Stocks were mixed yesterday. The Dow rose as components Home Depot# and Walmart both reported earnings that impressed investors, but both the NASDAQ and S&P 500 lost ground. Bond yields rose. Tech stocks were the biggest losers, coincident with the rise in rates.
August is often a month with little hard economic news. The largest retailers are reporting earnings this week, then earnings season is largely over. The second half of August is the heaviest time of year for vacations. Kids are getting ready to go back to school. One big event at the end of every August is the gathering of Federal Reserve officials in Jackson Hole, Wyoming. This year’s meeting isn’t likely to ignite sparks. Rather it will be a time for the Fed to show, verbally, its resolution to beat inflation.
Market watchers today can draw two conclusions, one bullish and one bearish. Judging from the market’s behavior over the past two months, the bullish interpretation dominates. It goes something like this. The Fed started to jawbone about inflation last Fall. It began to raise rates in March. Markets have responded. Interest rates along the yield curve have risen. In the view of bulls, short rates regulated by the Fed are now near neutral, the point where rates neither advance nor retard economic growth. To defeat inflation, the Fed will have to raise rates further, but inflation peaked a couple of months ago. Future rate increases will be less than the 75-basis point increases of the past two FOMC meetings. The Fed Funds rate will hit something over 3% by year end, at which time the Fed will stop and pause. Inflation will continue to unwind, a combination of the impact of higher rates and the resolution of supply chain problems. By mid-2023, the war against inflation will be over. The Fed will then start to reduce rates. They won’t go back to zero, but over a relatively short period of time they will return to neutral, about where they are today. As for the overall economy, it’s possible that economic growth might turn negative for a brief period and earnings will flatten, but that is the worst of it. Since markets are forward looking, the damage done to markets in the first half of this year did all the dirty work. It’s only up from here.
Now to the bearish side. It acknowledges that inflation peaked around June. Average gasoline prices are now down 20% and still falling. Home prices peaked as well. As supply chain problems resolve, supply catches up with falling demand. But, and here is where bulls and bears start to differ, not all inflation factors are on the road to resolution, notably labor. The unemployment rate is now 3.5%. There are almost two jobs available for every one unemployed person. Certain skilled positions are particularly difficult to fill. Note the problems with the airlines and filling teacher jobs. They are far from the only industries struggling to fill positions. Labor participation rates have risen since early during the pandemic but are still meaningfully below levels that existed prior. Factoring in a rising population over time, there are about 2 million fewer workers today than before the pandemic. The only thing likely to bring even a portion of them back is higher wages. Pilots, air traffic controllers and teachers are positions that require specific training. They won’t be filled quickly. At the other end of the labor spectrum, jobs that few want go unfilled. Here I am talking about laborers, farm workers, truck drivers, dish washers. These are positions often filled by immigrants, but legal immigration is down almost 75% from 2016. If the economy isn’t going to contract as much as the bulls surmise, the only way to balance labor supply and demand is through higher wages. Companies with pricing power will pass through the higher labor costs, but higher prices will crimp both demand and margins.
The bears will say the transient impact of inflation will resolve itself. Used car prices skyrocketed when new car lots were empty. What new cars were available were often sold above list prices. That will reverse as car lots refill over the next several months. As we see with some retailers, it is entirely possible that lots will become overloaded with inventory and cars will go on sale. We see that now at Walmart and Target. Thus, the bears will say that much of the inflation was indeed transient, the word Fed officials get ridiculed for saying. But not all of it. There were no supply chain issues when it comes to labor. If Covid stopped employees from working, those days are long past.
With all that said, it is quite possible that the transient components of inflation that overshot to the upside due to shortages will overshoot to the downside as supply and demand normalize. Thus, we may be headed for several months of significant drops in the CPI even as wage costs continue to rise.
That puts the ball back in the Fed’s court. As inflation falls to 3% or lower, how quickly will it declare victory against inflation? Bulls say quickly. They believe rate cuts will begin in the first half of 2022. Markets, at the moment, agree. Bears, however, point to the 1970s. Beating inflation down is the easy part. Crush demand for some period and inflation will always come down, coincident with declining demand. But keeping it down is different. If there isn’t slack in key parts of the economy, including labor, any resumption of strong demand will quickly reignite inflation. Think of the game musical chairs. If there are 100 players and 100 seats, finding an empty seat is a non-issue. But take away just one chair and the game is on. It’s the same whether you start with 100 chairs or 10 chairs. Just a slight change in supply (or demand) creates an imbalance. The resolution of imbalance in economic terms is either inflation or deflation.
