Stocks fell sharply once again on Friday bringing an end to a miserable month, quarter and year-to-date. Interest rates continued to rise sharply until Wednesday when the Bank of England announced it would intervene to support the pound. That helped to support stock prices for exactly one day. By Thursday stocks were back in steep decline, losing another 3% over the last two trading days.
By now we all know the basic outline of the story. Easing monetary and fiscal policy, designed to support a fragile economy recovering from a financial crisis and then a pandemic, continued for much too long. The induced excess demand brought on the worst bout of inflation since the 1970s. The remedy was obvious. For central bankers, that meant higher interest rates. At first, markets presumed that some economic deceleration could help to unsnarl supply chains and bring inflation back to normal quickly. The Fed incorrectly used the word “transitory”. While some prices did start to come down, notably gasoline, wages and rents continued to rise far too quickly. The rally in July falsely concluded that the end of the rate rising cycle could be near, but by late August the Fed forcefully reinforced the point that the Fed Funds rate was headed to 4.5% or higher, and was likely to stay there through 2023 into 2024. The 10-year Treasury yield, the prime driver of the P/E ratio applied to the stock market, shot up from 2.6% on August 1 to over 4.0% earlier this week.
The Fed and most economists note that for the Fed to tighten policy enough to slow the economy, interest rates must rise above long-term inflation expectations. In simple terms, there must be a real cost to borrow. In reality, what policymakers want is for interest rates to get to a level that will stifle excess spending and investment. Not until the last few weeks has that happened. Which explains why, despite a miserable bear market so far in 2022, economic growth has remained stubbornly strong. Only very recently have rates gotten to a level where they might begin to choke off spending. Of course, that isn’t a blanket statement. Mortgage rates shot up earlier than other rates. Housing has rolled over and declined noticeably. Home prices have followed suit and have begun to decline. They serve as a harbinger of what is to come elsewhere. Indeed, many investors now are complaining that Fed policy might have been too harsh. Rates rose too far too fast. The Fed’s rapid pace of rate increases didn’t allow for the traditional 6-12 month lag to see the impact of higher rates. By the time the Fed Funds rate peaks, perhaps around year end, the economic damage will become apparent and the Fed, too late to start tightening, may have stayed tight too long. Or so the story goes for that side of the argument.
While it is true that many input and commodity costs are already starting to fall, inflation isn’t dominated by the cost of commodities. What the Fed will focus on is wage inflation, the cost of shelter, and prices of services. As inflation rises, sellers have greater control over prices than buyers. When excess supply exists, the opposite is true. What is sought is a balance, where there is enough demand to enable slow steady price increases, but not too much demand to cause the imbalance that we have seen over the past two years.
As noted, we finally are at the point where there is a real cost to money. We should soon start to see a slowdown in the pace of rising wage demands. Rents should stabilize. Real-time data suggests that rent increases are slowing, following the defined downtrend now in place for home prices. Friday’s September employment report, hopefully, will see some slowdown in the pace of job growth and some moderation in the pace of wage inflation.
A 4% yield on 10-year Treasuries may not be the peak, but if the economy is going to slow and inflation is going to recede, even at an undefined pace, there is little argument to support a need for a further rapid rise in 10-year yields. For equity investors, that should be viewed favorably. Unless it becomes necessary to raise the Fed Funds rate meaningfully above 4.5%, any further rise in the 10-year bond yield should be moderate. In terms of equity investors seeking the end of a painful bear market, there should be some comfort in the thought that the decline in the P/E ratio for the market may be near an end.
If P/Es are approaching stability, the same may not be true for earnings. Earnings trends should follow interest rate moves upward. One hallmark of when markets have fully discounted earnings weakness is when a stock doesn’t go down on bad earnings news. Prior to last week’s earnings report, for instance, Nike had significantly underperformed the overall stock market. While it was still growing, Covid-related weakness in China, the strong dollar, and weakness in retail sales worldwide, in line with higher interest rates, weighed on the stock. But last week, as it reported earnings that were essentially close to forecasts for the quarter that ended in August, Nike’s stock got crushed, losing 13% in one day as it reported a rise of over 40% in inventories. We have seen this story play out before. In the Spring both Wal-Mart and Target had even bigger declines as both reported swollen inventories, a combination of weakening consumer demand and the unraveling of supply chain snarls. Nike investors clearly didn’t see the same degree of difficulty coming. Simply said, if Nike is an example, we should expect this earnings season, which begins in about 10 days, to see multiple examples of the necessity to readjust to lower expectations.
