Stocks continued their slide which began moments after Fed Chairman Jerome Powell spoke at Jackson Hole last Friday. All told, the leading averages fell about 5% since the speech, where Powell reiterated the Fed’s focus to continue to keep short-term interest rates elevated until there is convincing evidence that inflation is receding toward its 2% target.
The process of raising rates will probably be complete near year end. By then, the Federal Funds rate should be at least 3.5%, far enough above neutral to exert meaningful downward pressure on the economy. Already there are signs of slowing. GDP fell in the first half of 2022, although the actual negative readings were caused by changes in inventory levels rather than a decline in final sales. Housing activity has slowed significantly. Prices have started to come down, although they remain well above levels from a year earlier. Rents should peak soon. Commodity prices are also in retreat. Just look at the gas pump for confirmation.
As we noted on Monday, the Fed’s real focus will be on wages. The JOLTS survey, which counts job listings, came out this week and still remains robust. It’s not hard to see that employees still have the upper hand. The number of people quitting for higher paying opportunities remains elevated. Unions are actively organizing workers at companies heretofore that never entertained a union certification election. Inflation isn’t going to be defeated until the pace of wage growth slows, and that won’t happen until the U.S. economy keeps creating hundreds of thousands of new jobs each month.
Economic trends don’t change overnight. Reducing wage growth will be a process. It isn’t likely to happen without some level of layoffs. Unless there is suddenly a surge of new workers, which doesn’t seem even a remote possibility right now, the only way to restore balance is to reduce the demand for workers. That means layoffs. Layoffs are only going to happen after business conditions deteriorate. It doesn’t take an economic genius to do the math. Slower sales and less profits will be the catalysts that prompt businesses to lay off workers, and that either spells recession or something very close to it.
Let us remember, however, that the Fed has two mandates, price stability and full employment. Almost all Fed officials have said that the focus at the moment is price stability. That can be said today because we are not in recession. If, in 2023, we enter a recession and price and profit declines become more prevalent, it will be hard for the Fed to keep its foot on the brakes. One can argue how dangerous inflation may be, but if there is one economic indicator that is most important in America, it is the unemployment rate. That stems all the way back to the Great Depression. Americans may not like 8% or 9% inflation, but that is already gone. Lest we forget, the headline number in July was zero. Even looking at core inflation, backing out food and energy, the rate today is under 5% and falling. By the end of the year, it should be under 4%. The path toward 2% may take time, but it will be visible early next year. That doesn’t mean the Fed will start cutting rates quickly. It won’t. It will accept staying with tight economic conditions for a few extra months. It will even tolerate the unemployment rate going from 3.5% to 4.0%, but it won’t tolerate it going a whole lot higher than that. Note that if there is a recession and the economy subsequently bounces, businesses are not going to hire new workers right away. They will be gun shy waiting for affirmation that a turnaround is not a short-term blip.
Wall Street traders ride an emotional roller coaster. They can change moods literally overnight. One day, they were optimists that the Fed might loosen its pressure and cut rates before mid-2023, and a recession could be averted. After last Friday, when Chairman Powell said nothing new but simply reiterated the Fed’s resolve, suddenly traders turned into a bunch of Chicken Littles screaming recession was inevitable. The sky was falling!
They probably were overly optimistic before, and they probably are too pessimistic at the moment. Yes, 2023 earnings estimates are too high, but the market has known that for months. It hasn’t been pricing in a 10% profit gain next year for months, even though analysts have been slow to lower forecasts. Bond yields have nudged a bit higher over the past three sessions, but the bond reaction was far more subdued than the equity reaction. To be sure, the 2–10-year yield curve is inverted and has become a bit more inverted, a signal of pending recession. The fact that analysts haven’t fully adjusted their earnings models yet is not as relevant as you might think. The market is always ahead, adjusting to a more somber future before analysts do.
The reality is that while earnings in a weakening economy will come up short, we already know that. It has been discounted. Based on yields of higher-grade junk bonds, the proper P/E for stocks at the moment is about 17.3. If earnings are flat next year, meaning down in the first half and up a bit in the second half, my math pegs fair value around 3900-4000, right where we are at the moment. Emotion may send stocks lower. Some already preclude another test of the June lows. A healthy number of companies sit at their 52-week low today. Most of those have specific fundamental issues, but the long-term value of a business is not overly dependent on one year’s earnings. The basis for fair value is the present value of all future cash flows. That is why common sense says not to sell great companies selling at or below fair value. It also says to use the opportunity to upgrade. Look ahead, not back. Buy companies with great management teams focusing on expanding opportunities. Great companies take advantage and pivot in the right direction. Bad companies will try to defend a fading opportunity. It’s hard to concede your mistakes. Old growth companies mature. Some simply aren’t prepared for new opportunities. Others get disrupted and fail to regain leadership. Weak economies expose weakness, but they also expose strength and the ability to adapt. A difficult environment highlights the challenges and opportunities.
Today Saudi Crown Prince Mohammed bin Salman is 37. Richard Gere is 73. Itzhak Perlman turns 77.
James M. Meyer, CFA 610-260-2220