Stocks fell more than 1% as global tensions rose coinciding with Speaker Pelosi’s visit to Taiwan. So far, the Chinese response has been measured but that could change at any moment. In addition, Federal Reserve officials have been trying to convince investors that the rather dovish conclusion reached last week after Chairman Powell’s press conference was a misread of the FOMC’s intentions to continue to raise interest rates in its fight to lower inflation.
Both myself and markets have little way to predict any Chinese response to Mrs. Pelosi’s visit. It has promised a reaction. So far military fly overs and expanded military exercises near Taiwan seem to be a measured response. Clearly, there is risk that the Chinese will escalate tensions further. Markets could remain on edge for the next several days at least.
Hopefully, tensions will recede leaving the Fed’s collective response last week and through subsequent comments as the focus for market watchers over the next few weeks. As noted, Monday, the market read the changed reactions of Mr. Powell from a tight bracketing of future near term policy action in June to a data dependent open-ended projection for September as dovish. Quickly, the Fed has said markets overreacted. It’s fervent intent to bring inflation down and keep it down hasn’t changed. What has changed is that data is starting to show evidence that some inflationary pressures have started to ease. Starting to ease doesn’t equate to battle won.
Both sides are right. Lower commodity prices and a decline in housing demand are important precursors to overall victory. Mr. Powell suggests that after the July rate increase, the Fed was at or close to neutral. But simply reaching neutral, the interest rate levels that will neither escalate nor diminish economic activity, isn’t enough. Rates are still going higher.
How much higher? Since there is a lag between rate increases and economic impact, that remains somewhat a guessing game. Moreover, M2 money supply is now growing at an annual rate of 5.6% almost precisely in line with core CPI and several percentage points below nominal CPI. Given muted changes in money supply, economic growth must remain near zero or below if M2 growth keeps declining for any period of time. Note that the Fed plans to reduce its balance sheet by close to $100 billion per month. Much of that money will come from existing bank deposits putting further downward pressure on M2. Thus the Fed is right to state that, at least for now, it is committed to keeping pressure on inflation for several more months at least.
Investors who pushed stocks up close to 10% since the late June bottom look ahead. With an inflation inflection point becoming clearer by the day, they believe the pace of Fed rate increases is bound to slow. Consensus for September is 50 basis points. It would appear the 75-basis point increases are over. If inflation numbers for July and August are low enough (and they could surprise on the downside looking at slowdowns in plane fares, used car prices and even rents becoming more apparent), an increase of just 25-basis points isn’t beyond possibility. In a sense, Chairman Powell said the same when he noted that the Fed would be data dependent. Investors took that to mean something as low as 25-basis points was possible even if 50-75 was a more likely range.
That didn’t mean the new range would be 25-50. It meant that at a transition point it would be necessary to assess the absolute rates of change 6-weeks hence and then make an intelligent decision unconstrained by past guidance.
The overlay across the evolution of Fed policy is the rate of change in the economy itself and the ability of companies to react. After all, stock prices aren’t a reflection of Fed policy or rates of overall economic change. They are a function of individual corporate earnings and a P/E related mostly to the 10-year Treasury rate. In that regard, the vast majority of companies have done an excellent job managing through a very difficult economic period. Of course, there have been exceptions. No one says managing a Fortune 500 company is easy. Some industries have more pricing power than others. Some have better growth characteristics, but for every Intel that really messes up, there are dozens who meet or exceed expectations despite the headwinds of inflation, economic deceleration, sanctions and Covid.
There’s the bottom line. Inflation is past its peak. Whether the Fed raises rates 25 basis points or 50 basis points at each of the next several meetings, the headwinds are receding. Wheat is starting to ship from Ukraine. Oil markets have settled down as the supply shortages are less than feared. The surge in demand that accompanied the reopening of our economy is starting to ebb.
All of this won’t come without some pain. Many companies will stumble along the way. Many of the speculative favorites of the past two years have been properly undressed and are now correctly seen for all their warts. Ultimately, there will be some loss of jobs, and other economic pain. But, if there is a recession, both individuals and businesses started from strength. They both have financial reserves, if needed. Homeowners have real equity that will survive any modest decline in values. Markets look ahead. Whether or not June proves to be the bottom or not will depend on how sharp and how long any downturn might be. The forecast now is that any downturn will be modest, but that is still a guess, just as data dependent as the next FOMC rate decision.
There may have been a certain amount of fear of missing out in last week’s buying spree. Given the lack of changes in interest rates during yesterday’s plunge, it would stand to reason that most of the weakness related to political fears. On Wall Street, those rarely last long. This market isn’t ready to go up 7-8% per month, but it probably has no reason to revisit June lows either unless the economic decline accelerates beyond expectations. September and early October are, seasonally, the weakest time for stocks. That suggests a couple of months to digest July’s recovery hopefully setting the stage for further recovery in the late Fall if inflation continues to fall.
Today, Tom Brady is 45. Martha Stewart turns 81. Tony Bennett reaches 96.
James M. Meyer, CFA 610-260-2220