By now you have seen the numbers for the first half of the year. They don’t paint a pretty picture. It was the worst first half for equities since 1970, a year when Fed Chairman Arthur Burns sought to fight 6% inflation, a battle he eventually won, at least temporarily. More on that in a moment.
As Q3 begins, there are many signs that the pace of inflation is slowing. We are seeing it across most commodities. Yesterday alone, the price of a barrel of oil fell by about 10%. It won’t be long before that is reflected in the price of a gallon of gasoline. New homebuilders report a sharp drop in traffic. Prices are starting to roll over sequentially, although they remain sharply higher year-over-year. Retailers are losing pricing power. Restaurant reservations are down, again a function of sticker shock. We never doubted that the Fed would defeat inflation, but are a bit surprised how fast things are changing. These trends should be reflected relatively quickly as CPI and PPI numbers are reported over the next two months.
These trends are impacting both the bond and stock markets, but in different ways. Bond yields are declining across the board. The yield curve in flattening. Treasury yields from 2-10 years are essentially the same (about 2.8%). The curve threatens to invert soon, particularly if the Fed sticks to its game plan of raising the Fed Funds rate to 3% or higher by the end of this year and closer to 4% in the first half of 2023.
Stocks have been falling all year for three reasons:
1. Tighter money and higher rates have led to a purge of speculation. That process is in its late innings.
2. Higher bond yields lead to lower P/E ratios, an obvious headwind to stocks. With rates well off peak levels, that headwind is rapidly dissipating.
3. Earnings estimates for 2022 and 2023 remain too high. They are not based on a serious economic slowdown, margin squeezes, or a recession. This still has to play out. In our estimate, stocks today are discounting flat earnings for 2023 compared to this year. That’s possible but likely too optimistic. Note that while posted consensus earnings estimates from analysts still hover around $250 for the S&P 500 next year, markets are not buying that. Using a forward P/E derived from computing an earnings yield related to high quality junk bonds (stocks are the riskier class), it appears that the market right now is discounting earnings next year closer to $220. The obvious question is whether $220 is too high or too low.
To answer that question, one has to make certain assumptions about Fed policy. Based on statements made by Fed officials at the June FOMC meeting and the dot plots of participants, one could conclude that the composite thinking at that moment was that Fed Funds would be raised to somewhere close to 3.5% by early 2023 versus about 1.60% today. At the time Fed Chairman Powell suggested another 50-75 basis point increase in July, which could push rates to 2.25%. There are 3 additional meetings in 2022. Doing simple math one can easily see the path to 3% by year end.
However, the economic backdrop is changing rapidly. Housing demand has collapsed. Not only have commodity prices started to fall, but they are falling sharply. Supply chains are starting to heal. Consumer price resistance is rising. Said rather simply, supply and demand are coming back into balance a lot faster than perceived just a few weeks ago. The market gets this. All one has to do is look at changes in bond yields. Markets are now forecasting at least two fewer Fed Funds rate increases than it did a few short weeks ago.
We all know by now that the Fed was incredibly late commencing its fight against inflation. Indeed, for almost a year, the markets have been leading the Fed, setting the direction of interest rates before the Fed actually moved. That is why mortgage rates, not under Fed control, soared to over 5% before the Fed Funds rate got over 1%.
Unfortunately, it appears the Fed is still behind the curve, but in a different way. Markets see a weakening economy. They see the pace of inflation slowing. June CPI data doesn’t come out for another week, but more timely survey data, and real-time price changes, strongly suggest that inflation is going down. Markets further believe that if the Fed sticks to its game plan, raising the Fed Funds rate to over 3% while reducing the size of its balance sheet by almost $100 billion per month, it will do more harm than good.
