Stocks fell sharply on Friday immediately after Federal Reserve Chairman Jerome Powell gave his highly anticipated speech. While stock prices took a big hit, bonds showed very little change, although yields are up a few more basis points this morning. The 2-10 Treasury spread steepened by less than 1 basis point before giving back that one basis point in early trading today. Mr. Powell’s speech, only nine minutes in length, essentially repeated what an array of Fed officials had been saying all week. The Federal Funds rate is headed to about 3.75% or a shade higher by year end. It will stay in that proximity until the Fed sees convincing signs that demand is slowing, that wage pressures are easing, and that sufficient slack is created to ensure that inflation stays close to its 2% target once it gets there. Getting there may take until 2024.
Just as markets can confound investors immediately after each FOMC meeting, the reaction to Mr. Powell’s speech can be confusing. Traders, particularly algorithmic traders, place bets before each meeting or speech. They then close out their bets quickly within hours. Friday’s 1000+ point drop must be looked at in conjunction with Thursday’s 300+ point gain. Also note, that the big move happened on a Friday at the end of August on very light volume. There has been follow through in premarket trading but most of the continuation to the downside has been less than 1%.
With that said, let me turn to what lies ahead. The Fed soon will have raised rates past neutral, if it hasn’t already. That is, it is setting monetary policy to slow economic growth. Whether that growth rate stops before reaching zero or not is problematic and unanswerable at this point in time. Obviously, all else being equal, slowing demand reduces upward pressure on prices. Inflation falls. We have already seen part of that impact even before the Fed Funds rate reached neutral. As I have discussed many times, less demand helps to unclog supply chains. In some cases, short supply and back orders quickly morphed into oversupply. We have seen this at retailers, particularly at mass merchants and department stores. We have also seen this for products in high demand during the height of the pandemic including personal computers, bicycles, and outdoor grilles. Commodities quickly react to changes in supply/demand imbalances. Gasoline demand almost always peaks around Memorial Day. Prices that reached $5 per gallon are now headed toward $3 per gallon. The same story follows along the commodity complex although war and drought have also impacted price.
If you look at any measure of inflation, the two single most important contributing factors are the costs for shelter, and wages. Home prices peaked in late spring and are starting to fall. Rents will follow. They will likely peak in late summer or early fall.
That leaves wages, perhaps the only portion of the inflation complex that has not seen deceleration over the past few months. To understand wage trends, one has to understand the employment cycle. After business improves, companies hire new workers. Rarely do companies hire workers in advance of improving business. Similarly, companies reduce headcounts after sales start to fall. Few executives will listen to Jerome Powell speak and conclude that they must lay people off now, especially if current sales are still strong, but that doesn’t mean they won’t be cautious. The first thing they will do is pull listings for new hires. If business starts to fall, they will reduce hours, maybe cut overtime. Over the past few years, when so many businesses were heavily impacted by the pandemic, companies were forced to cut skilled workers. When demand quickly recovered, it couldn’t get those workers back. As a result, there aren’t enough teachers to staff schools nor enough pilots to fly planes. Laying off your best trained staff is a last resort, a point punctuated by recent experience.
Thus, employment is a lagging indicator, the last economic indicator to turn negative. Almost all other signs of economic activity are likely to be in decline before there is a meaningful negative change in employment. As we have been discussing, there have already been real signs of slowing growth leading to a deceleration in prices. If I back out inventory accumulation from GDP calculations, the economy was still growing albeit at an anemic pace, in the first half of the year. Yet hiring has remained robust. In July, our nation added well over 500,000 new jobs. Only once in the past year has there been a monthly increase of less than 400,000. As far as the data is concerned, there has been absolutely no slowdown in the labor market. No slowdown means wage pressures remain high. Annualized, wages continue to grow at nearly a 6% pace. There is recent anecdotal evidence to suggest some modest relief in wage pressure, but it remains elevated. The next employment report is due Friday. Monthly numbers are difficult to forecast and they get revised often. Most forecasts for August are for growth in the 200,000-300,000 range. No need to guess; we’ll see on Friday. I almost always say that high job growth is good. But when the goal is to create slack in the labor force, the only good news Friday will be a moderation in the monthly growth rate.
The Fed isn’t going to lose this battle. It never does. Whether it loses the war, designed to keep inflation down, depends on how fast the economy grows once the Fed releases its monetary pressure. The problem isn’t restricted to the U.S. Europe faces an even tougher fight because it must import so much of its energy needs at exorbitant prices. Natural gas prices in Europe today are equivalent to oil prices of about $450 per barrel. Despite green initiatives, it’s no wonder there is a shift in Europe from natural gas back to oil and coal.
Thus, the reality is that interest rates may stay above neutral at least into the second half of 2023 and perhaps into 2024. Consumer demand will fall. Investment spending will be negatively impacted. Almost certainly, earnings estimates for 2023 still need to be adjusted downward. This doesn’t represent a change based on what Mr. Powell said on Friday. What Mr. Powell said is a wake-up call for anyone who felt inflation could be eradicated within months allowing markets to signal clear sailing ahead. That thought was premature.
While I don’t expect a rush toward old highs in the stock market, I don’t see why the lows of June won’t hold either. Creating labor slack doesn’t require a massive increase in unemployment. It simply requires balance. Note that in mid-June, when stocks set their bear market low (so far), the 10-year Treasury yield reached 3.49%. This morning it sits at 3.11%. Long-term inflation expectations are actually lower today than they were just a little over two months ago.
There is an additional thought long-term investors need to consider. GDP can be looked at as population growth times improvement in productivity. Population growth has been falling and there are few signs it will return to pre-pandemic levels anytime soon. Birth rates are down and so is immigration. As for productivity, it has been awful lately and it almost always deteriorates in weak economic times. Thus, once labor markets rebalance, there is little reason to believe that real growth in the U.S. can be sustained at a rate higher than 2%. Europe’s outlook is even bleaker. China is also slowing coincident with its population peaking. Thus, worldwide growth, after any pause/recession, is unlikely to be sustained above 3%.
If interest rates normalize once labor balance is restored, and earnings rise about 5% per year, the days of persistent double digit annualized gains in stock prices may be a memory. That doesn’t mean there isn’t a roadmap to using equities as a base for most investment programs, but it does mean that companies dependent on a robust economy for success will have tough sledding.
Technology and science will remain a foundation for growth. We remain an entrepreneurial nation. Entrepreneurship can be as simple as McDonald’s or Nike, doing something very traditional better than anyone else. Over the next decade, the vehicles we drive will change, how we entertain ourselves will evolve, and how we pay for goods and services will become more digitized. Technology almost certainly will lead to the creation of the next Facebook or Google. Spending to combat climate change will increase. Inefficient industries like the way healthcare is delivered or the role of higher education will improve. The opportunities, even in a world of slower growth, are limitless. As Chairman Powell said, there may be some short-term pain that must be endured, but that pain won’t seriously impact the long-term earnings power of successful businesses.
Today Airbnb founder Brian Chesky is 41. Supreme Court Justice Neil Gorsuch is 55. Former Treasury Secretary Bob Rubin and actor Elliott Gould both turn 84.
James M. Meyer, CFA 610-260-2220