Stocks staged an afternoon rally yesterday, erasing early losses. For the week to date, stocks are still in the red after falling 9 of the past 10 weeks. But the sickening pace of decline witnessed in April and early May has given way to a more volatile sideways pattern with a slight downward tilt. If you look at the list of stocks reaching new highs, it is populated with energy stocks. The list of stocks reaching new lows, which was huge weeks ago, is now mostly filled with companies that have disappointing fundamentals.
The big corporate news yesterday came from Target. It said that steps to clear excess inventory will be big, quick, and expensive, more expensive than the company suggested just a few weeks ago. That didn’t reflect a change in traffic or sales patterns. Rather, it reflected a change in corporate strategy to fix mistakes quickly and move on to what could still be a healthy holiday season later this year. Target’s stock still fell on the news, but the collateral damage to other retailers was limited. The big economic news this week will be Friday’s CPI report. While analysts will fuss as to whether inflation has peaked or not, the rest of us simply must look at what we spend every time we fill up our car, pay our restaurant bill, or go to the supermarket. Yes, I know that purists look at inflation ex-food and energy, but the rest of us don’t. The good news is that economic activity remains robust. Some retailers have the wrong assortment, other companies are still dealing with supply chain issues. But simply go to the airport or visit any popular tourist destination and you will know that collectively we are all having a good time. Some of us may be eating into our savings a bit, but that’s a story for another day.
The bad news is that because we are all seeking good times simultaneously, supply can’t keep up with demand. When that happens, you get inflation. Inflation is accelerated by supply chain issues that remain and the impact of the Ukraine war on key commodities such as oil and wheat. As the impact of war continues to erode Russia’s infrastructure and their ability to deliver oil, supplies will take a further hit. Blockades in the Black Sea are limiting wheat exports, and we see the impact via higher wheat prices. Other poorer nations see the impact via less food. The problem is still getting worse, not better.
With all this happening, the Fed is getting ready for next week’s FOMC meeting. We know the outcome already. Fed Funds rates will rise by 50 basis points, with a promise of at least another 50-point rise in July. Depending on the inflation data we see between now and then, Chairman Powell will hint at policy beyond. If the inflation numbers stay elevated with no sign of abating, he will lean toward further 50 basis point increases. Right now, Fed Funds futures are pricing in a peak rate in the neighborhood of 3.25% early next year. That is clearly a moving target. It can move a lot between now and then. As it moves, so will the stock and bond markets.
I keep saying it is too early to judge the ultimate outcome. Assuming the Fed lives up to its commitment to defeat inflation, that part is easy to predict. Whether inflation recedes all the way to 2% is still a guess, but the war won’t be won until inflation is below 3% for some period at a minimum. The bigger question is the economic damage required to get there.
There are lots of variables. At the moment, the biggest may be the impact on world supplies from the Ukraine war. Russian oil exports have declined, but they are still robust. However, Western oil service companies have departed. Russia doesn’t have or make the equipment or infrastructure necessary to sustain the oil fields in place. War could potentially disrupt pipelines temporarily or permanently. In short, Russian output will continue to decline. Replacing a million barrels per day in a world that consumes over 90 million barrels per day may not seem that difficult, but it takes time to build production in an industry where annual depletion of existing fields can reduce output by 3-5 million barrels per day. If Russian output declines further, the problem only gets larger. I could do the same math for natural gas. You get the point. Prices for gasoline will likely peak early this Summer in front of seasonal declines in demand, but don’t expect $3 gasoline anytime soon.
Miraculously, Ukrainian farmers have produced a wheat crop during wartime, but most of the wheat can only reach market via the Black Sea. The country’s only remaining major seaport is Odessa. The Russian Navy is blockading ships from moving out. World outrage is growing, but it’s up to Putin whether the wheat can get to market or not, unless the West wants to escort ships out and risk direct confrontation. Judging the outcome is not a task for an investment analyst like myself.
Politics and war aside, where we are today is a world with healthy demand, constraints on supply, a full employment workforce, and simply said, an imbalance of supply and demand. The Fed is in the very early stages of dealing with these issues. Higher long-term rates, and the pending runoff of mortgage debt from the Fed’s balance sheet, have already lifted mortgage rates to over 5%. Housing demand has started to decline. The pace of price increases is starting to slow. As an unintended consequence, however, the higher rates are also reducing the supply of homes available for sale. Owners of existing homes with 3% mortgages must think twice about cashing in on high prices and moving. They may get more money for the house sold, but where are they going to go? Rents are skyrocketing, and if they plan to buy another house, those prices are elevated as well. Plus, the new mortgage of 5%+ means the new monthly payment may exceed the old one. Home prices won’t go down until demand falls faster than supply, if that happens at all.