There is a monetarist definition of GDP that says GDP = M x V, where M is the money supply and V is velocity, or the rate of turnover of money. Two years ago, M was growing at an annual rate of 20%+ as both Congress and the Fed were flooding markets with money to support an economy quarantined by Covid-19. As late as this past Fall, the growth rate was still 13%, even after many of the government handout programs had ended. Now it is 6%. That is about the pace of inflation. In a slowing economy, V is going to shrink. People and businesses hoard money in tough times, they don’t spend it. If the Fed sticks with its plan to pull $1 trillion or more out of the banking system, M growth will contract further. It could even shrink. You can do the math. If V falls and M either grows less than the pace of inflation or contracts, a recession would logically ensue.
That’s the bad news. The good news is that markets, staying ahead of the Fed once again, are predicting that Fed Funds rates may not get to 3% or more. If money supply growth continues to fall, Fed asset sales will become obvious bad policy.
Jerome Powell has always said that he was data dependent and any predictions made after an FOMC meeting shouldn’t be taken literally. They are always subject to change.
Thus, the message of the market is the following: The odds of recession are rising because the Fed started too late and was forced to slam on the brakes. Debt levels are massive, at the sovereign and corporate levels. 300 basis points of cumulative rate increases is simply too much. With the economy slowing sooner and faster than previously anticipated, longer bond yields may have peaked already. The same holds for mortgages. The fight against inflation isn’t over. Wages are still rising quickly and rising occupancy costs will show up in CPI data for several more months. There are still 2 jobs available for every unemployed American.
At the start of this note I mentioned Arthur Burns’ battle against inflation in 1970. He won that battle, but he didn’t win the war. After a brief recession the Fed and Congress stepped on the accelerator again. Then came the Arab oil embargo. Inflation came back with a vengeance. The Fed beat it down again after a nasty recession in 1973-74, only to get too accommodative once again when the economy rebounded. There is an obvious lesson here. While there are many differences between today’s economy and that of the 1970s, one fact is crucial as we peer past the inflation war being fought today. The U.S. cannot sustain growth higher than the growth rate of its labor force, combined with productivity improvements. There is little reason to believe that productivity can exceed 1.5% for a sustained period, nor can population growth exceed 0.5%. That suggests that sustainable growth that will not reignite inflation will be 1.5-2.0% at best in real terms (excluding inflation). That will be a tough pill to swallow.
Finally, I want to circle back to the market. A miserable first six months doesn’t have to be followed by a miserable back half of the year. So-called green shoots of optimism are starting to appear. The pace of inflation is slowing. We aren’t going to get back to 2% right away, but we are beginning to move in the right direction. Lower interest rates are support for the equity markets, particularly for high-quality growth stocks selling at reasonable multiples. The appetite for story stocks with limited revenues and no earnings simply isn’t there. There may still be a final flush of excess speculation.
A few key events lie in front of us. This week we will see a lot of employment related data. As investors you want to see signs that the frantic pace of hiring is over. Next week we will see June inflation data. The end of next week starts earnings season. This will be a very tricky one, dealing with ongoing supply disruptions, rapid cost increases, rapid shifts in demand, and the negative impact of a record dollar value. Finally, July 27 will conclude the next 2-day FOMC meeting. What the market really wants is for the Fed to start leading markets rather than the other way around. One way for that to happen will be to acknowledge the economic changes taking place today, the slowdowns in both demand and inflation, and a need to pay more attention to changes in money supply. Right now, what investors want to see is a slower pace of tightening and a better focus looking forward, not backward. The Fed raised rates 75 basis points last month, only days after the release of the May CPI report, a perfect example of looking backwards. May will almost certainly be the peak month for inflation.
Markets look ahead. Once investors conclude that the Fed will win its battle against inflation and can temper its pace of rate changes, they will react positively. They will do so even if there is a mild recession either underway or brewing. But if the Fed presses ahead with aggressive rate increases, as it promised in June, equity investors will likely face increased odds of a significant recession. That message wouldn’t be received well.
There is a lot to look forward to over the next three weeks, but by the end of July the vision of the near-to-intermediate term future will become a lot clearer, for better or worse.
Today, Kevin Hart turns 43. Both Sylvester Stallone and former President George W. Bush are 76. Finally, the Dalai Lama turns 87.
James M. Meyer, CFA 610-260-2220