Stocks gave ground Friday as debt ceiling talks broke down. President Biden and Speaker McCarthy will meet again this afternoon with no signs of an imminent agreement. It’s pure Washington theatre. The vast majority of forecasters have been predicting a midnight solution all year long. They still believe a settlement will happen. Clearly, the consequences of the alternatives are most unappealing.
At least according to futures activity this morning, markets haven’t entered anxiety mode. The June 1 deadline is barely more than a week away. Clearly the stakes are high. A true default could cost Biden his Presidency and McCarthy his speakership. Thus, there are large incentives to get a deal done. Obviously, to do that the President has to accept some spending restraints and Republicans are going to have to moderate requests. Any compromise will have unsatisfying components for everyone. The ultimate end will be pretty close to the following; spending restraints for at least two years, and the recapture of unused Covid relief money now that the pandemic has been declared over. A short-term expansion of the debt ceiling, one that might last anywhere from a week to a couple of months, is possible. But that would only be a final fallback if reasonable negotiation progress is being made. Neither side wants a replay. The key is that both Biden and McCarthy say firmly that a default is completely unacceptable. Deferring other payments like Social Security or military pay might be a slightly better alternative, but such a move would bring instant rancor and be a negative for any incumbent. Our nation has never defaulted on its debt obligations. Messrs. Biden and McCarthy don’t want to create the first.
Once the debt ceiling crisis is averted, attention will rapidly shift back to the economy. This week we will see reports on manufacturing activity and the Fed’s favored PCE inflation indices. Likely, economic activity will be down while inflation will be persistently high. While neither is likely to displace current Fed thinking that a pause in rate increases is likely in June, persistent inflation leaves open the possibility of another rate hike to come. Moreover, stubbornly high inflation would suggest the possibility of a rate cut this year is less than currently implied by markets.
There is lots of debate about the linkage between employment levels and inflation. We had low unemployment for much of the time between the Great Recession and the Covid-19 pandemic without inflation of over 2%. Clearly, there was economic slack left to absorb pricing pressure while technology allowed buyers to improve price discovery and easily find the cheapest alternative. That technology will only improve price discovery going forward. All of us want a soft landing. No one wants a recession, but will a soft landing be enough to shift pricing power back from seller to buyer? That’s an open question. The correct response is that the less slack any slowdown creates in world economies, the less stimulus central banks can add down the road. For decades, the tendency has been to stimulate for much too long after a recession. It took more that five years for the Fed to institute a rate increase after the Great Recession of 2008/2009 ended, and for three years it only increased rates 25 basis points per year. No wonder inflation finally emerged.
We all know that Fed actions to raise interest rates take time to impact economic activity. Some interest sensitive sectors, like housing, see the impact earlier. But the echo effects happen later. Housing starts peaked in early 2022. Home improvement retailers are starting to feel the pinch a year later. Covid related supply disruptions confuse forecasts. Auto demand and prices remain strong despite higher funding costs because so much demand was deferred by supply shortages and empty dealer lots. But as dealer lots fill later this year, and the pressure of higher rates reduce demand, a situation where supply exceeds demand could quickly reverse, forcing dealers now used to selling cars at list price or above to offer handsome discounts.
Right now, all signs point to recession. Manufacturing activity is weakening. Retail sales rose slightly in April but only after declines the previous two months. Housing prices are now down year-over-year as resale activity falls sharply. Leading economic indicators have been declining for months. Continuing unemployment claims are almost 50% higher than they were in September. Job postings are in decline. It will be a recession the Fed creates. Its length will be largely determined by future Fed action. Right now, the best guess is one that starts in the second half of this year and continues into early 2024.
Clearly, the bond market agrees. Long rates are well below the highs seen last fall. Short-rates are a bit distorted by the debt ceiling crisis but seem to have peaked as well. The stock market is a bit more sanguine. But, given the bumps are a bit more severe in some parts of the economy than others, the impact may not have been fully discounted. Foot Locker’s# report Friday that sneaker demand has slowed markedly was a surprise. A tepid forecast by Wal-Mart wasn’t. Given softening demand and the high cost of money, managements across the board are cutting inventory and deferring expansion plans to conserve capital and right size businesses. It’s the right decision.
Until there is more economic clarity, stocks are likely to stay within a trading range, one most have been in for the past year. Momentum has led to a few stocks pushing to or past 52-week highs. But fundamentals have to catch up. In a soft economy, that will be difficult. Perhaps most encouraging is the fact that homebuilders are doing well, despite high interest rates, a testimony to strong latent demand. But that latent demand is what may keep inflation higher for longer, something the Fed doesn’t want to see. In all likelihood, this portends a long cycle of higher rates and elevated inflation, at least compared to levels experienced from 2008 to 2020. As that reality sinks in, market leadership may rotate once again.
Today, Tommy John is 80. A good pitcher in his day, he will be best known as the first celebrity to recover from a surgery technique that today bears his name. Former Philly Pops conductor Peter Nero is 89.
James M. Meyer, CFA 610-260-2220