Frances, that's an excellent point because there's been this thesis in the market this week that, oh, inflation has peaked. Well, the PPI yesterday, as you know, came in at 11.2% increase over the past 12 months, CPI before 8 and 1/2% increase. These are large increases that probably really don't reflect the prices that average Americans are paying for food. My question to you is, do you a sharp spending slowdown this spring because of the inflation that is now rippling through the economy?

FRANCES DONALD: I see a material slowdown across most sectors in the United States. And here's the thing-- possibly mathematically, we may have seen that, year over year, CPI start to come down. And that's just because CPI math is not real life. What matters most to the demand destruction elements is where that inflation is concentrated. During COVID, we were seeing it in things I'm going to call largely discretionary-- home renos, fences, pools, even a car. You're not buying those things every month, and if you don't want to get them, you can live without them.

We're moving towards a different, more nefarious type of inflation. Food and energy are items you cannot substitute away from. They're going to be more painful for the American consumer. So, in a way, yes, of course, the bond market is going to care if we have a 20 basis point miss on headline inflation to the upside or the downside. But I'm moving away from the idea of trying to pin the month that CPI peaks. I care about the detrimental impact of the type of inflation on the consumer. And what I suspect is in the next three to six months, we're going to see how the shifting nature of inflation becomes more important than the headline.

JARED BLIKRE: And Frances, let's think this out here. And assume your premise, three to six months, we see a weakening consumer. Demand is not necessarily there. The Fed, on the other hand, has indicated they're going to hike 50 basis points pretty much until something breaks. You throw quantitative tightening in there, actually potentially selling assets as soon as May, June. What does this big picture look like to you?

FRANCES DONALD: Well, the market's already telling you it's a policy mistake that we're getting these big curves flattened. Or yeah, we've always had some sneaky steepening in there, market pricing and cuts as of 2024. Well, of course. Nine hikes this year is going to be very painful for the US economy. Now, my suspicion is that in the next quarter, we're going to see PMIs come down pretty aggressively. Housing is weakening. Retail sales will slow. And the Fed will have cover to, yes, continue a normalization.

We're not in a crisis anymore. We're not in a recession, but have a bit of cover to pivot more dovishly. And if they do that, the cycle gets extended. You could see a re-steepening of the curve. But we got a couple of months before that data slows and provides enough cover for them to do so. So in the meantime, we're going to have to pretend with a pretty hawkish Fed.

BRIAN SOZZI: Well, if the economy is going to slow down at this rate that you're talking about, Frances, do you think the Fed, by later this year, just stops raising rates and lets inflation run hot?

FRANCES DONALD: Well, it's possible, but again, it depends on the nature of what the inflation is and will also depend on that really critical inflation expectations. Chair Powell told us on March 16, there's very little the Fed can do about this year's inflation. What are Fed hikes going to do for port openings in China or energy crisis or lack of wheat production in the Ukraine? They know there's nothing they can do to combat that type of inflation. What they're trying to do is make sure long-term inflation expectations remain anchored, so that's another key part of the puzzle.

They'll have to choose, how much growth are we willing to sacrifice to bring down those long-term inflation expectations, which is why when we see consumer sentiment data, what I care most about is that 5 to 10-year inflation. That's going to be one of the key drivers. And expectations for that remain relatively well anchored. If they become unanchored, the Fed's probably going to choose inflation expectations over growth. That's not going to be fun for any of us. But the Fed has a job to do.

JARED BLIKRE: And so I'm an investor here, listening to all this talk. I'm a little bit scared perhaps. I'm looking at my bank account, my 401(k). What do I do right now?

FRANCES DONALD: Well, it depends what your investment horizon is. We go through many cycles all the time. I'm not calling for a recession. We see times when the PMI goes sub 50. These are growth slowdowns. If you're a long-term investor, you stay the course. If you're playing more tactically, now is the time to be a little bit more neutral, a little bit more defensive than perhaps what we've seen in the past, with a more tilted towards the United States. That makes sense as we head into a growth slowdown.

But again, if you're a long-term investor, we've seen these wiggles before. We've already seen an equity market that's priced in a lot of weakness. Homebuilders down 30%, have already told us it sees slowdown coming. Same with discretionary, so a lot of the story in. What I think is not well priced is that bond market right now, especially the front end. It's going to have to take some of those hikes out of the front end. It'll be time to think about adding to duration a bit.

BRIAN SOZZI: Frances, before we let you go, for the layperson out there, how could they go about spotting recession? Are there three things that you look at most acutely?

FRANCES DONALD: So things that you want to watch right now are what is happening to the Fed. Are they going to actually engage in a pivot? I love purchasing manager indices. They're really good at showing you slowdowns, cyclical ups and downs. You can watch those and watch what's happening to the consumer, from real wages to the type of inflation. I think that's going to be a key component of this story.

But at the end of the day, sure, we make a living off of the big r-word, recession. Are we going to see it or not? Slowdown is very similar. We're going to move a little bit more defensively. You're going to see a little bit more pressure on the economy. Whether or not you trigger the r-word, I think is maybe more about headlines than it is actual investment or your day-to-day life.

JARED BLIKRE: Oh, calling us journalists out on making the story here. I'm not going to say the r-word. I'll leave that for others. Always great to see you, Frances Donald, global chief economist and strategist over at Manulife Investment.