A sharp rally Monday followed by a more moderate one yesterday relieved a lot of selling pressure on the stock market. Normally, I look at two solid days in a row as a trend reversal, but today is FOMC day when Fedspeak dominates. Long-term bond yields in recent days have stayed within a narrow yield range of 4.8-5.0% waiting for the outcome of today’s meeting.
It isn’t a matter of what the Fed does today but what is said by Chairman Jerome Powell afterwards. As for what is going to happen, the answer is nothing. Rates are going to remain unchanged. It is very unlikely Powell will say the Fed is done raising rates, not after a Q3 GDP print of +4.9% and monthly employment increases of well over 300,000 at the last report. But core inflation is now back below 3%, there are clear signs the economy is growing at a slower pace, and the sharp rise in longer term yields is doing much of the Fed’s heavy lifting at the moment.
At its September meeting, the FOMC members changed their tune, surprising Wall Street. They emphasized a belief that a soft landing was more likely than a recession. As a result, they could continue to defer increasing the Fed Funds rate further. Instead, they would likely leave rates high for an extended period to ensure inflation remained low after target levels were reached.
In football, when a play is reviewed, there must be conclusive evidence to overturn a call made on the field. The same applies here. The call on the field is be patient, let the lag impact of prior rate increases play out, and leave rates where they are until there is a conclusive reason to change them. Data over the past six weeks shows a continued slow ebbing of inflation and a slowdown in the economy’s growth rate. Some can argue they would like to see inflation slow faster. Some worry that the immense borrowing needs of the Treasury ($776 billion this quarter alone) combined with a continued reduction of the size of the Federal Reserve’s own balance sheet will stress financial markets. But so far, there is not enough evidence to justify a change in course.
The Fed surprised markets in September. Generally, it doesn’t like to do that. It is unlikely to purposefully do so again today. With that said, what markets do will hinge on what Powell says at his post-meeting press conference. Much of what he will say is obvious. Trends are moving in the right direction but they need to continue doing so for a more extended period of time to force a change in interest rate strategy. He will note the positives. Inflation is clearly falling. There are signs of some slack in the labor market but not enough. Housing activity is down. But there are also concerns. Recent wage settlements (e.g., the auto industry) have been inflationary if they can’t be offset by higher productivity. The economy continues to add jobs at too fast a pace. Note that today’s JOLTS report might come into play here. In other words, he doesn’t want to appear more optimistic or pessimistic than he was in September. Today is likely a holding pattern.
There are two areas of interest. First, what will be his response to the rapid increase in longer-term rates since July? Obviously, they work to slow the economy, but if they go much higher would it be too much of a good thing? Powell will clearly say that Fed policy doesn’t determine long-term rates. True. But the impact on the economy and inflation are clearly determinants of future Fed policy. Powell likes to shy away from commenting on fiscal policy or politics. But clearly, Treasury’s borrowing needs of over $3 trillion annualized is not something to be ignored. Both Congress and the White House pay lip service to fiscal discipline. But neither is seriously moving in that direction. If asked, Powell would likely support more fiscal discipline but stop there. If he does, add his name to those paying lip service. Clearly however, huge deficits make the Fed’s job more difficult.
The second issue that could make waves is the future of the Fed’s program to reduce its balance sheet at an annual pace of $1 trillion. Such a reduction serves to push more of the nation’s debt burden on the public. The increased supply for money (the aforementioned $3 trillion) is only half of the equation. Typical buyers, including foreign central banks, U.S. commercial banks, and the Fed itself are not filling the gap. The net result is a rise in the term premium, the real cost to money. As that rises, it increases real pressure on economic growth. When the price of a mortgage exceeds the likely annual rate of appreciation of the value of a home, the economic reason to buy versus rent diminishes, not to mention the ability to service the loan at a higher interest cost. As noted above, Powell can’t control Washington’s borrowing needs. But it doesn’t have to keep reducing the size of its balance sheet by $1 trillion annually. What might cause the Fed to slow its pace? That remains an open question.
The bottom line is that this shouldn’t be a big market moving meeting. But nuances to Powell’s comments can change that if markets read any change of direction. What is more likely is that the December meeting will be more critical. We will get quarterly projections then and have two more labor and CPI reports before that meeting.
With that said, let me change focus completely and add a few words about the labor settlements with Detroit’s Big Three auto makers. While all contract details haven’t been publicized, it appears the cost per worker will approach $90 per hour by the end of the contract versus roughly $65 today. Foreign auto companies today are in the mid-$50s or a bit higher. Tesla is below that. Simply said, Detroit is at a cost disadvantage that is only going to get wider. While Detroit got some productivity concessions from the union, any future actions that result in lost jobs will be contested.
Successful manufacturers, particularly within industries which carry high fixed costs, are fanatical about costs. The advantage to a newbie like Tesla is that it starts with a clean piece of paper. Every cost element requires justification. This contrasts with legacy companies with high fixed costs already in place. They need to extract costs that have been in place, sometimes for decades. Every extra unneeded step is a cost.
Legacy companies have another burden. The auto industry is in a seismic shift away from internal combustion engines. That shift won’t happen overnight. Right now, one can argue convincingly that Americans don’t like the electric options presented to them. They still want their SUVs and trucks. But technology will change that. I don’t know whether every future car will be Tesla-like, but the world clearly is moving away from gas-guzzling monsters.
Detroit, however, makes all its money from those guzzlers. They won’t give them up easily. The problem is compounded by the fact that, at least so far, their alternative offerings using newer technologies have been very unappealing. Consumers don’t want to pay more for a car that offers less value. They don’t want to buy an electric car and not be able to pull into a neighborhood gas/charging station and “fill up” within a few minutes. Right now, the gap is big and consumers are staying away. Tesla keeps growing sales but only because it is cutting prices (and margins) steadily.
When an industry undergoes seismic disruption, all too often the winners are the disruptors and the previous leaders fade away. A few pivot and survive to fight another day, but not all. None of IBM’s mainframe competitors make computers today. The PC industry killed the minicomputer industry. Digital photography murdered Kodak. Home Depot# slaughtered most local hardware stores. Does anyone want my yellowing Sears catalog? For the Big 3 to succeed, let alone thrive, they need to recognize the urgency to get to and stay at the forefront of the movement away from traditional autos. They have to realize that their profit centers today won’t be their profit centers tomorrow. History suggests such a pivot is a Herculean task. Maybe that’s why they all sell at such low P/E multiples. One final guess. Fast forward to the 2030s. My guess is that the hot cars then will include names that don’t even exist today. Names like Dell or Nvidia or even Home Depot weren’t early pioneers. They built upon the success of pioneers. Dell was the first to sell direct. Nvidia developed GPUs to challenge MPUs. Home Depot simply became a hardware store on steroids. Tesla is the first domestic company (there are several in China) to make an attractive electric car profitably. It won’t be the last. There are chinks in its armor. Service and support are issues. Its current models need upgrading. So far, none of the pretenders have found the magic. But the only certainty is that Tesla will not have the mass market auto business to itself.
Today, Lyle Lovett is 66. Gary Player turns 88.
James M. Meyer, CFA 610-260-2220