Friday’s CPI report didn’t make investors happy. Led by sharply higher energy expenses, and the fastest growing shelter costs in decades, the message loud and clear was that inflation shows no signs yet of abating. Recognizing that government steps to curb inflation only began in March, the numbers we are seeing now weren’t impacted one way or the other by Fed Funds increases in rates to date, but the message was clear. It is going to be a long and persistent battle to get inflation under control. The initial surge was due to cumulative and excessively easy monetary and fiscal policy worldwide for over a decade. It took years for inflation to surge. It will take many months or even years to stabilize it. From Wall Street’s perspective, the picture can be both stark and simple. The higher and more persistent inflation may become, the tougher the medicine the Fed must apply. That means higher interest rates for longer and it means the risk of recession increases. The result, as of week’s end, is that the risk of recession has increased, an undesired consequence of the need to get inflation under control.
The Fed has barely begun to fight the war, at least when it comes to interest rate increases. So far, the Fed Funds rate has been increased twice for a total of 75 basis points, 0.75%. By mid-September, there will likely be 3 more 50-basis point rate increases, perhaps with a 75-basis point increase thrown in. The Fed Funds rate could then be 2.25% vs 0.75% today and that won’t be the end. There will be two more FOMC opportunities to increase rates before year-end.
While the Fed Funds rate is still under 1%, the Fed’s messaging of future rate increases has already caused rates from 1-30 year duration to surge. Two-year rates have already surpassed 3%. The 2-10 year spread is in danger of surging once again. The rapid rise in rates longer than one year has already impacted the economy. Demand for housing has fallen quickly. That will become more apparent in the months ahead as data begins to show a sharp slowdown in the pace of activity and price increases.
Home purchases are tied to lifestyle, but the decision to buy is deferrable. Groceries and gasoline are not. Consumer confidence may be ebbing, but Americans are still active spenders. Confidence surveys are at all-time lows. $5 gasoline will do that, but people aren’t staying home. They are traveling in record numbers, filling movie theatres once again, and eating out in restaurants. Unemployment is still 3.6%. “Only” 390,000 new jobs were created last month. There remain 2 job postings for every one person out of work. To repeat a point, I make repeatedly, inflation is a monetary phenomenon. It happens because demand exceeds supply. We may all have to drive, but if gasoline were $25 per gallon most of us would find other ways to get around much of the time. Ultimately, high prices will kill enough demand to rebalance supply and demand. Fed officials are correct. There is little they can do to increase supply. They can only achieve balance by reducing demand. By how much is unknown. A little bit means a soft landing. A lot means recession. The message last Friday was that the calming words that a slow steady increase in rates will bring inflation back to 2% without causing a recession ring hollow now. That doesn’t mean recession is inevitable, just more likely.
That was enough to send stocks sinking. The last two weeks have been the worst for the market since January. The Fed officially holds its FOMC meeting this Tuesday and Wednesday followed by a much anticipated press conference. While some are again talking of a 75-basis point increase in the Fed Funds rate this week, that seems unlikely. The Fed would like to stay on message as much as possible. But Jerome Powell could acknowledge that if inflation keeps rising through June and July, a path to higher rates sooner may be appropriate. He may also describe a path forward for the Fed Funds rate well into the fall. What the Fed doesn’t want to do is raise rates too far too fast while, at the same time, the economy starts to deteriorate faster than hoped. Given the lag time between policy implementation and impact, that becomes a tough judgment call.
So far, I have been discussing the path of interest rates. Wall Street will follow the path for earnings just as carefully. That prospective outlook isn’t getting prettier given the persistence of inflation, ongoing supply chain issues, and a downturn in demand for consumer goods. The supply chain problems aggravate the outlook for earnings in two ways. First, they create shortages that decrease supply, causing imbalances, higher prices, and less demand. Second, in anticipation of supply chain problems, buyers must stretch lead times. When a retailer, for instance, must buy 6-9 months ahead rather than 3-6 months, the odds of making mistakes, either in quantity or selection increase. That problem came into focus recently as we learned that both Wal-Mart and Target had too much inventory and too many items that were now out of favor. Car dealers would love to fill lots with big profitable SUVs, but will their popularity wane with $5+ gasoline?
Thus, profits are already getting hit from several directions. Demand for goods are decelerating. Under that environment, passing on higher costs becomes more difficult, and longer lead times mean more mistakes. The offset, so far, has been surging demand for services and experiences. But after all the catch up vacations this summer and over the coming holidays, will Americans be willing to pay the price for airline tickets they are willing to pay today? Second quarter earnings season begins in mid-July. It will be a solid quarter overall but there will be pockets of weakness as we saw in the first quarter. Moreover, managments are likely to offer sober outlooks for the rest of this year. As the economy slows and inflation persists, it is hard to make the case that analysts will be raising earnings forecasts for the balance of this year and next.
