Stocks fell again on Friday as equities declined for the fourth straight week. A combination of inflation fears, and economic concerns related to the Russian invasion of Ukraine continue to weigh on the market.
While war news still dominates headlines, Wall Street attention will likely shift to Wednesday’s Federal Reserve press conference following the conclusion of the two-day FOMC meeting that afternoon. Chairman Powell has stated his intent to ask the Committee to authorize a 25-basis point increase in the Federal Funds rate. That is now a foregone conclusion. Prior to his statement recently, there had been some suggesting the Fed would start a series of rate increases with a 50-basis point move. That could be discussed briefly but 25 is baked in the cake. The keys that every investor will be watching is what Mr. Powell says about the path for future increases and when he might lead the FOMC to start reducing the size of the balance sheet.
The Ukraine war and its economic impact could work to slow US economic growth. In that sense it is doing the Fed’s work, but the real focus, for now, is to get inflation under control. The war is only serving to make inflation worse curtailing supplies of key commodities. While the Fed itself can do little to change supply in either direction, raising rates, and selling assets will dampen demand and soak up excess monies Congress and the Fed have poured into the marketplace in recent years. While the Fed was expansionary for more than a decade before the pandemic, it accelerated its pace during the Covid-19 crisis and continued to do so right up to last week. Congress added more fuel to the inflation fire authorizing more than $5 trillion in spending. President Biden and the Democrats in control of Congress would gladly spend trillions more if they could. To be sure, they will try, but they won’t have much success under current circumstances.
While some suggested even as recently as a couple of weeks ago that the Fed could back off its pace of rate increases thanks to the war, today that doesn’t appear to be the case. The Fed has a dual mandate of price stability and economic growth. Its goal is to bring inflation back toward its long-term 2% goal without causing a recession. Slower growth is OK; recession is not. Given the time lag between interest rate increases and their impact on the economy, it is tough to gauge how aggressive to be without endangering the economy itself. Economists rate the odds of recession at 25% or more next year or in 2024, but I caution that economists’ crystal balls are notoriously inaccurate the farther out they look. Think of weather forecasts as an analogy.
What we do know is that both the economy and inflation are strong today. Barring further major escalation of economic sanctions, the worst of the war related price spikes may be behind us already. Oil touched $130 per barrel last week. This morning it is just over $100. Other commodities that spiked are also leveling off. It may take another couple of weeks for gasoline prices to recede and they will go higher before that happens. To put that in perspective, I will use a personal case. My car gets about 24 mpg. I drive 24 miles round trip every day to work and back. That’s $5 per day versus about $3 before recent spikes. Assuming 250 working days per year, that means my cost increase by about $500 dollars per year to commute. I could take the train and save $1250. That’s a choice I probably don’t want to make but some will if dollars trump inconvenience. We see this same dilemma playing out throughout the economy. Americans may eat at home more versus dining out. They may buy a few less new clothing items. Three plane trips per year to see family may become two if airfares stay elevated. If those substitutions are made, they should show up rather quickly, certainly before the arrival of summer. So far, however, (and it is very early) they haven’t appeared. We’ll know more in another week or two.
For now, I would expect Fed Chairman Powell to hedge his future bets by not committing to a specific number of future rate increases. Rather he is likely to say that, at the moment, bringing down inflation is the focus. The Fed will keep a close eye on the economy but beating inflation and bringing it down before it becomes embedded in future expectations is key. To that end, while interest rates have resumed their increases over the past week, they still indicate strongly that long term inflation expectations are still well contained. The 10-year Treasury yield this morning of 2.07% is a multi-year high but far below peaks of recent years when inflation was barely over 2%. The 2-10 year yield spread, while declining, is still quite positive. The bond market isn’t flagging a recession yet. So far, so good. Hopefully, Powell will reiterate the Fed’s commitment on Wednesday and markets will be content, at least for now.
A lot of talk has been made about a Fed put. That means that if the Fed becomes scared that markets are going to drop sharply or there are signs of economic weakness, the Fed will surrender its fight and do what is necessary to stabilize markets. In the fall of 2018, after the Fed increased rates for the fourth time in a year, markets fell sharply. The Fed quickly retreated and started to lower rates again seeding the inflation that was to come, but this time may be different. Today’s unemployment rate is 3.8%. GDP growth lately has been 2x historic norms. Supply chains are constrained, in part, by too much demand. Inflation is almost 8%, not 2%. The Fed knows that if it gives up too soon, as it did in the mid-1970s, inflation could get out of hand. That doesn’t mean markets can get so bad that the need for liquidity will trump all else. I don’t think a 10-20% market correction will be enough to force the Fed to deviate from its game plan. The risk of a mild recession is less than the risk of runaway inflation. What complicates matters is that this is an election year, but recession this year is unlikely in any case. Demand is simply too strong and there is too much excess money sloshing around that can be tapped.
Two other points to note. The first is the war. It continues with no end in sight. Russian power and its brutality point to further advances. As we have all learned in our wars in Vietnam, Iraq, and Argentina, conquering territory and occupying a country where one isn’t wanted are two very different situations. Russia has the capability to obliterate Ukraine with great loss of life on both sides, but it will never be viewed positively. Occupation will be expensive and deadly. Putin now knows that. I don’t know how that changes his long-term plan. Presumably no one does but Putin. Rational arguments may not apply here. For now, markets have adapted to the likely economic consequences, but the unknowns can be market moving in either direction.
Lastly, I want to mention Covid-19. It has fallen off the front page, in part due to war news and in part due to the fact we are well past the peak in new cases, hospitalizations and death, but the same isn’t true in China. There, new cases are reported at about 3,000 per day. They are probably much higher. China’s zero tolerance policy is locking down cities again. The culprit is an Omicron variant, highly contagious. If one member of a family gets sick, his isolation is likely to impact his whole family. China has weak vaccines and little herd immunity. Thus, Omicron is fading throughout much of the world, it will impact Chinese production for weeks. That could be bad news for companies like Apple# that do much of their manufacturing and assembly work in China.
We are in a period where there is usually a vacuum of corporate and economic news. There are still more than 2-weeks to go before the end of the quarter, but this has not been an ordinary quarter. January saw the peak in the Omicron surge. The war started in February. Companies pulled out of Russia in March. All these had economic consequences. I expect a sharp increase this quarter in earnings preannouncements. They could start as early as this week. The key is how much of the bad news is already priced in. If stocks shrug off any bad news, that would be a good sign. Visa versa, if downward revisions in earnings forecasts force further stock declines, any hint that a bottom in the stock market is near may evaporate.
Today, Simone Biles is 25. Steph Curry turns 34. Billy Crystal is 74 while Michael Caine reaches 89.
James M. Meyer, CFA 610-260-2220