The Tightening Cycle Is Approaching

Stage 3: Guideposts We’re Watching

Odds favor a third stage of this tightening cycle likely to be marked
either by an economic downturn or failure to meet the inflation target,
prompting more tightening. Either would be bad for most portfolios.
FEBRUARY 14, 2023

BOB PRINCE
AARON GOONE

© 2023 Bridgewater Associates, LP

A
s economies have progressed through this tightening cycle, they
have passed through two primary stages. First, when the markets
recognized that MP3 policies had produced an overshoot with respect
to spending and inflation, they discounted a coming tightening. Then central
banks actually tightened. Second, as the tightening progressed, inflation
peaked and then drifted lower. The markets discounted that the end was
increasingly near and that within a few months we’d have 2% inflation and
moderately positive growth, which would allow short-term interest rates to
begin a steady two-year decline.
We were in sync with the first stage of this cycle and out of sync with the second stage, mainly because we
were looking ahead to the stage after that. Now we are approaching either the soft landing or the beginning of
a third stage. Given current conditions and the cause/effect linkages, odds favor that there will be a third stage
and that it will mostly likely take the form of an economic downturn. And if that doesn’t happen, inflation is
likely to remain above central bank targets, prompting a continued rise in short-term interest rates or at least
a period of sustained higher interest rates than what the markets are now discounting. As an illustration, odds
favor the below left chart, and if not that, then the below right chart, and maybe both.

USA RGDP (Y/Y) BW Leading Growth USA Short Rate Forward Discounting

6%
5%
5%

0% 4%
OR
3%

-5% 2%

1%
-10%
0%
2016 2018 2020 2022 2020 2022 2024 2026

Given where we are, it’s worth looking at some of the key guideposts to see which direction we’re headed.

© 2023 Bridgewater Associates, LP 1

Going back before going forward: as shown below, the rise and then fall in inflation drove discounted tightening
up and then down in the US and Europe. Recently, our estimate of inflation a year from now has stabilized and
turned up a bit at about 3.5% in the US and 4.25% in Europe. That’s not low enough to end the tightening cycle
or to allow short-term interest rates to fall. Discounted tightening has bumped up a bit given what’s going on.

USA Discounted Tightening (6m) EUR Discounted Tightening (6m)

USA 1yr Leading Inflation Est EUR 1yr Leading Inflation Est
2.0% 7%

8%
1.5% Stage 2
1.5% 6%
Stage 2
Stage 1 7%
Stage 1
6% 1.0% 5%
1.0%

5%
0.5% 4%
0.5% 4.25%
4%
3.5%
3%
0.0% 3% 0.0%

Jan-22 Jul-22 Jan-23 Jan-22 Jul-22 Jan-23

The tightening cycle has had a big impact on interest rates through the steady rise in the short-term interest
rates and the up and down cycle in discounted tightening.

USA Nominal Yields (10yr) EUR Nominal Yields (10yr)

Avg of Short Rate and 6m Discounted Tightening Avg of Short Rate and 6m Discounted Tightening
2.0%

4.0% 2.5% 2.5%

1.5%
3.5% 2.0%
2.0%
1.5% 1.0%
3.0%
1.5%
1.0% 0.5%
2.5%
1.0%
0.5%
2.0% 0.0%
0.5% 0.0%
1.5%
-0.5%
0.0% -0.5%
Jan-22 Jul-22 Jan-23 Jan-22 Jul-22 Jan-23

© 2023 Bridgewater Associates, LP 2

Discounted tightening has also had a big impact on the equity markets…

USA Stock Price Index (S&P 500) EUR Stock Price Index (Eurostoxx 50)
Discounted Tightening (6m, Inv) Discounted Tightening (6m, Inv)

4,750
0.0% 4,250 0.0%

4,500
0.5% 4,000 0.5%
4,250

1.0% 3,750 1.0%

4,000

1.5% 3,500 1.5%

3,750

2.0% 3,250 2.0%

Jan-22 Jul-22 Jan-23 Jan-22 Jul-22 Jan-23

…and to a lesser extent the dollar.

USA Real FX vs TWI USA Discounted Tightening (6m)

2.00%
20% 1.75%

18% 1.50%

1.25%
16%
1.00%
14% 0.75%

0.50%
12%
0.25%
10%
0.00%

Oct-21 Jan-22 Apr-22 Jul-22 Oct-22 Jan-23

Going forward: in prior research, we’ve laid out what we think is a reasonable path to equilibrium. In a nutshell,
we see it looking something like this.
• To get 2% inflation, you need a deceleration in wage growth from the prior 5% to about 2.5%.
•  o reduce wage inflation, you need to cut nominal spending and income growth in half to 3-5% and
T
raise the unemployment rate by 2% or more.
•  o raise the unemployment rate, you need to drive nominal GDP growth materially below wage
T
growth and compress profit margins enough to produce about a 20% decline in earnings.
•  fter that, you need to hold short-term interest rates steady for about 18 months, until 2.5% wage
A
growth, 2% inflation, and 2% real growth are sustainably achieved.
• Then cut short-term interest rates to about 1% below then-existing bond yields.

So are we on track or not? Below, we scan through some of the guideposts we are looking at to assess where we
are in the tightening cycle.

© 2023 Bridgewater Associates, LP 3

The Level of Nominal Spending Is the First Driving Force
We get an updated picture of nominal spending growth every week from two perspectives: the spending side
and the financing side. Both suggest that nominal growth has stopped declining and has stabilized at around
7%, which is too high.