When interest rates stabilize and earnings expectations better align to reality, markets should bottom. The final pieces of the puzzle are signs that the end of the Fed’s rate hiking cycle is within sight, that earnings expectations have moderated, and that an end to the tightening cycle is within sight. That should become apparent as key economic data, i.e., employment and shelter cost trends, persistently start to move in the right direction. That could start shortly.
There are signs that those factors come together sometime this quarter. Despite a rapid tightening of central bank policy, there are indications that the Fed will not have to raise target Fed Funds rates far above current expectations. Moreover, if inflation slows perceptibly over the next several months, the need to keep policy tight throughout 2023 may be too pessimistic. Rapid market swings often bring about one or more crises that force policy relaxation. It is likely that the Bank of England’s announcement that it would step in and support the pound was in response to escalating pension fund losses and threats of hedge fund collapses within the UK.
Third quarter earnings reports are likely to bring some downside adjustment to earnings forecasts. Will they be enough? I don’t know, but it will be a move in the right direction. Our economy is strong today and balance sheets are solid, but some weakening in the face of higher interest rates is expected. There are few signs that a significant recession is necessary or likely to bring down inflation. Unlike the 1970s, when inflation festered all decade before Paul Volcker had to institute harsh action, the CPI did not rise more than 2% year-over-year this cycle until March 2021. Our government largely stopped its post-Covid handouts a year ago. Supply chain shortages are being resolved. As new cars arrive on dealer lots, used car prices will tumble. Lumber prices are 70% below last year’s peaks. The cost to build a new home or repair an existing home will moderate. The need for overly harsh actions simply isn’t there. At the same time, the economy needs slack to prevent a reemergence of inflation.
Putting this all together, interest rates are now restricting economic growth. That is well priced into markets. Earnings expectations need to be recalibrated. That will begin this quarter with some residual adjustment likely after year end. While the Fed is bent on raising its target rate to something over 4.5%, it won’t ignore flash points that disrupt financial markets. The British response last week is a clear signal of central bank awareness. The saying “it’s always darkest before the dawn” applies aptly to bear markets. It is rare for bear markets to last much longer than a year. The average is closer to 9-10 months, suggesting a possible end soon. In July, markets were overcome with false optimism. The reverse may also be true. There are few signs that a severe recession is coming or needed. Earnings forecasts for 2023, which have shown a 5-10% gain, probably must be adjusted lower. A wide range would be for S&P earnings to fall into a $200-$225 range next year, anywhere from flat to down about 10%. Flat would suggest a market near current levels. A 10% decline would suggest a bottom of 3200-3300. It is simply too soon to be more precise. A bottom in or near October would be consistent with seasonal market trends, and earnings within the targeted range.
Most important, however, is that one should expect an economy, once the bear market ends, to revert to a more normal historic pattern, one where interest rates build in a real cost to borrow, and where earnings grow in line or slightly better than nominal GDP growth. That means a Fed Funds rate of more than the long-term rate of inflation, a 10-year bond yield higher than the Fed Funds rate, and a market P/E near historic norms of 15-16 times forward earnings. The era where central banks forced higher than normal growth rates by allowing borrowing to be free in real terms is over, or at least it should be over. Proper balance leads to prudent investment decisions and more durable long-term expansions. The temptation to step on the accelerator always exists. Good bankers will resist the temptation. Should fiscal policy be too expansive, it is hopeful that central bankers will moderate the pressure. Expansions can be long lasting, but only if balance can be maintained.
Today, Gwen Stefani is 53. Fred Couples is 63. Reverend Al Sharpton turns 68. Finally, Chubby Checker is 81. Let’s twist again.
James M. Meyer, CFA 610-260-2220