Stocks struggled to turn in a positive performance for the second straight session after taking a shellacking last week. Earnings news is starting to be less and less consistent with what we have witnessed the past two weeks. Yields on 10-year Treasuries have touched 3% and fallen back. The trend remains higher but the pace seems to be slowing. All this happens in front of today’s conclusion of an important FOMC meeting that will refine the future path of interest rate increases and balance sheet reductions.
There are lots of reasons for investors to be negative. Interest rates are rising, inflation is persistent, and GDP growth is slowing. On top of that is another Omicron variant, a war in Ukraine, and lockdowns in China. Very little seems to be moving in a positive direction. One old saw says that there are plenty of reasons one might choose to sell stocks, but the only time you have to buy is to cover a short position. Thus, market sentiment is putrid, and at least for the last four months there have been more sellers than buyers.
Financial assets have a value. As for stocks, they are dependent on future growth in earnings and a discount factor related to interest rates that we call the Price/Earnings ratio or P/E. For months, earnings have been going up, but have been offset by the pace that P/Es have declined. At last week’s low, the forward-looking P/E was under 17 for the first time in many years. It was over 23 at its peak after the apex of the Covid-19 pandemic. Thus, valuations have corrected quite a bit. Compared to history, they are close to historic norms. That doesn’t make stocks cheap here, but they no longer seem expensive. This may not be the time to throw the baby out with the bath water.
Looking forward, the two obvious keys are the future path of interest rates and earnings. That leads me to today’s FOMC meeting. Markets price in future expectations. What markets expect from the Fed at the moment is the following:
1. A 50-basis point hike in the Fed Funds rate today. That will be the largest single increase in over 20 years.
2. Guidance to expect another such increase in June, followed by perhaps a third in July.
3. A pronounced goal to get to a neutral Fed Funds rate before the end of 2022. A neutral rate is one that will not entice growth above or below a rate governed by population growth and sustained productivity gains. A neutral rate would make the Fed a non-factor in determining the path of future growth. No one knows exactly what that rate is, but for now the guess is centered at about 3%.
4. The Fed is expected to let maturing bonds run off without replacement starting in June.
5. Sometime after June, the Fed could begin to accelerate the run-off of its balance sheet by selling bonds in the open market. The combination of sales and maturities could reach a pace of close to $100 billion per month later this calendar year.
All the above represents current consensus and, therefore, is largely priced into the bond market. As for the stock market, normal earnings growth for both this year and next are priced in. No recession shows up in earnings forecasts yet. Whether that is a bad assumption or not is still too soon to call.
When investors are nervous, they listen more attentively. They are scared by those screaming the loudest or offering the most dire predictions. This is not 2008. Bank balance sheets are in great shape. At some point, the rise in mortgages should curtail excess demand for housing and bring price inflation down, but nothing the Fed does will increase the supply of new homes or apartments. In fact, higher rates will curtail the growth of supply in an underserved market at a time when millennial families are looking to move into suburban houses from urban apartments. Auto sales are more limited by supply shortages than higher financing rates. Clearly the Fed has the ability to crush home and auto demand, but only for a time. Again, this is far different than 2008.
Inflation is a monetary event caused by an imbalance of supply and demand. During the pandemic, the Fed and Congress flooded the economy with money at the same time supply chains snarled, reducing output. The result was inflation. Today, most of the government handouts are done. Money supply growth has fallen from 10-15% to a range of 5-10% and is moving lower. If money supply growth is lower than the pace of inflation, it is restrictive. Either inflation has to come down or the production of goods has to decline. The former would symbolize victory in the battle to reduce inflation. The latter would lead to stagflation or recession. Again, too soon to call.
That brings us to this afternoon’s post-FOMC press conference with Fed Chairman Jerome Powell. Mr. Powell doesn’t live in a vacuum. He is well aware that the first four months of the stock and bond markets this year were the worst annual start since 1939, and that it was his doing!! He was the messenger that told us the Fed would be laser focused on defeating inflation. His fight would require more intense rate hikes and balance sheet reductions than previously thought. That is what brought us to this afternoon. The key today is whether Mr. Powell needs to give an even sterner message or not. Is he ready to set the plate for an even higher Fed Funds rate than 3% or so? Is he going to accelerate balance sheet reduction before the consensus I laid out earlier in this note? I don’t think so. What he will say is that all future options are open. Someone will ask him, for instance, whether a 75-basis point increase is coming. He likely will respond and say nothing is impossible, but that he doesn’t see the need for one at this point in time. In other words, today is not the day to move the needle further, partly to calm markets a bit, and partly because there is no evidence today of the need for such drastic action.