Thus, the bears fear one of two endings economically. Either the Fed will end its inflation battle too soon and risk repeating the cycles of the 1970s, or it will continue with short rates higher for longer to increase slack that will prevent inflation from reigniting quickly once it chooses to back off. Both bulls and bears agree that the Fed Funds rate will go toward 3.5%, but they disagree how long the markets will stay there.
There is another weapon the Fed is using to fight inflation, which is reducing the size of its balance sheet, thus reducing money in circulation. So far, balance sheet reductions have been modest and overshadowed by slower debt issuance by the Treasury, a function of high tax receipts and prior borrowings done early in the Covid cycle to ensure market liquidity. Over the next 12 months, the Fed will double its pace of balance sheet reduction and the Treasury will increase its pace of debt issuance. That impact hasn’t been felt by markets yet.
At Jackson Hole, it is highly likely that the Fed will adhere to the bearish side of the argument. It will note the 1970s and vow not to repeat the same mistakes. It will note the persistence of inflation. But fast forward six months. Suppose top line inflation is down below 3% and falling at the same time the economy is slumping into recession. Earnings are weak and forecasts are for lower results in the future. There will likely be lots of public pressure to declare victory and move on. The Fed will know any such declaration will boost markets immediately. Can it be resolute and keep rates high for an extended period to create enough slack to keep future inflation at bay? Bulls say the Fed will cave to the markets. Bears say the Fed was late getting started, and it will be late declaring victory, waiting to see upward wage pressures evaporate. Another six months simply isn’t enough time for that to happen.
So which side is right? The answer is obvious. We won’t know until we get there. Inflation is going to fall. Both sides agree. In theory, the Fed should want to fight the inflation battle just once. Staying resolute in a weak economy while markets are down is another thing. Markets always want low rates and massive liquidity. Just look at 2021. No one wants the lid on the cookie jar. We will see how it plays out.
That brings me back to markets today. What we learned this earnings season is that corporate managers can do an effective job during a rather flat economy with lots of supply chain issues. Rising rates have flattened in recent months. It is likely that markets reflected too much pessimism in June, but now 50% of losses have been recovered. P/Es are now 18+ times next year’s earnings, assuming little negative impact from a slowing economy. Pessimists might argue that earnings estimates need to come down further and the multiple is a bit higher than 18. Either way, markets aren’t a bargain today. But if there is a soft landing, if the bulls are right, the path forward for earnings will be higher. If inflation is defeated, even for only a couple of years, interest rates will start to come back down. Lower rates and higher earnings will push stocks higher.
If the bears are right, interest rates stay close to where they are, but earnings forecasts take another leg down. Some retest of the June lows is possible, although it is hard now to see that being severely tested unless the Fed creates a serious recession lasting into 2024.
The bottom line is that the risk/reward equation for investors is a lot more balanced today than it has been for a while. The euphoria of 2021 is gone. It has shown sparks of life in recent weeks, but just sparks so far. With the Fed likely at least two-thirds of the way toward peak Fed Funds rates, the bears have less to feed on. My guess is that Jackson Hole might be a wake-up call for the bulls not to assume that rate cuts start in the second quarter of 2023 as futures now think. That appears to be a bit too soon. It may require some mid-course correction in markets as the timing of the first rate cut gets pushed out. With that said, Fed officials are miserable forecasters of what they will do just a few months out. Ultimately, markets will react to the Fed’s actions, not simply its words. For the bulls, the good news ahead is that top line inflation is likely to come down very quickly in the months ahead.
Let me close by offering one market to watch as key. The housing market. It soared into the spring of 2022 and then got crushed by higher mortgage rates and price increases that got out of hand. Buyers vanished, but they won’t vanish forever. Lots of millennials want to live in a house, not an apartment. Lots of empty nesters want to move into active retirement communities. On the surface, it is starting to look a bit like 2008 all over again. But it isn’t. Inventories of homes for sale are still low. Falling prices aren’t going to bring out more sellers. Mortgage rates are starting to decline, but they won’t go back below 3% anytime soon. Potential buyers see falling rates. Until they bottom, these buyers will stay on the sidelines.
Homes for sale that are priced right for today’s market are still selling fast. Short term, there is a mismatch between buyers seeking bargains and sellers still hoping to get prices from six months ago. That will resolve. Homebuilders are seeing declines in traffic and are having to give concessions to close deals or prevent those under contract from backing away. That too will resolve quickly. There aren’t many foreclosures, as there were in 2008. Both buyers and sellers are out there, they just must meet on price. When that starts to happen, housing demand will resume. Prices will stabilize. The millennials and active adults will come back. Housing is always a leading indicator. It will be an early indicator for economic activity, and it will be a leading indicator for the future path of inflation.
Today, Donnie Wahlberg is 53. Sean Penn turns 62.
James M. Meyer, CFA 610-260-2220