Stocks resumed their upward march yesterday despite further increases in interest rates.
“We made a mistake.”
How often do you hear anyone in Washington say that? Hardly ever. Federal Reserve Chairman Jerome Powell said that in a speech this week, and he said it in crystal clear fashion. The Fed thought there was slack in the labor market when there wasn’t any. It thought inflation was transient when it wasn’t. It failed to understand that all the quantitative easing done during the pandemic, combined with $5+ trillion in authorized incremental fiscal spending, would ignite demand. It saw a transition in GDP from goods and services that hasn’t happened fully to date.
As a result, inflation was both fiercer and more enduring than believed just a few months ago. In hindsight, the Fed should have moved sooner.
But that is all water over the dam. It can’t go back, but what it can do is recognize its mistakes, change course, and fix the problem of inflation that is running way too hot. To make matters worse, the Ukraine war has added oil to the fire, accelerating inflation’s pace by restricting the supply of key raw materials like wheat, oil, and precious metals. The full impact of those shortages may still be ahead of us.
As a result, the Fed has made it clear that the fight against inflation now takes total precedence. The Fed has a dual mandate of maintaining price stability and full employment simultaneously. But price stability is now so out of whack that getting inflation under control could require it to induce some economic slack and some increase in unemployment. Simply said, it will try to soften demand enough to balance pricing and hopefully avoid recession. But if a recession is necessary to regain control of pricing, it is a cost the Fed is willing to endure. At least that’s today’s mantra.
The bond market is getting the message. Yield curves are flattening. Some portions of the curve are starting to invert, a sign that bond traders believe a recession in 2023 or 2024 is increasingly likely. So far, equity investors are not as convinced. Last week, after the FOMC met, Chairman Powell seemed more confident that a recession could be avoided. The Fed only increased interest rates by 25 basis points. This week, he said 50-basis point increases are on the table at one or more meetings this year. That suggested the Fed Funds rate could reach 2% before year end. Stocks wavered for a few hours Monday before rallying in the afternoon.
Stock markets operate in a nominal world. Inflation can bloat revenues and profits if higher costs can be passed through. The key word there is IF. At some point, buyers protest rising prices and change habits. They spend less on discretionary purchases. Thus, while nominal sales keep rising, courtesy of inflation, real sales don’t. Margins get squeezed and profit growth slows. If the pressure of inflation and the attendant rise in debt service costs begin to pinch too much, profits could fall. That’s the dark side, the threat of recession. Lower real growth and lower earnings. So far, investors feel that outcome poses too extreme a picture. Since the Fed started raising rates last week, leading averages have soared 6% or more. That’s not chump change, although most stocks are still down for the year to date.
Stocks and bonds compete for investment dollars. At the moment investors are fleeing the bond market as the rise in interest rates causes bond prices to fall. Bond coupon rates today are no match for 8% inflation. The only safe havens in the debt market at the moment are in the highest quality names and the shortest maturities.
A popular acronym, TINA, has emerged in recent years. It stands for There Is No Alternative. It has made the case for owning stocks versus bonds. Longer duration bonds never do well in a rising rate environment. Bond market cycles are long. Rates rose from the end of the Korean War until the early 1980s and then fell steadily until the start of the pandemic. These were both 30-year cycles. It is too early to tell whether or not we are firmly entrenched in an up cycle. Nonetheless, bond attractiveness today is more about tamping down volatility than generating positive real returns.
Hence, TINA. But that presupposes that we are in an economic environment that allows sales and profits to grow. Stocks won’t go up if earnings start to fall. Right now, most analysts foresee continued profit growth, albeit at a slower pace than the recent past. If the Fed succeeds in lowering demand just enough to return inflation to target without causing a recession, stocks will do just fine. Once again, we see the IF word. It is simply too soon to formulate a fact-based conclusion. Over the next few months, we will see both encouraging data and news that makes us nervous. Investors will focus on the inflation numbers because that is where the Fed says to focus. It should start to recede over the next six months, but getting back to 2-3% will take time, perhaps a lot of time. In the interim, growth will slow and the cost to borrow will rise.
We are only at the start of a Fed tightening cycle. The full impact is 1-2 years away. In the interim, the picture will start to become clearer. As it does, volatility should decline. The market’s ultimate direction will likely follow the path of profits. It isn’t unusual for volatility to rise when the Fed starts to raise rates. But stocks then often resume their uptrend until profit growth stalls, if it stalls at all. That is where we are today. The hope is that recession can be avoided. The bond market questions that. The stock market is more optimistic. They both won’t be right. For now, we read the tea leaves with guarded optimism.
Today, Kyrie Irving is 30. Actress Keri Russell is 46.
James M. Meyer, CFA 610-260-2220