Oil and Inflation
A surge in oil prices rippled through global markets this week, impacting stocks and bonds on worries that higher energy costs will fuel inflation and force the Federal Reserve to boost interest rates. Crude oil prices topped $90 per barrel as the US launched a fresh wave of strikes against targets in Iran, raising concern about further disruptions in oil flows. Those risks lifted global bond yields to the highest since 2008, reducing the appetite for equities at the start of a seasonally weak month. The S&P 500 lost about 1% yesterday, also dragged down by a decline in technology stocks. It is no wonder that Energy has actually been the leading sector this year, outpacing all other sector returns by far.
A Hall of Mirrors
New Federal Reserve Chairman Kevin Warsh spoke at the Fed’s annual gathering in Jackson Hole, Wyoming, last week. While prefacing the meeting as one involving a “quieter Fed,” Warsh’s speech ended up being one of the longest Fed comments on record. Chairman Warsh laid out a series of guiding principles that will inform his decisions and that of the voting members of the FOMC in the future. Remember that Alan Greenspan, former Fed Chair, once stated, “If I turn out to be particularly clear, you’ve probably misunderstood what I’ve said.”
One key potential problem Chairman Warsh pointed to was that of a “Hall of Mirrors.” That is, if markets rely materially on the Fed’s guidance, and the Fed relies on market prices, then the Fed is more likely to be blinded to new developments. That scenario makes it more likely for the Fed to be caught unprepared for a turn of events and more likely to commit errors in policy. The Fed Chair also noted that there should be no misunderstanding about the Fed’s price stability objective of 2 percent. This is a firm, fixed target. The question remains then, what are the inputs that will trigger a response from the Fed, or its “reaction function,” if it is not looking to markets for direction? This may seem like circular speak, but markets certainly reacted, placing a nearly 70% probability of a rate hike later this month and a 90% chance of higher rates by the end of the year.
The Economy According to Warsh
According to the Fed Chair, expectations for growth in both capital expenditures and corporate earnings are running high. The follow-on effects on asset prices, business confidence, consumer income, and spending are equally important to gauge. So far, credit spreads on corporate bonds are near the low ends of their historical range, indicating a lower level of economic uncertainty. Meanwhile, bond issuance volumes have been strong this year, especially from technology companies funding data center buildouts. Bank standards for commercial and industrial loans are on the easier end of the spectrum as well. Certain sectors, like housing and agriculture, are showing signs of strain, but financial conditions are not considered to be restrictive, according to the Fed. On the employment side of the Fed’s dual mandate, the U.S. appears to be doing okay. The jobless rate, at 4.1 percent, remains low by historical standards. Yesterday’s JOLTS report from the Labor Department showed that U.S. job openings ticked up to 7.27 million in July from a revised 7.18 million in June. The report also showed that layoffs fell, and so did the number of people quitting.
Returns and Resolutions
August was an unusually eventful month for U.S. stocks, characterized by three all-time highs for the S&P 500 and a remarkable comeback in technology stocks. This was dampened by inflation concerns and rising expectations of Fed rate hikes along with the escalation of conflict in the Middle East on the final trading day of the month. Inflation and government debt levels have become international concerns, and global bond yields have climbed back to the highest level since 2008. At least Congress will avert an October 1st government shutdown, passing a stopgap funding bill to finance the government through December 11th. That pushes future funding battles until after the November midterm elections.
The Fed Chairman is concerned about a faulty hall of mirrors feedback loop for adjusting interest rates. The most famous hall of mirrors is of course in the Palace of Versailles, where the World War I peace treaty was signed. However, a hall of mirrors also features prominently in Ray Bradbury’s novel “Something Wicked This Way Comes.” Higher rates appear to be that thing coming our way.
Actor Keanu Reeves turns 62, actress Salma Hayek turns 60, and former Pittsburgh Steelers quarterback Terry Bradshaw scores 78 today.
Christopher Crooks, CFA®, CFP® 610-260-2219
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