Stocks fell sharply yesterday, with the NASDAQ leading the way down after Federal Reserve Vice-Chair Lael Brainard said simply that the Fed is going to go all out to fight inflation. 50-basis point rate increases are on the table at each meeting. In addition, the FOMC should lay out a map to reduce the size of its balance sheet at its coming meeting in May. While none of this contradicted consensus forecasts, recent signs of economic weakness and a slowing of the ascent of some commodity prices gave some traders hope that the pace of rate increases might be slower than Ms. Brainard suggested. The consequence of her comments was a 15-basis point rise in the yield on 10-year Treasuries and a 2% drop in the NASDAQ index. The Dow Transports, perhaps a harbinger of future economic activity, continued its sharp drop that started a week ago.
The message Ms. Brainard sent was both stark and simple – inflation must be reversed. Looking backward as to its cause would be a waste of time. Chairman Powell has already said, admittedly in politically spun verbiage, that the Fed was late to respond and let inflation get out of control. Of course, there were intervening factors and it wasn’t the Fed that spent an extra $5 trillion over a couple of years. But the Fed knew the money was going to be spent and didn’t react until it was too late.
That is water over the dam. Now it is time to fight. Inflation is already starting to slow spending, even though Americans have trillions of accumulated savings built up during pandemic isolation. Trucking activity has begun to slow. I expect traffic at housing developments, particularly those focused on first-time buyers, to slow as the Spring selling season ends. Retailers are feeling the strain. Stocks of truckers, homebuilders and retailers have been hit hard.
Ms. Brainard’s comments need to be judged against this economic backdrop. Next to Mr. Powell, she is the most powerful member of the FOMC and the most respected. She was among those last year who said to wait to slow QE. Obviously, without saying it in words, she now admits, like Mr. Powell, that the Fed was off course.
While there are some who have felt that the Fed lacks the willpower to attack inflation if such a battle might cause recession, Ms. Brainard and Mr. Powell have both said they are committed to the inflation fight. Mr. Powell has a business background. Ms. Brainard is a trained economist. Both understand the insidious cost of persistent excess inflation. We learned clearly in the 1970s what happens when the Fed lacks the stomach to complete the fight. No repeat this time.
Consensus today is for roughly 8 rate increases this year and perhaps a few more next year. In addition, the Fed should reduce the size of its balance sheet via bond runoff at maturity and even outright sales. Estimates of the size reduction range from $1.0-2.5 trillion, roughly the equivalent of the excess savings that have been sloshing around feeding speculation in asset prices along the way. Today we should see further clarification as the Fed releases minutes of its March FOMC meeting.
What does this all mean to markets? To start, let me note that any forecast of the amount of rate hikes the Fed will make over the next 12 months, or the size of balance sheet reduction, are unlikely to be accurate. You don’t have to look back a year, just look back three months to see how the current forecast differs from what analysts and economists thought during the Omicron wave. I have no idea how many rate increases it will take to seriously win this battle, nor does it really matter. What matters is that the Fed seems intent to beat inflation, and if a mild recession is necessary to accomplish that, so be it.
That is a rather stark statement. It is particularly stark in a mid-term election year. It won’t help incumbents. But hey, it was the incumbents who authorized the spending of $5 trillion and who continue to want to spend billions more under some new age portfolio theory that clearly isn’t working as planned.
The statement doesn’t mean a recession is certain either. Over the next few months, it is likely that the rate of increase in some key commodities, particularly oil, will start to slow. I am not trying to predict the future price of oil. We know, courtesy of the sanctions, that supply is tight. It was already tight before the war, and Summer driving season is almost upon us. But oil price trends are seasonal, and they tend to peak around Memorial Day. Natural gas prices are probably peaking now seasonally as the heating season comes to an end, although European reaction to the repulsive Russian behavior with promises to buy less Russian gas may delay any price decline for a few weeks. Also remember that inflation measures the rate of change in price, not the actual prices itself. At some point, higher prices will create demand destruction. We will drive less. New home buyers will drop out of the market if they can’t afford what they want.
Are the odds of a recession higher assuming the Fed is determined to fight inflation? Absolutely. Is one inevitable? Too early to call. Clearly growth will have to fall. Clearly wage growth will have to moderate. Last Friday’s employment report showed that the labor participation rate for prime working ages was pretty close to pre-pandemic levels. It remains hard for employers to find employees, and the problem is most acute in key jobs, notably within healthcare. Suddenly the trucking shortage is turning into excess supply, and shipping cost increases have been a key component to inflation today.
We are a long way from solving all of yesterday’s problems. As noted, hospitals and nursing homes can’t get enough aides and nurses. Auto dealer lots are still barren. Every car delivered is pre-sold. Semiconductor shortages persist. I often use a traffic analogy. It is apt. Gridlock at 5 pm starts to break up at 6 and is long gone by 7. Order backlogs for suppliers include some level of double ordering, maybe triple ordering. The cause is excess demand, just as auto gridlock is caused by too many people leaving work at the same time. But when the gridlock ends, it ends quickly. Remember the Spring of 2020 when you couldn’t find toilet paper or hand sanitizer? Then suddenly you could find all the toilet paper you wanted. Retailers are still awash with excess sanitizer and are almost giving it away.
Ms. Brainard told us what we already knew, but what we knew isn’t what we wanted to hear. The sharp rally from the February lows was probably too much too soon. The return of speculation as 10-year Treasury yields flattened around 2.35-2.50% is now going the other way as the yield passes 2.60% with no end in sight. Stocks don’t have to return to their February lows, but there isn’t any reason why they can’t. Right now, growth is slowing, interest rates are rising, and the battle against inflation has just begun. The important CPI reading for March may give a hint as to whether it is still rising or whether core inflation around 5.5% is a peak.
Fed medicine, higher rates, and balance sheet runoff won’t have a serious impact until later this year. In the interim, the downward economic pressure will come from the pain that inflation itself causes. Wages may be rising rapidly, but inflation is rising faster. Until that reverses, it will put downward pressure on economic growth. The good news is that wage rate growth could exceed inflation rates within months, particularly if oil prices can find some stability.
By the end of the first quarter market correction, the NASDAQ squeezed into bear market territory (down 20%+) while other averages were clearly in correction mode (down 10%+). Such moves would be consistent with a very mild recession. Maybe those lows will hold. Maybe a full retest will not be necessary. Maybe the fight will be tougher than expected and new lows in the market lie ahead. As I keep noting, no one knows the answer yet.
Few expect economic acceleration either. I don’t want to get overly bearish based on one bad day. My two-day rule says we need to see another one today to confirm a market reversal likely to challenge recent lows in some fashion. Thus, I am not making any conclusions. But it is hard to be optimistic either. First quarter earnings season begins next week. It is likely to be very mixed, courtesy of Omicron, sanctions, and the impact of rising inflation. But it is the forward-looking guidance from managements that will tell the tale. I expect most to be guarded, especially those of companies most sensitive to changes in economic growth rates. So far, the best places for investors to hide have been utilities, energy, chemicals. REITs, pipelines, insurance, and a few persistent growth names that were not insanely priced. For the most part, these companies are less economically sensitive, or they were beneficiaries of higher interest rates or higher commodity prices. For now, I don’t see a new rotation to economically sensitive areas. As for bonds, keep maturities real short and quality high.
Today, Paul Rudd is 53. John Ratzenberger of Cheers fame is 75. Billy Dee Williams turns 85.
James M. Meyer, CFA 610-260-2220