USA NGDP Growth (Y/Y) USA Coincident Nominal Spending (Y/Y)

15%
10%
10%

5% ~7%; too high 5%

0%
0%
-5%

-10%
-5%
1980 2000 2020 2020 2021 2022 2023

Has Nominal Spending Fallen Below Wage Growth? No.

When nominal spending growth minus the hiring run rate needed to grow the economy is above wage
growth, corporate profits can be maintained and labor markets can grow. If labor markets grow, you don’t get
a contraction in incomes to bring spending down, and wages can stay high. Timely reads suggest spending
remains too high relative to wage growth to slow wages down.

USA Wage Growth (Y/Y) USA Wage Growth (Y/Y)

USA NGDP Growth Minus 2% (Y/Y) USA Coincident Nominal Spending Minus 2% (Y/Y)
12.5% 10.0%

10.0%
7.5%
7.5%

5.0% 5.0%

2.5%
Spending not less
than wages; 2.5%
0.0% not weak enough.

-2.5%
0.0%
-5.0%
1980 2000 2020 2020 2021 2022 2023
2% represents a simple estimate of the hiring run rate needed to normally grow the economy

© 2023 Bridgewater Associates, LP 4

Are Job Openings Falling? They Were, But Have Recently
Risen Again.
Demand for labor as measured through openings is one of the better indicators of the supply of labor and
subsequent wage growth. While there has been some cooling in openings over the past year, the last few
months have seen a bounce.

USA Wage Growth (Y/Y) USA Wage Growth (Y/Y)

Job Openings Rate Job Openings Rate

7%
7%
6%
5% Good leading 6%
indicator
6%
5% 5%
4%
4% 5%

3% 4% After some
3% cooling, 4%
a bounce
2% 2%
3% 3%

2000 2010 2020 2020 2021 2022 2023

Business Sources of Funds Are Drying Up, a Threat to

Business Hiring and Spending
When you look at the economy, households do the bulk of the spending, and businesses do the hiring. The hiring
provides income to the households, which they spend. Given labor markets, household incomes have supported
a steady growth in nominal spending. However, business sources of funds from profits and credit have rolled over
and turned negative. As you would expect, when this happens, they cut back first on buybacks and M&A, then on
capex, and last of all hiring. This is an indication that we’re close to the line with respect to a downturn.

Household Uses Business Sources

Change in PCE (Ann) Last 6m Change in Profits and Borrowing (%GDP, Ann) Last 6m

10% 10%

5% 5%

0%
0%
-5%
-5%
-10%
-10%
-15%

-15%
2020 2021 2022 2023 2020 2021 2022 2023

© 2023 Bridgewater Associates, LP 5

But Earnings Have Not Yet Fallen Enough to Produce a
Contraction in Labor Markets
As we have discussed in prior research, earnings need to fall in order to induce the layoffs needed to cool the
labor market and bring down wage growth, which is a prerequisite for a sustainable 2% inflation rate. After
cooling late last year, our weekly reading of earnings growth has bounced rather than accelerating downward.

USA EPS Growth (Y/Y, Fwd) Coincident 3m Coincident EPS Growth (Ann)

40% 40%

20%
20%

0%
0%
-20%

-20%
-40%

2000 2010 2020 2020 2021 2022 2023

These guideposts suggest that the soft landing is not imminent and that a third stage in the tightening cycle
lies ahead, where interest rates will stay high or higher in contrast to the steady decline that is discounted to
begin in the middle of this year.

© 2023 Bridgewater Associates, LP 6

Other Observations: The Reversion of Spending on
Goods Versus Services Is Exerting an Influence
Another interesting influence is the reversion in consumption patterns from goods back to services. As shown
below, after spiking in the early stages of the reflationary recovery from the pandemic, real goods demand has
been weak. Meanwhile services demand has recently been strong, with modest scope for continued reversion.

USA Real PCE (ln, Indexed to 2020)

Goods Pre-COVID Trend Services Pre-COVID Trend
20%
5%

10% 0%

Reversion Reversion -5%

0%
-10%

-15%
-10%

-20%

2020 2021 2022 2023 2020 2021 2022 2023

© 2023 Bridgewater Associates, LP 7

This is showing up clearly in the monthly personal consumption statistics. Nominal spending on services
has continued to grow at a rapid clip of about 6% annualized. Real and nominal demand for goods has been
gradually weakening. This shift in the mix of demand has implications. Services spending is an upward pressure
on employment and wages, while weak goods demand has a more pronounced impact on listed company sales.

Persona
Nominal Real
Dec-22 Nov-22 Oct-22 Sep-22 Aug-22 Dec-22 Nov-22 Oct-22 Sep-22 Aug-22
Personal consumption
expenditures

Dur goods

equip
ecr g
ehicles
dur goods
Nondur goods
be rage
ear

goods
nondur goods

es

car

ecr

insurance

Nonpr
households

ed g rse

© 2023 Bridgewater Associates, LP 8

A diffusion index of monthly real PCE goods demand has been a good filter of recessions. As shown below,
since 1960, in each of the six prior cases that the diffusion index was negative, there was a contraction in
growth. On the other hand, when growth dropped negative but the diffusion index was positive, the apparent
downturn quickly reversed. The diffusion index recently breached the zero line for only the seventh time since
1960—another indication that we’re headed for a third stage of the tightening cycle.

Real Coincident Growth Share of Real PCE Rising or Falling

10.0%

A good filter, no false signals More

Real 7.5%
PCE
Rising 5.0%

2.5%

0.0%
More
Real
PCE -2.5%
Falling
-5.0%
1960 1970 1980 1990 2000 2010 2020 2030

© 2023 Bridgewater Associates, LP 9

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