Stocks fell once again on Friday and have now retreated to levels last seen a month ago. Tomorrow morning a report on consumer prices will be released moments before the FOMC commences its two-day meeting. Both the release and the meeting are likely to be market moving.
While we don’t know the CPI data yet, the outcome of the FOMC meeting isn’t in much doubt. Leadership has already telegraphed a 50-basis point increase in the Fed Funds rate. It rarely goes against its own guidance. It would take an awesomely bad CPI report to move that needle. Moreover, market watchers are making two broad assumptions. First, the pace of future rate increases will slow. Second, inflation has peaked and data over the next several months will bear that out. But what makes tomorrow’s CPI report and Wednesday’s conclusion of the FOMC meeting so important to markets are the nuances.
Saying that inflation has peaked is meaningful, but the downward path forward is more important. Goods inflation and commodity inflation are both falling meaningfully. Although CPI data to date doesn’t show meaningful deceleration in shelter costs, other more timely numbers make it clear that housing prices are falling and rent increases are decelerating in a meaningful way. Since shelter costs account for more than a third of the CPI, when that starts to be reflected, the pace of inflation will slow.
So far, services and wage inflation have been more stubborn. With that said, there are plenty of anecdotal signs, what post-Great Recession we called “green shoots”, starting to appear. Wage demands lag inflationary pressures. Those pressures rise in response to higher inflation. Workers need more to stay even. But as inflation abates, the intensity of the demand for more pay slows. It may not slow right away, but it will follow.
None of these answer the question whether inflation can get back to 2% where it was pre-pandemic. If it can, no one can tell us when with any clarity. That’s the fuzzy part of the crystal ball. Tomorrow’s CPI report and the commentary to follow the conclusion of Wednesday’s FOMC meeting might provide clarity. At least that is what market watchers will be looking for.
Without clarity though, we can still provide a glide path for the near term. The Fed will continue to raise short-term rates. That means the front end of the yield curve will continue to rise. We don’t know which side of 5% will be the peak, but it’s likely to be in that vicinity. Since it likely won’t stay at its peak for too long, the rate itself won’t make a big difference to long-term investors. More important will be where the rate comes down to once the Fed concludes it is on a path to bring inflation back to normalized levels, at or near 2%. If there is one lesson Fed officials have learned over the past year or more, it is that zero interest rates have plenty of unintended consequences. They promote stupid borrowing and stupid investments. Some of these mistakes end up having large consequences. Look at the current state of the crypto world as just one example. Look at SPACs for another. Look at the wildly overpriced world of tech stocks with no earnings and no prospect of ever earning money as a third. It isn’t just here. Look at the Chinese real estate bubble as a fourth. We had one of our own as well, both residential and commercial.
Thus, unless the Fed is tone deaf, don’t look for the Fed Funds rate to go back to zero anytime soon. If inflation can fall back to 2-3%, a Fed Funds rate will have to be higher than longer-term inflation expectations. Furthermore, after any recession, yield curves stop inverting, meaning the yield on longer dated bonds will be higher than the Fed Funds rate. Right now, the yield on 10-year Treasuries sits around 3.5%. I’d be a fool to try and tell you the next 25 basis point move. But if the Fed Funds rate settles at 2-3% as the economy normalizes, the yield of 10-year Treasuries will logically be higher, perhaps not far from where it is today.
Now let’s look at earnings. Right now, markets expect earnings next year to be about $225 for the S&P 500. History says that number should erode a bit, especially if the economy slows from here, almost a certainty given the Fed’s path toward higher rates. If it does, how important is a short-term dip caused by a brief slowdown or recession? Long term, the answer is not very much. Of course, declining expectations will result in short-term dips in equity prices. But real values attach to normalized earnings, the results a company can, should and will achieve in normalized times.
A stock is the present value of future years. There will be years of economic pain and there will be years of economic euphoria. There will be conditions, like Covid, that pull sales forward for some and delay them for others, but time will balance out these short-term shifts. Long-term values will depend on a company’s ability to grow, to manage costs, and to create a glide path to future profit growth. Therefore, if the S&P earnings for 2023 fall toward $200 but quickly rebound to normal in 2024, say around $240, stocks will react short-term, but long-term values will ultimately win out.
The real key, as long-term investors, is to know when any company’s normalized pattern is changing. When is 10-20% growth no longer sustainable? Are new products a propellant to future growth? When do management changes make a difference? Knowing the answers to these questions ahead of the crowd are much more important than a knee jerk reaction to any one CPI report.
Thus, I don’t know how the news of the next two days will shape the market near term, but I don’t think either event is very important long term. We know inflation is going to wane, and we know the Fed will keep money expensive for much of 2023. I still can’t conclude whether we face a slowdown or a recession. I do know that on the other side, demographics and productivity dictate that slow growth will follow. I must invest with that in mind. Finding great companies that can sustain above-average growth long term is my key objective.
Today, former tennis star Tracy Austin is 60. Former Olympic gymnast, Cathy Rigby is 70. Finally, Dionne Warwick turns 82.
James M. Meyer, CFA 610-260-2220