Markets don’t normally move or overly react to monthly CPI reports. That is, until Covid hit global economies, leading governments and central banks around the world to print money hand over fist. Demand for goods and services rose while supply chains collapsed. Now we’re left with old policy tools attempting to fix undesired side effects. Concerns mount as to how aggressive this tightening cycle needs to be in order to get supply/demand back in balance and bring inflation down towards a stated goal of ~2% from a currently sky high 9%, all while not throwing the economy into a severe recession.
June’s CPI report was another worse than expected update that creates even more confusion with respect to the Fed’s path. Granted, this is old data and came during the middle of June, prior to an epic collapse in commodities and, most importantly, oil prices. However, new vehicle prices restarted their ascent. Supplies are not getting better quick enough. This impacts used car and auto repair prices as well. Clothing prices showed a shocking jump, disagreeing with industry comments from Walmart# and Target# that inventories are bloated and discounts are here. Walk around any mall in America and you’ll see “For Sale” and “Clearance” signs everywhere. Even though corn, wheat, soybeans and many other ingredients are well off their highs today, they also were surprisingly elevated for June’s report. Again, backward looking, but still worrisome to a Federal Reserve that is trying to get their hands around a situation they helped create.
Fed Fund futures, which are very volatile these days, now put a 50/50 chance of a 100bps rate hike in two weeks, along with another 75bps in September. This would put Fed Funds in the 3.25% – 3.50% range in a few months. That would be more rate increases in three meetings than what occurred over three years during the last tightening phase. As you may recall, this led to a 20% stock market correction in the final quarter of 2018. To say the markets can’t handle higher interest rates would be a massive understatement. Further, the yield curve is becoming increasingly inverted. The current 10 year / 2 year Treasury spread is negative 19bps. It has been as high as 27bps this week, levels not seen since the popping of our Y2K bubble. If the Fed follows through with projections, the entire spectrum could be below Fed Funds. That has always ended up with a recession (which we technically may already be in if Q2 GDP is negative).
In response, stocks priced in a stronger slowdown. After a decent drop on Wednesday morning, they regained footing to finish nearly flat on the CPI report day. An impressive feat after such a disastrous (backward looking) CPI number. Yesterday brought forth more aggressive selling in the morning hours, pretty much across the board. Oil and commodities keep free falling. Light crude has gone from $130 to $87 in short order. Copper has collapsed 35% recently as well. In recessions, hard commodities normally lead to the downside as demand dries up. Lackluster earnings reports, led by JP Morgan#, pushed banks and financials to a ~2% loss. We also know what happens to banks in a recession, as loan demand and issuance dry up and credit/mortgage/auto payments are deferred or default. This crushes earnings for almost all financially related entities.
The rest of the market staged another day of impressive action with the Nasdaq finishing positive after falling 2% early in the morning. Semiconductors led the charge higher following positive comments from industry leading manufacturer, Taiwan Semiconductor#. Even with the impressive rebound, 75% of stocks finished in the red Thursday.
The next Fed meeting in two weeks becomes another headliner. It is clear the economy is slowing. Buyers are stepping away from finished homes at an alarming rate. Job postings are down 17% across the country and are negative in 47 states. Unemployment claims are rising. Commodity prices have come down quicker than they went up. Stocks are in a bear market. Periods of inverted yield curves are precarious times to be an investor. Oil remains in tight supply, but U.S. gasoline demand is well below historic norms. Wages are slowly retreating from their torrid pace. To me, all of this adds up to a quickly slowing economy. If inflation weren’t so elevated, one might think the Fed would be cutting rates, especially if leading indicators continue to decline.
Instead, we’re left with more questions than answers. A few months ago, the Fed had a plan to front load a few rate hikes, then move to small increments while letting the process flow through the economy over the next year. Remember, rate cuts/hikes typically take 6-9 months before making an impact. May’s inflation report pulled forward those rates hikes, resulting in 75bps instead of 50bps in June. Now investors are contemplating 100bps in July and another 75bps in September. Front loading is one thing, but this aggressiveness could prove to be too destructive, leading to a deeper recession than priced in already. A Fed policy mistake is looking like a foregone conclusion. Their track record is littered with them. The question is how much damage will they inflict and for how long. Fed Fund futures are now calling for a peak in rates by December and rate cuts early in 2023!
However, much of the potential recessionary damage is already done. Markets know, and have priced in, most of what I’ve detailed here. The S&P and Nasdaq are down 22% and 31%, respectively, from January highs. These are the worst starts to a year since 2008 and could rank in the bottom 5 of all-time with any more declines. The Consumer Discretionary and Financial sector benchmarks are down 35% and 27%. Interest rates spiked earlier in the year, but the 10-Year Treasury yield is down 50bps in a month. Balanced portfolios (60% equities / 40% fixed income) are down 16%, on pace for their worst year ever. Consumer sentiment, due to rising costs, are at all-time lows. Bearish advisors are everywhere.
All of this adds up to a lot of bad news already being priced into markets. Predicting short-term moves, or trying to market time an exact bottom, has always been a difficult task to consistently implement for even the most proven professionals. Prior starts to years with performance like 2022 brought forth a reversal and improved returns. The biggest mistake one can make today is selling everything and sitting in cash or a CD. Invariably, that move misses the reentry point and the investor winds up buying back at higher levels or never again. Temporary volatility is quite normal, as are recessions. Most successful investing requires patience, sticking to an asset allocation and preparing for long-term wealth accumulation.
Here is an interesting graphic from Charlie Bilello detailing previous market corrections and follow-through:
This makes pretty good sense too. It is widely known that investing in stock markets at high P/E or Price to Sales levels yields subpar returns. After significant corrections like we just had, valuations come down. The average stock now trades at 13x earnings. Forward returns look a lot better than before based on price and valuation alone.
Granted, the risk remains that a Fed overshoot creates something more than a slight recession. That is an unquantifiable event. What we do know is that decades of investing shows what works and what doesn’t. Now is not the time to run, but pay strict attention to your asset allocation. We would still keep some powder dry for opportune entry points into favored names as we wait for confirmation of a final bottom and line of sight to the end of this tightening cycle. Now that interest rates are higher, should bonds be a larger part of your portfolio? Are stocks that you own positioned for the future and a leadership role? It has not been pretty, but cleansing years bring forth opportunities…over the long haul.
Comedian Gabriel Iglesias turns 46 today. Oscar winner Forest Whitaker is 61.
James Vogt, 610-260-2214