Stocks fell across the board yesterday as fears of recession rose. Bond yields fell.
Today marks the conclusion of the Fed’s FOMC two-day July meeting. Anything but a 75-basis point increase in the Fed Funds rate would shock investors. The Fed doesn’t like to shock investors, but like all FOMC meetings, the actual rate decision is simply a prelude to what’s to follow in Chairman Powell’s post-meeting conference.
After the last few meetings, Mr. Powell has reasserted his laser focus to defeat inflation. But now everyone on the planet, including Mr. Powell, recognizes that the Fed should have terminated its bond purchase program sooner and started to raise interest rates before March. With the CPI up over 9% in June, clearly the data to date has been frustrating for those battling inflation. Since the last FOMC meeting in June there have been increasing signs that economic growth is slowing. Housing activity is declining. Retail sales are up, but almost all due to price. The slowdown is uneven to be sure. Travel is still very strong, and Americans are happy to be going back to venues, whether it be concerts or weddings.
The slowdown in demand has demonstrated itself via a rather sharp reversal in commodity prices. Gasoline prices are down well over 10% in a few short weeks and will likely fall below $4.00 per gallon soon. Wheat futures are now below where they were before the war in Ukraine began. Lumber prices have been cut in half. All this will be reflected when both July and August price data is released. Indeed, it is quite possible that the headline CPI for one of those months could actually decline.
A short-term sharp reversal in commodity prices doesn’t mean the inflation battle is over. Wages are still strong. While unemployment claims are rising, monthly job growth in June was still well over 300,000. Housing prices have flattened, and even declined in some markets, but rents are still rising.
At times I have talked of the monetary view of GDP. Preliminary second quarter GDP data will be released Thursday morning. It will likely show little or no growth depending on the relative size of our trade deficit and quarterly changes in inventories. Building inventories adds to GDP, liquidation does not. Traditionally, one thinks of GDP as the sum of consumption, investment and government spending. A monetarist takes a different view. They look at GDP as the product of the amount of money in the banking system (mostly bank deposits and money market funds) times the rate that money changes hands, which they refer to as velocity. At one point, during the peak of the pandemic, when our Government was bailing out companies, funding PPP loans (most of which were never paid back), doubling unemployment payments, bailing out airlines, and parceling out child credits, the money supply grew at an annualized rate of 21%. Even last Fall the rate of growth was still over 13%. Since inflation is purely a monetary phenomenon, is it no wonder that a year or so later inflation was 9%+? The only reason inflation wasn’t higher was that so much of those handouts sat in banks since the recipients couldn’t readily use it all. No weddings. No trips. No new fancy clothes. You get the point.
Those handouts (almost $6 trillion cumulatively) have stopped. M2 (the most used measure of money supply) in May grew at a bit over 6%. That’s consistent with inflation back down below 3%, perhaps a year from now. The Fed says, furthermore, that it wants to reduce its balance sheet by almost $100 billion per month. Should it actually do that, draining more than a trillion dollars out of the banking system in the process, M2 might even go negative for a period of time regardless of how high short-term interest rates go.
I don’t expect that the Fed will stop raising interest rates this week. Not only does it want to defeat inflation, but it wants to keep it from coming back. That requires a certain level of slack. It took Paul Volcker over two years to do that in the early 1980s, while enduring two recessions.
Balance could be restored via some combination of lower demand and higher supply. The Fed claims that it has no control of supply. Thus, it is focused entirely on reducing demand. That isn’t entirely true. In some cases, less demand will unstick some of the supply chain problems. Car manufacturers, for instance, are starting to get the chips they need to complete cars. Dealer inventories will get restocked over the next several months. Homebuilders will be able to complete a house in 9-10 months rather than 12-15 months. That will save a lot of labor time. One should also note that Congress recently passed a $1+ trillion infrastructure bill. All those new roads, bridges and airports won’t be up and running next week, but over time they will make business more productive. If all goes well, within days President Biden will be able to sign a $50+ billion bill to support the construction of new semiconductor plants on our soil. Close to $10 billion will go toward the development of advanced technologies, from fuel cells to quantum computers.
Simply said, things are moving in the right direction.
That doesn’t mean there won’t be a few sinkholes before the skies clear. Companies are losing pricing power. That will squeeze margins. An economic slowdown means lower demand. We heard that again this week from Walmart, and from a broad range of tech companies. As noted earlier, slowdowns tend to be uneven. Some businesses are affected sooner than others. Some more than others. A few aren’t affected at all. That is becoming apparent during earnings season.
All this begs the obvious question. Are we in for a soft landing or a stiff recession? That depends on how fast inflation subsides. It depends on how quickly and how far the Fed raises rates. Mr. Powell will set the table for the next FOMC meeting at his press conference this afternoon. Last time he offered a range of 50-75 basis points for a presumed rate increase in July. 75 basis points seems pretty definite, as noted earlier. He will acknowledge the declines in commodity prices for sure, but likely won’t offer any predictions for the CPI reports to come. My best guess is that he will offer the 50–75-point range again for September, but leave himself wiggle room in either direction. Transitional moments are not the time to be writing strategy in ink, but that still leaves a path to 3% or more by the end of this year, consistent with previous guidance. Commodity prices are not likely to fall as fast as they have recently over the next couple of months. The problems in Europe and Ukraine aren’t going away. Getting inflation below 3% is the easy part of the battle. Keeping it there during the next recovery is the hard part. That is unlikely to happen with unemployment close to 4%. It will be encouraging over the next few months to see inflation decline from a 9% peak. Creating the necessary slack will cost jobs, reduce sales growth and squeeze margins. Managing a company through that quagmire won’t be easy. As Walmart showed Monday evening, the best-in-class won’t avoid all the potholes. When you reach the top of the mountain it’s all smiles, but mountaineers will tell you that the descent can be the most dangerous part.
As we have been noting for some time, it isn’t the results that matter, it’s how they compare to expectations. This is the biggest week for earnings. Several kingpins reported over the past 24 hours including Microsoft#, Alphabet#, Visa#, General Motors, McDonald’s# and GE. Of those just named, only McDonald’s had a sterling quarter. Its shares rose. For the others, maybe the best way to describe results is mediocre. In almost all cases, the results were no worse than what had already been priced in. After the first quarter, earnings season was a minefield. So far this quarter, despite generally tepid results, there have been very few disasters. Walmart, which also shocked investors after Q1, is the one obvious exception.
Does that mean we can become more optimistic next quarter? Not at all. The equity markets had a horrid second quarter, in large part ratcheting down expectations for future earnings. Now the question becomes whether they have been ratcheted down enough. That will depend on the track of our economy. Which brings us back to the uncertainty we have been dealing with since the Fed started to tighten. Will it be a soft landing with flat or modestly declining earnings? Or will it take higher rates for a longer period to defeat inflation, creating a sharper recession in the process? We didn’t know the answer 4 months ago and we still don’t. There are still some big companies that will report this week and next. If yesterday’s experience is instructive, expectations are closer to reality today than they have been for many months. We are far from saying “all clear”, but at least corporations, the Fed, and investors seem more in synch today than they have been in some time. That should offer some relief.
Today, Maya Rudolph is 50. Peggy Fleming turns 74.
James M. Meyer, CFA 610-260-2220