Looking ahead, there are two possible logical outcomes, a soft landing or a recession. Clearly, the Fed’s message was in support of a soft-landing. The unemployment rate, now at 3.8% is expected to peak around 4.1% suggesting net jobs continue to grow, on average, every month. However, the pace of growth will be even slower than the average of 150,000 net new jobs over the past three months. With that said, the same projections assume we won’t enter a sustained period of negative job growth. The dot-plots of all participants predict a range of growth through 2026 between 1.2% and 2.0%. No recession. As for inflation, the forecasts predict a slow decline toward the Fed’s 2.0% target. None expect that target to be reached before 2025. All expect inflation to be between 2.0% and 2.2% in 2026. Needless to say, a prediction by any economist of what inflation will be in 2026 should be taken with an appropriate grain of salt.
The actual predictions themselves shouldn’t be taken literally any more than my weather forecast for three weeks from today. But, taken in proper context, these projections are the backbone of current policy decisions. Let’s start with the understanding that the Fed isn’t trying to create a recession. It wants to defeat inflation without one. That happens rarely, but it’s worth a try. So far, so good. We aren’t in a recession yet. But, as I noted in Wednesday’s comment, the ingredients for a recession exist today. It’s still a jump ball.
While the Fed essentially did nothing Wednesday, the market’s reaction was rather decisive. Oddly, the Fed’s attempt to make the case for a soft landing may have increased the odds of a recession. Raising longer term rates puts more pressure on mortgages and raises refinancing costs for those carrying debt that must be rolled over. The decision to keep liquidating the Fed’s balance sheet ensures a reduction in monetary supply and increases stress on the financial system. Simply said, the risk of accidents increases, particularly in commercial real estate, including office buildings and apartments.
In short, the market’s reaction was proper. Higher rates, the increased risk of recession, and higher financial stress negatively impact high P/E stocks, capital spending, cyclical companies dependent on the pace of the economy, and companies with debt-laden balance sheets. While there are always harbors in the storm, again as noted Wednesday, storm threats increase.
The next FOMC meeting is October 31-November 1. Between now and then, there will be just one employment report, one CPI report, and one report on retail sales, maybe the best proxy for consumer spending. The FOMC tries to be forward looking but is reliant on data. Chairman Powell has used the “data dependent” term countless times. Data is backwards looking. CPI “data” tells us shelter costs have been increasing at 7.3% over the past 12 months. Anecdotal data today suggests housing prices are stable and rental increases are falling toward zero. We can project the shelter cost component of CPI (about 40% of core inflation) might fall to 1% over the next several months, but the “data” says inflation is still hot. I don’t want to insinuate that inflationary pressures are disappearing. Look at wage increases and all the strikes. Look at the lack of productivity. It hasn’t been above 2% since mid-2021 and it has been negative for much of the time since then. If economic growth rates decline while the economy continues to add jobs, productivity will likely turn negative again. Combine low productivity, population growth of about 0.5%, and 4%+ increases in wages, and it is hard to see inflation falling toward target anytime soon.
Thus, the FOMC conclusions all coalesce around the assumption that a soft landing happens. It still might. As I said earlier, it’s a jump ball. But if the Fed is wrong, if consumer demand falls or job creation doesn’t continue at its current pace, then a recession happens. It would probably be modest. But slipping productivity, inflation still above target, and tighter monetary conditions point to the likelihood that near term profit forecasts are too high.
Investing is a battle of odds. The center point is a soft landing, slowly falling inflation, and GDP growth near current levels. The upside is something better than expectations. A more rapid deceleration in inflation. Faster growth. Better productivity. Lower interest rates 6-12 months from now. The downside, simply said, is a recession. Lower profits. Given current P/E ratios, the market has not built in the possibility that earnings could decline sequentially any time soon. Markets are not anticipating any further spike in long-term rates. If I start with the assumption that current forecasts are wrong, and I had to choose whether reality will exceed forecasts or not, I would choose the downside.
What does that mean for investors? Let’s start with bonds. For most of the last two decades, bonds have been a losing proposition. Rates were below the rate of inflation, sometimes substantially so. Today, with core inflation below 4% and likely to be below 3% not too long from now, bonds offer positive returns. Said differently, money won’t burn a hole in your pocket. Or, you will earn a positive return, at least for now on your cash. That means there is no urgency to invest cash if you get a positive return simply standing still. You invest because you see better risk-adjusted returns in stocks, real estate, or any other asset class. But when other classes look expensive, bonds look pretty good. For a long time, there was an acronym, TINA, which, applied to the stock market, said “there is no alternative” meaning stocks were hot and bonds were not. I am not making a prediction here, but if you felt a recession and falling profits were ahead, you could apply the TINA acronym to staying in safe short-term fixed income until the skies started to clear.
Markets are forward looking. Generally, academic studies strongly suggest stocks look 6-9 months ahead. Even if there is a brief mild recession 6-9 month from now, the skies could be brighter. But that’s a guess, not a prediction. In 2009, we were using the term “green shoots” to suggest an ending to the Great Recession. Right now, it is too early to see green shoots. I still see storm clouds, falling productivity, the end of post-pandemic spending exuberance, a tough investing environment and higher interest rates. I am not forecasting a big recession, even under the worst of circumstances. But I am suggesting to stay patient. Build your buy list. Set buy points. If your stock falls to that level, buy a little. If it falls further, buy a little more. It is more important to pick the right company than the exact bottom. At the same time, purge your mistakes. If they are down this year, they will be subject to tax selling. Let them go. You can always buy them back.
Today Andrea Bocelli is 65. In 1515, on this date Anne of Cleves was born. She became the 4th wife of Henry VIII. What separates her from the others, is that she lived to witness the coronation of Mary I. Unfortunately, she died at the relatively young age of 41, probably of cancer.
James M. Meyer, CFA 610-260-2220