Chairman Powell, whose title is now Chair Pro Tempore (as his 4-year term ran out) until the Senate votes on his next term, was back on Capitol Hill speaking with elected officials over the past two days. After opening remarks, politicians began peppering him with questions about the economy, inflation, jobs and what effect the Russia/Ukraine conflict will have going forward. By the end of this exchange, it felt like a typical Fed meeting. We got a lot of answers on rate hikes and Powell’s thinking, which leads to a good indication of what to expect over the coming months.
First and foremost, a 25bps rate hike is all but guaranteed in a couple of weeks. A month ago, many expected 50bps at the onset of this tightening cycle. Then, after Putin’s actions wreaked havoc on international growth estimates, investors started pricing in no movement in March. Bulls and bears can point to the recklessness of either scenario but 25bps seems appropriate for now. Readers of our letters know there is no easy solution to today’s inflation picture.
Having printed trillions of dollars since the Global Financial Crisis in 2008, markets are addicted to low rates and easy money. This all came to a head with the latest and largest cash infusion in 2020. Now growth is slowing while inflation is running rampant. Keeping rates low will keep inflation high, biting into discretionary spending along with destroying lower-income balance sheets. Raising rates too fast runs the risk of pushing us into a recession as growth is already naturally coming down.
Although Ukraine and Russia do not directly account for a significant piece of GDP on a global scale, they are large producers of numerous commodities. Wheat, crude oil, natural gas, corn, iron and lumber prices are up 5% – 35% in just the past week. Fears of an elongated battle and/or further invasions beyond Ukraine are surely on the minds of Europeans. Typical spending habits, vacations and daily routines by Europeans have been altered. This amplifies an already difficult Fed position. It might even feel like a recession in Europe if this lasts longer than many had hoped. What happens in Europe still has an impact here at home. Since we can’t go back in time and reduce the Government handouts, raise rates or stop the expansion of Fed bond holdings, we’re stuck with an economy already slowing and facing multiple question marks. As we all well know, markets hate uncertainty. In some cases, they’d rather hear bad news than no news.
Chairman Powell’s testimony erases at least one concern for the time being. We should expect a small, 25bps rate hike at each of the next few meetings, assuming inflation doesn’t get wildly worse. Of course, an end to the Russian invasion would also help slow commodity spiking costs. Increases of 50bps could be used down the road if inflation stays hot. The Fed will also gradually get their balance sheet back in line by allowing bonds to mature without reinvesting down the road. This is likely a summer timeline at the earliest. With Fed confusion partially out of the way, stocks responded strongly as investors assumed rates will not spike into an inversion. The S&P bounced 2% on Wednesday and held onto most of those gains outside of the growth sector yesterday.
Anything that points to a lower chance of inverting the yield curve will be taken as a positive, and rightly so. Inflation has always led to Fed intervention and sometimes to an inversion that sparked a recession. History shows these mistakes quite clearly, especially in crude oil spikes:
Not every recession was preceded by a 50% rise in oil prices, but the track record speaks for itself. Taking out the Y2K Tech bubble of 2000 and the Global Financial Crisis of 2008, which were not directly tied to rising commodity prices, inflation and rising energy prices are a major ingredient to ending bull markets. Previous Fed regimes responded aggressively to rapidly rising commodity prices. A slow and steady approach may be the exact medicine for today’s economy.
We are not as dependent upon energy as in the past. The U.S. can now produce 11mm+ barrels a day, even more if companies are so inclined. Automobiles can drive a lot farther on a tank of gas than even 5 years ago. Electric vehicle sales are skyrocketing with many more new models coming to market soon. Wind, solar, hydrogen and other alternatives keep expanding. While energy costs were major inputs to our industrial economy in the 70’s, today’s world is dominated by services, technology and much more productive uses. Current estimates point to the nearly 50% gain in crude so far in 2022, resulting in a $75B hit to consumers. Bad, but not a killer number. It is not prices at the pump that will cause a recession, but an overly aggressive Fed that tightens too far, too fast. Powell’s comments, so far, point to a somewhat optimistic tone on that front. Futures went from pricing in nearly 7 rate hikes this year down to 5.
To even out the positives, Chairman Powell’s exchange with Senator Shelby turned the tides a bit on risky assets during yesterday’s testimony. Shelby was explicit in questioning Powell’s resolve and contrasted that with Chairman Volcker who increased Fed funds to 20% in 1981 to fight inflation. This helped push the U.S. into a recession in 1982, but finally put an end to massive inflation from the 70’s. It also proved to be the start of one of the greatest bull markets in stocks.
On the comparison question, Powell’s response was noteworthy. Shelby pressed “are you prepared to do what it takes to get inflation under control at all costs?” Powell responded “I hope history would show the answer is “yes”.” Growth stocks swooned on this note. A typical Fed put has been in markets for years now. Anytime stocks suffered, the Fed responded with money printing. We are long past that period now. Price stability today is a departure from the past few years. Excessive risk taking continues to be a difficult proposition if the Fed is not worried about stocks suffering in order to get inflation down.
With the Fed a “known unknown”, at least for now, the pressure on stocks is tied to Russia. Fighting around a large nuclear power plant last night brought even more fear to the market as futures are firmly negative along with ~3% drops in many European benchmarks. Investors will not want to be overly long the market going into the weekend unless there is a clear line of sight towards a cease fire.
That does not mean values aren’t already here. Target# and Best Buy# reported earnings this week. Both stocks were hammered late last year, however bad news was more than priced in. These stocks are near all-time lows from a valuation standpoint. They also have solid, growing dividends. Even though earnings weren’t exactly earth shattering, both stocks jumped 10% immediately following investor calls. In certain pockets of the market, stocks may have already bottomed. Time will tell, but nibbling on world-class leaders with fair valuations should prove profitable over time. Staying away from the high-flyers, which have no Fed put protection anymore, remains a difficult proposition.
Most of us know her from “Home Alone” and “Beetlejuice”, but millennials would recognize Catherine O’Hara, who turns 68 today, from “Schitt’s Creek”. Patricia Heaton turns 64 today.
James Vogt, 610-260-2214