Stocks gave ground on Friday despite strong earnings from Dow component JPMorgan Chase#. Bond yields climbed. March retail sales were notably weak. The recent flood of data supports the conclusion that both our economy and inflation are slowing. One can argue the pace. While a majority of Fed officials now support the notion that a recession is on its way, consensus is growing even stronger that the Fed Funds rate will be raised to at least 5% when the next FOMC meeting concludes May 3.
Whether there is one more rate increase or not probably has very little meaning on the overall economic and inflation glidepaths over the next several months. For investors, the key question is what might that glidepath look like. Let me offer a few scenarios.
- Soft Landing – Under this assumption, consumer spending remains resilient even if it falters a bit. Lower shelter costs work their way through inflation calculations, leading to a reported inflation rate of less than 3% before the end of the year. Banks will raise lending standards, effectively doing the Fed’s job, but not to the extent of creating more chaos. After a brief economic pause, short-term interest rates will gradually decline and growth will reaccelerate.
- Recession – The die has already been cast. With the exception of the leisure and hospitality sectors, economic activity is already in decline. The Fed was too late to start the fight against inflation, and the Fed will double down on its mistakes, raising rates too high too late in the game. While the Fed Funds rate is still below 5%, the prime lending rate at banks is about 8%. Many small businesses have to pay prime plus. They are already responding by cutting inventories and taking whatever steps they can to increase liquidity and lower borrowing costs. Some won’t be able to do enough to avoid closure. Weekly unemployment claims are rising at an accelerated pace once again, a sure sign of pending recession.
- Chaos – Every financial rate hiking cycle has ended with some sort of crisis. Were the failures of Silicon Valley Bank, Signature Bank, and Credit Suisse the entire crisis or the tip of the iceberg? We don’t know, but we do know that higher interest rates will provide increasing stress to the banking industry. It could be months before this question is answered. Since World War II, the Fed response to every crisis caused by monetary tightening has been to pause or reverse rate increases. Until now. The Fed raised rates in March after the bank failures, and most expect it will raise them again in May, unless another crisis erupts.
Whatever the outcome, the economic world has changed back to one that preceded the 21st century. Record low interest rates, free money, and excessive leverage are gone. Each of the above scenarios offers a different path to the world I am about the describe. A soft landing will mitigate the need for significant future interest rate cuts. Why should the Fed cut rates while an economy continues to grow? Yes, it can lower them a bit to allow growth to reaccelerate to a normal pace. But after all that has been done to defeat inflation, the last thing the Fed will want to do is allow demand to reaccelerate to a point of creating shortages and put pricing power back into the hands of sellers. A recession, should one occur, would lead the Fed to cut rates sooner. At the moment, that is the consensus forecast. Markets are pricing in two rate cuts later this year. The mean forecast at the moment, according to Fed Funds futures, is that the Fed Funds rate will drop all the way to 3.25% by the end of 2024. That seems extreme to me. Assuming future rate cuts are done in 25-basis point increments, that suggests seven rate cuts after the assumed increase in May. Markets are also forecasting higher profits in 2024 after a flat-to-down year this year. The forecasts of seven pending rate cuts amid an earnings resurgence seems incompatible.
Chaos, of course, brings out a different playbook, one that highlights massive short-term liquidity steps. The Fed overplayed that game after the Internet bubble burst, leading to an overextended housing market. It made the same mistake again after the Great Recession, instigating a surge in speculation, and ultimately, a surge in inflation. P.T. Barnum is famously quoted, “fool me once, shame on you; fool me twice, shame on me”. He presumes that one doesn’t repeat the same mistake three times in a row! Chaos talk is fodder for the media that wants to sensationalize everything to attract interest. Regional and smaller banks will have to take steps to strengthen lending standards and may have to pay more to retain deposits, but earning less and going out of business are two very different outcomes. Undoubtedly some banks will fail, but our banking system is not near the edge of collapse as JP Morgan demonstrated on Friday.
With the exception of chaos, both of the other scenarios end with interest rates substantially higher than they have averaged over the course of the 21st century. Borrowing is not likely to be free again. That isn’t bad. In fact, from an overall perspective, it is good. It means future investments have to be rationalized against a backdrop of real borrowing costs. It will lessen the creation of zombie office buildings, shopping centers, and apartments. It will reward a company’s ability to generate its own free cash flow, even in tough economic times.
From an investor’s viewpoint, it also means bonds have value. When money is free, meaning the interest payments received are less than the rate of inflation, all the value of a bond is embedded in the principal payment to be received at maturity. Given that there will be some inflation, negative real interest payments plus an ultimate principal payment worth less at the end versus the beginning, makes for a very unappealing investment. Contrast that today when money-market funds and Treasuries of very short maturities now pay almost 5% and you can see why so many consumers are taking excess cash out of banks and buying them.
All financial assets compete for the same investment dollars. If more begins to flow to fixed income, that leaves less to flow to other asset classes including stocks. The market’s mechanism to adjust is to lower the price earnings ratio. Indeed, P/Es have come down substantially since the bear market of 2022 began.
The stock market has been a battle between all these cross currents for the past year. Look at the chart below.
What seemed like a dog fight over the past 11 months or so looks more like a stalemate. The S&P 500 has traded in a relatively narrow range of 3800-4200 over that span. Where does it go from here? If you buy the soft landing thesis, a case can be made for a breakout above 4200 soon. If you predict chaos, the breakout would likely be below 3800. But if you are in a majority, which includes the Fed, expecting a recession, the market is likely to remain within this range for some time to come. Bull markets don’t begin prior to the start of a recession.
This is earnings season. While JPMorgan Chase stole the headlines on Friday, the action of other companies that reported earnings was more muted. Companies, as they report, will beat expectations. They always do because managerial hints before earnings are announced always serve to lower expectations. But the real key is what they say about the outlook beyond the first quarter. If there is a pending recession, that commentary is not likely to be very encouraging. Equity markets like the end of a rate hiking cycle, but this one has been so well forecasted that it probably has already been discounted. What may not have been discounted are (1) a more negative near-term earnings outlook, and (2) the strong possibility that interest rates for the foreseeable future remain higher than markets now expect. That would imply P/E ratios are still too high. The S&P 500 is at the upper end of a long trading range. I expect it to remain within that range for several more months. No need to chase quite yet.
Today, actress Jennifer Garner turns 51.
James M. Meyer, CFA 610-260-2220