He will get some help on the inflation front soon. Oil and wheat prices have come off their peaks. Same for lumber. That’s not true for all commodities, but it will still be a help. Remember, inflation measures the pace of changes in price, not actual price levels themselves. Wages and rents will be tougher to contain, but for now the artillery displayed should be enough to win the battle against inflation.
That leads me, finally, to two more dates. The first is May 6, the day of the monthly employment report. Focus on (1) the pace of new job growth, (2) the pace of change in wages, and (3) the labor force participation rate. We always want to see new jobs, but since an overheated labor market is the cause of wage inflation, we would like to see growth muted. Growth has exceeded 400,000 jobs per month for over a year, so something lower than 400,000 would be good. It is probably too early to expect any reduction in the pace of wage growth. As for the participation rate, the higher the better. If 250,000 new jobs are created by 500,000 new workers entering the market, the pressure on wages to rise declines. These two numbers are not predictions, but rather numbers pulled out of the air to make a point. Markets will react to any non-consensus change in the labor force, wages, or participation rate.
The final date of note is May 9. Victory Day in Moscow. Putin wants to make a statement to the world and that statement is likely to be related to Ukraine. I will stop right there. I have no better idea than anyone else what will happen. Most likely what will happen will have some economic meaning to financial markets, and some form of extreme behavior could invite even more sanctions.
The bottom line is that much of what is feared is priced in. Stocks are back to normal valuations for the first time in quite a few years. The pace of future rate increases should slow. If Mr. Powell doesn’t accelerate his timetable today, we could see a relief rally, maybe even a robust one. But there are no real tailwinds yet to propel stocks upward on a sustained basis. Fed balance sheet reduction (and it hasn’t started yet) will remove some of the market’s speculative ammunition. So will reduced money supply growth. The accelerants of the past two years, ultra-low rates and gobs of new money, are history. One measure of GDP is population growth times the rate of productivity improvement. The former is now well under 0.5% (it was 0.1% last year), and productivity growth hasn’t been sustained above 2% for many years. 2% is likely normalized real growth looking ahead. If the Fed can succeed in reducing inflation to 2% or a bit higher, we are looking at a nominal growth path of 5% or less. Growth is also slowing around the world, especially in China. 3% worldwide growth long term is wishful thinking. After years of double-digit growth in the stock market, this is a sober outlook, but unless central banks want to get back to artificially goosing the economy, it’s tomorrow’s reality. 4-5% nominal growth can still produce 5-7% growth in earnings per share. Combined with dividend payments, the long-term outlook for stocks still mirrors history. We are in the midst of a reset. A lot of the speculative excesses have been wrung out of the market.
This is not a time to ratchet up the pessimism. Rather, I think it is time to ratchet it down a bit. Just as 2021 was accompanied by too much speculative optimism (remember SPACs?), right now there may be too much fear. We don’t know if the Fed has to create a recession to stop inflation. It might. But it will be a Fed created one. And the Fed at some point will move rates down to contain the damage once inflation is moving in the right direction. While the Fed can only control demand, not supply, less demand will unravel stuck supply chains. Look at Amazon. Six months ago, it told us that it was having difficulty getting packages delivered to Prime members within its guaranteed one- and two-day windows. This week it told us it now has excess distribution capacity both in terms of warehouse space and trucks. A gridlocked rush-hour highway is freely moving two hours later. When auto makers catch up with demand once they get an adequate supply of semiconductors, prices of both new and used cars will come down. So, let’s not get too pessimistic at exactly the wrong time.
I am not suddenly an optimist. I think the odds of recession are significant, but I am not ready to declare one obvious. As supply goes up, the need to stomp hard on demand declines. That is all the more reason for the Fed to maintain a forceful, steady pace but not panic. Hopefully that is this afternoon’s message, and hopefully the market will like it.
Today, Rory Mcllroy is 33. Randy Travis turns 63.
James M. Meyer, CFA 610-260-2220