Right now, with the S&P 500 sitting around 3900 and earnings estimates for this year near $225-230, the multiple sits at about 17, slightly above historic averages. But even after the recent rise in interest rates, the market cap rate is lower than historic norms, suggesting stocks are fairly priced. The key is next year. At the moment, earnings forecast consensus is close to $250, a gain of almost 10% from this year. My crystal ball says that seems highly improbable. Real growth next year would be lucky to be 2% and that assumes a soft landing. A 10% growth in earnings assumes some widening of profit margins, hardly likely in a world of decelerating demand. Most economists don’t expect the Fed to start cutting rates until 2024 assuming inflation is back to targeted levels. 2024 is too fuzzy in my crystal ball, but 2023, at best, seems to be a tepid year with decelerating inflation, but there are ranges around that outlook. If the Fed is still behind the curve a year from now, then we will be hearing the word stagflation a lot. If the Fed succeeds in bringing inflation down by stepping on the brakes too hard, then 2023 will be a recessionary year. In either case, I think $225, or flat 2023 earnings, is a more conservative forecast. If there is a recession, the number could be closer to $200.
Thus, here’s my bullish case. Earnings reach $250 next year and the multiple stays near 17. That yields a target of 4250 in the S&P 500, 9% above current levels. On the other hand, should earnings fall to $225 and the P/E falls to 14, a bit below average but consistent with bear market bottoms, my target would be 3150 or almost 20% below current levels. That would mean a 40% bear market from peak to trough, an above average decline, but not extreme. There is room in between. For instance, if earnings are $235, nominally higher than this year, and the multiple simple falls to 15-16x, a bottom near 3650, or another 6-7% is a conservative but reasonable expectation.
Putting this all together, the near-term bias is still to the downside. This week, there are several headline events. Today, is a bear market Monday after an extreme late week selloff. Traders will be hoping the lows of three weeks ago hold. Wednesday is the conclusion of the FOMC meeting, always a market moving event. Powell is likely to be hawkish without being alarmist. He likely will argue for a path of steady rate increases over the coming months. We’ll see whether that placates investors. They weren’t placated after the last FOMC meeting. We will also get important economic data this week on housing (likely to be bad), producer prices (bad as well) and retail sales. As noted, a month from now starts earnings season. Again, the risks are to the downside. In particular, I would expect the stocks selling at multiples of revenues rather than earnings to continue to get trounced. The purge of speculation isn’t complete.
Previously, I had suggesting that the adage “sell in May and go away” may apply this year suggesting a flat volatile summer for the stock market. Last week’s report that inflation is stronger and likely more persistent moves that needle directionally downward.
Since this is all about a war against inflation, what will turn the market around is any sign that inflation is starting to abate. There may actually be some early indications of just that. Although the reported data to date suggest housing prices continue to surge, that is probably coming to an end. Mortgage applications are way down. Builder lot traffic is slowing. Prices aren’t falling but they certainly aren’t rising nearly as fast as they were three months ago. Retailers overstuffed with inventory must mark down the excesses. Auto manufacturers are starting to receive the semiconductors they ordered. While other supply chain issues remain, car lots should start to get restocked in the fall. That will abort the sharp rise in used car prices. Gasoline prices are still rising, but they should peak before the end of summer. Higher interest rates and high prices are the cures for inflation. They just take time.
2023 is not going to be a repeat of 2008. Banks are in great shape and so are consumers. There is an obvious cure to the inflation problem. With that said, equity valuations were more extended in 2021 than in 2008. Speculation simply got out of hand. A good part of that has already been squeezed out of markets, but there is a way to go. Uber, for example, still sports a valuation close to Ford and GM even though its economic model still produces no profits. The spread in costs between a ride with Uber and a conventional taxicab keep rising. Food delivery costs are wages and fuel, both surging. If there is a business more commodity like than food delivery, let me know. Yet there are 45 analysts that have a Buy rating on Uber versus 4 that say Hold. None say sell. That doesn’t leave a lot of margin for error. The point is that a 30-40% bear market is possible without a serious recession. Note I said possible, not probable. It is rare for a bear market to fall 25% or more without a recession. The last time that happened was 1987, 35 years ago.
Bottom line: I continue to believe this is a time for caution, at least until we get persistent positive signs that inflation is moving in the right direction. The Fed will tighten, sell assets, and take the right steps. No matter what steps it takes, the damage from too much easy money for too long has been done. Eradicating it will take time and involve some degree of pain. Markets are already down close to 20%. Some of the pending damage has been discounted. Maybe most. It’s too early to tell, but last week told us the battle is likely to be longer and tougher than previously thought. That isn’t the signal investors want to hear.
Today the Olsen twins are 36. Chris Evans is 41.
James M. Meyer, CFA 610-260-2220