One impact of supply chain issues is that businesses must order farther ahead to have goods to sell. In industries where demand can vary seasonally or due to other changing factors, that’s a challenge. Target and Walmart have made that point in spades in recent weeks. But let’s look forward and move to the auto industry. We all know dealer lots have been bare due to the shortage of key components like semiconductors. But what we collectively wanted to buy two years ago may be very different than what we may choose to buy later this year, or early next year when dealer lots are restocked. Americans loved their large SUVs. The auto companies loved them as well. They were their most profitable products. But a year ago gasoline was under $3. By next week it will be over $5, up to $10 if you live in California. Will we still buy cars that require over $100 spent at every fill up? I don’t have the answer and neither do auto dealers. The risk of a similar inventory mismatch that we see at Walmart and Target is increasingly likely. I mention retail and autos because we can all relate to what I say, but the problem isn’t relegated to these two sectors. It heightens the economic risks that all companies face going forward.
Which leads me to a conclusion. All the disruptions and changes happening in our world elevate risk. In the investment world, risk isn’t good. We don’t know whether we face a soft landing, a modest recession, or a more severe one. Will the Ukraine war still be a huge cloud a year from now, or will it be resolved in some fashion? China will reopen for sure, but what will its steady-state growth rate be post-pandemic? Even if a soft landing is achieved, what will be the impact of less globalism and changing supply chains? Finally, how does a central bank lick inflation without creating slack in the labor force? Can it create just enough slack to slow wage pressure without some significant rise in unemployment? I would say the odds of that happening aren’t very good. In short, while it may be too early to adjust 2023 earnings estimates, the risks to those numbers are elevated, and to the downside. The equity markets may have already discounted the future course of interest rates, but one must question whether they will need to lower earnings expectations as well.
The worst part of this year’s stock market decline came during Q1 earnings season, yet overall earnings expectations actually rose. What caused the disruption were some high profile misses from giant names like Amazon#, Netflix, and the aforementioned retailers. There will be other misses next quarter, not necessarily the same names. We are learning that adjusting to changing times is difficult. It will get more difficult as the economy’s growth rate slows. It will also get more difficult as the M2 money supply slows. Indeed, it already has, from a 13% pace last Fall to under 5% today. Money supply is controlled by the Treasury, not the Federal Reserve. The money supply has dropped because of less elevated Federal spending (with the end of Covid-support payments), combined with burgeoning tax receipts thanks to a booming stock market in 2021. Excess reserves in the banking system are already down by over $1 trillion, and that is before the runoff of the Fed’s balance sheet begins. That helps to explain the purge in speculation. If the money supply continues to grow at 5% or less while inflation is 8%, it doesn’t take a genius to figure that won’t support real economic growth. The Government is finally doing its job to attack inflation. The battle will take months, maybe years. The only cure is to rebalance supply and demand. The only way the Government can attack that problem is to reduce demand.
By Fall, the outcome of that battle will be clearer. Inflation will be falling. Demand will be softening. What we don’t know is the pace and the end points. Ideally, we want to see nominal inflation fall below 5-6% and core inflation recede to 4% or less. At the same time, we want to see real GDP growth stay positive. The manner in which the evidence stacks up with our hopes will determine where stocks are headed after Labor Day.
I want to end with a bit of a rant. Peter Rawlinson is the CEO of Lucid Group, a new company that is building high-end luxury electric cars. In 2021 he was paid over $500 million, mostly via restricted stock. As reported in today’s Wall Street Journal, much of his restricted stock grants have already vested. To put this into perspective, Lucid last year lost $4.7 billion. In the first quarter, it shipped 360 cars, or about 4 cars per day. It has already slashed its expected output this year due to supply chain issues. I have no idea whether Lucid will ever earn a dime. I understand giving a CEO big incentives, but why not tie them more closely to key economic metrics? Like not losing $4.7 billion. Like meeting or exceeding production schedules. Lucid may be the next Tesla, or it could also be the next DeLorean or Bricklin. Why should any CEO be paid so much money upfront? Wall Street is properly focusing on making money, generating free cash flow, and returning money to owners. No wonder Lucid’s stock is more than 65% below its 52-week high.
Today, Kanye West is 45. Nancy Sinatra turns 82.
James M. Meyer, CFA 610-260-2220