Stocks rallied once again, the second strong session of the past three. Bond yields climbed but remained within their recent range with the 10-year Treasury closing at slightly below 3%. In a market up just under 2%, transportation stocks were up more than 3%. Homebuilders rose a like amount. Leading semiconductor manufacturers rose 4% or more. It was clearly a day for the cyclicals to shine. By the end of the session, stocks were within 2% of where they were in the days leading up to the last FOMC meeting.
The obvious question is what happened in the interim. From peak-to-trough, stocks fell about 10% after a Fed meeting that pretty much suggested a future path in line with consensus expectations. Yes, there were some preaching that rates should have risen by 75 basis points, but that has always been a minority viewpoint that Fed Chair Jerome Powell has largely dismissed, at least for now. The timetable to begin reducing the size of the Fed’s balance sheet also matched expectations. 10-year Treasury yields were near 2.9% before the Fed met and they have only risen marginally in the interim. Earnings have largely matched expectations as well although there were a few high-profile notable exceptions to the downside. Finally, economic data also has fallen in line. Inflation numbers suggest a peak about now. Early signs of some slowing in retail and housing demand are consistent with a path to higher rates. Both retail spending and housing demand remain solid.
What has continued, at least until this week, was the purge of speculation. This week’s recovery has given that purge a reprieve but there are few signs that the stocks long on sizzle and short on earnings have found bottom yet. The same holds true for crypto currencies, ravaged not only by a reduction in demand, but also by a collapse in one of the more popular stable coins. We found out this past week that stable doesn’t have the same meaning in the crypto world as it does in the real world. Of course there were increasing calls for regulation, but given that no two people seem to agree how to regulate crypto, any serious consensus toward regulation appears far away. It remains a caveat emptor market place.
But why the rally? One obvious answer is that stocks went down too far too fast for little fundamental reason. While the sharp decline increased skepticism that a recession could be avoided, there was scant evidence to support increased likelihood of a recession in 2023 or 2024. We know higher rates will slow demand, but how much and how far remains an open question.
What we do know is that the economy right now is doing pretty well. Despite all the headlines about inflation, Americans continue to line up to travel. Given the continued difficulties to travel abroad, more and more people are opting for vacations in the US. Planes are filling up fast, as are hotels. The strong dollar will attract more foreign guests than at any time since the pandemic began.
Of course, strong demand isn’t the cure for inflation, the root problem du jour. That’s why the Fed is raising rates and selling assets. It will take a while to see the impact but there are early signs. Apparel sales are slowing down. Higher mortgage rates are forcing first time home buyers to continue to rent. The high cost of necessities robs many of the ability to spend on discretionary items. The slower demand is beginning to impact pricing power. We see hints everywhere. Netflix raised prices and saw US subscriber counts fall for the first time. Uber and Lyft needed to raise prices to offset higher costs but traffic growth slowed. Open Table reservation data shows a steady decline over the past 4 weeks as high menu prices force Americans to trade down or eat at home. Home Depot# saw an 8% decline in traffic during its April quarter.
So why are stocks rallying?
1. Stock prices returned to fair value. Some stocks got downright cheap. Valuation matters. When they get cheap enough, buyers return.2. Fears that the Fed was so far behind the curve that it could never win the battle against inflation without a severe recession were probably overstated. The Fed plans to raise the Fed Funds rate another percentage point before the end of July and will target the 3% range by year-end.
3. 5-year inflation expectations have retreated a bit. They are now close to 2.7%. If the Fed Funds rate gets to 3.0% or more, accommodative policy present for most of the past dozen years will finally be replaced by tighter conditions. When interest rates were near zero and inflation was 2% or higher, there was a huge incentive to borrow and leverage. Tighter money removes that incentive. If the Fed Funds rate is only moderately higher than long term inflation expectations, the net effect need not be as turbulent as market conditions were suggesting just a week ago.
The bottom line is that the economy is on a glide path toward slower growth. Maybe that means growth falls below zero for a brief period. Maybe not. We note again that inflation is a monetary phenomenon resulting from an imbalance of supply and demand. We know higher rates will lower demand. That’s not a guess; it’s a given. We also know that current supply chain issues also relate, in part, to too much demand for too few goods. Lower demand will unsnarl some of that gridlock.
In the meantime, good companies do what they always do. They adapt. The trick is to find the right balance. We have seen lately when both Wal-Mart and Amazon# reported what happens when one expands too quickly at a time when demand slows. The best will react quickly and limit any damage. Regardless of whether we avoid recession or not, there will be many companies that can still grow because they are offering superior products and services that will allow them to gain market share. Great companies gain the most share in tough times as their competitors hit speed bumps and lose access to financing on favorable terms.
Even if a recession can be avoided, there are also likely to be a series of mini-crises like we saw last week in the crypto and hedge fund worlds. To the extent these occur within financial markets, there will be spillover as we saw during the recent declines. Sometimes that spillover can be nasty.
If we are to experience a recession, it isn’t likely until next year or later. Unemployment is too low, consumer balance sheets are too solid, and demand in many sectors of our economy is too great for that to happen quickly. Moreover, should there be one, it won’t be evident for several more months.
The market will go up and stay up when we can see the blue skies of an improving economy on the horizon, when the Fed signals an end to tighter policy is near, and when the purge of speculation has run its course. I don’t think any of the three have happened yet. That doesn’t preclude a healthy intermittent rally as emotions on the Street ebb and flow. It doesn’t mean some stocks haven’t already reached a bottom. But for stocks to truly bottom, one has to see earnings expectations rise and inflation expectations fall. Too early for either.
The old saw, sell in May and go away, meaning markets often move sideways through the summer months and into early fall, may be apt. A lot of damage has been done to markets over the first 4 ½ months of 2022. It has discounted a lot of negative news and removed a lot of speculative spirit. That makes the playing field today a bit more balanced. All rallies don’t have to be sold. All dips are not necessarily buy signals. It is quite likely we have entered a new market phase, one more balanced waiting several months for either evidence of recession or a soft landing. As the Fed tightens, liquidity will be reduced. Volatility will endure.
Today, Tina Fey is 52. George Strait turns 70.
James M. Meyer, CFA 610-260-2220