Equity markets didn’t seem to like what the Fed had to say last Wednesday judging by the reaction of the stock market in the ensuing sessions. 10-year Treasury yields rose sharply. Since they are a measure of long-term inflation expectations, the Fed’s course toward a soft landing with moderating inflation either didn’t sit well or wasn’t believable. Either way, it was the worst week for stocks since March.
Just to summarize the message, the Fed said that its glidepath towards lower inflation consists of higher interest rates for a longer period of time. In reality, the message has been fairly consistent for some period of time. But markets didn’t buy in. According to Fed Fund futures, certainly a measure of the market’s expectations, investors had expected to see a series of rate cuts next year starting in late spring. According to the dot plots of FOMC participants on Wednesday, maybe one rate cut should be expected in 2024.
As noted many times, any predictions by the Fed or others more than 90-days out should be considered suspect. We can all speculate about the future, and indeed, markets constantly reflect the consensus of expectations. But they are wrong far more often than they are right. Thus, the name of the game is to bet directionally. Are expectations too draconian or too optimistic? Answer that question and it will define the near-term direction of markets.
The Fed is clearly betting the odds of a soft landing are increasing. If the FOMC members believed a recession was likely, they would have figured on more future rate cuts sooner. There are lots of reasons to support their view. GDP is still growing. There is no sign today of imminent recession. Immigration is spiking, part legal and part not so legal. Staying away from what constitutes the right immigration policy, the facts say 1 million new immigrants entered last year with a corresponding spike in the work force. Just last week, the Biden administration asked for 470,000 work permits for Venezuelan immigrants. If the U.S. is going to open the floodgates and let millions in, does it make sense to prevent them from working? The alternatives are welfare and crime. New immigrants are not going to design semiconductors; they will wash dishes and mow lawns. But they are additive to GDP growth. Again, not judging whether this is good or bad policy, it is positive for economic activity and enhances the chance for a soft landing.
On the other hand, there are headwinds as we have listed before. China. Labor unrest. Higher energy prices. Declining corporate profit margins. Rising consumer debt. Signs the excess benefits of government handouts were running their course. The bottom line is that we know the economy is slowing. Whether it bottoms out above the zero line or falls into recession is an unanswerable question at the moment.
However, if we assume that the Fed is going to keep rates elevated, at least relative to the recent past, that paints a new picture. There has been a lot of commentary in recent days talking about the “higher for longer” path for interest rates. This isn’t a new path; it’s a reversion to the path that existed for decades before the Great Recession. And it collides with administration policy that spends more and doesn’t really care much about deficits. If one simply counts the PPP loans forgiven, the employee tax credits everyone is advertising in the media, and the student loan forgiveness being advocated, the total is well over $1 trillion. Without debating the societal benefits or lack thereof of such programs, there is little argument that they are inflationary, forcing the need for higher rates. The trap then becomes the increases forthcoming in debt service, Medicare and Social Security. Over a two-year period, they total over $1.5 trillion. No wonder rates have to stay elevated!
If monetary policy is to be defined as a reversion to a multi-decade mean, Fed Funds should settle north of 3%, and 10-year Treasuries should settle north of 4%, soft landing or not. The commensurate fair P/E for stocks should be about 15-16 times forward earnings. Even with the recent decline, the P/E is closer to 18. The gap ultimately will be closed by either higher rates, lower stock prices, or a combination of the two. The gap between 16 and 18 is only a little over 10%. It doesn’t have to be closed immediately. Obviously, this doesn’t require a major correction or bear market. But it does define stocks as expensive still, despite recent declines. There are technicians who extoll that August and September are traditionally weak while Q4 is traditionally strong. True. But early October normally extends August-September declines. In a nutshell, it is probably still too early to be aggressive.
In summary, even though it remains impossible to say soft landing or recession, and accepting the benefits of rising inflation, the bond market is still biased toward higher rates, and stocks remain expensive. With that said, some stocks have come down enough that prices are beginning to look tempting. Conversely, traditional safe harbors (e.g., consumer staples) are still expensive. If you want to nibble, do so gingerly.
Lots of birthdays today. Catherine Zeta-Jones is 54, and her husband Michael Douglas turns 79. Will Smith is 55. Heather Locklear turns 62 and Mark Hamill is 72. Cheryl Tiegs is 76, and finally, former Defense Secretary Robert Gates is 80.
James M. Meyer, CFA 610-260-2220