The Fed, Inflation and Market Perspective
• Inflation may have peaked last month. The latest CPI number posted a light decline in the inflation
gauge to 8.5%, year over year. While inflation may have peaked, the Federal Open Market Committee
(FOMC) will require more evidence of a slowing economy before monetary tightening subsides.
• Expectations are building that the next FOMC rate hike will be 50 basis points versus the prior 75 basis
• Although housing markets have already reversed course as higher rates and still expensive housing
prices stymie homebuyers, the job markets remain resilient.
• Expectations are for a mild recession given the job market strength and a well-telegraphed Fed response.
• During the past two months, we have witnessed a market rebound of up to 50% of losses from the June
16 market lows. Although this rebound may have been a bear-market rally, opportunistic buys still exist
across the market spectrum.
This year has been a blur. For news junkies, daily streaming TV headlines have whetted appetites for a constant flood of politics, the battle for Ukraine, rising prices, and the latest Covid variant. Now add monkeypox and midterm elections to our daily news feed, and the distractions keep coming.
From the investor’s perspective, the drama began anew late last year and ramped up this year on March 17. First to unravel investor confidence was Fed Chair Jerome Powell’s November 30, 2021 comment that it was “probaby time to retire the word transitory,” referring to the increasing and persistent price levels (inflation) throughout the economic supply chains. This statement was followed up a few months later, on January 21, as Powell again commented that “inflation had persisted longer than we thought and…we would begin moving away from accomodative policies.”
The first monetary policy “shot” didn’t occur until March 16 in the form of a 25 basis point hike, but investors had already read the tea leaves of things to come. On January 3, the broader market sell-off began, which, as of this writing, bottomed out June 16.
Through mid-August, the Federal Reserve has delivered on its promises with four Fed fund hikes to date—the most recent adding another 75 basis points. Those hikes bring the current intrabank lending rate to a range of 2.25% to 2.50%. The question at hand is, what’s next?
The most recent release from the Fed’s minutes reaffirmed the central bank’s intent to continue raising rates until inflation drops “substantially.” And despite several regional Fed members talking up a 75 basis point hike for the upcoming September meeting, the markets are expecting something less dramatic—a 50-basis point increase. Uncertainty, though, was enough to unnerve investors this past week (August 15-19) and otherwise end a four-week rally which had added back nearly 16% from the S&P’s June 16 lows. With Fed Chair Powell speaking at next week’s (August 26) global central banking conference in Jackson Hole, Wyoming, a number of investors are now preferring to sit on the sidelines until some clarity on Fed policy is provided.
Although no explicit news of a rate hike will be forthcoming from Fed Chair Powell in this upcoming meeting, he should provide a glimpse into the expected tone of the next FOMC meeting on September 21 and 22.
Where the economy sits today and how the continuing monetary policy changes work their way through the economy will set the stage for policy changes that investors and consumers can expect over the balance of 2022 and into the following year. A number of the factors that were pushing prices high over the past 18 months are behind us. Rising rates have already begun slowing consumption growth, a factor most certainly felt in the housing markets.
Over the last seven months, short-term rates in the U.S. have risen at the fastest pace in nearly 40 years, and this increase has permeated through the lending markets. Although the economic backdrop for consumers is somewhat positive, given still relatively healthy balance sheets and job markets, business activity has begun to slow both here and overseas.
As evidence, the Eurozone manufacturing’s Purchasing Manager Index (PMI) has dropped into contraction territory as Germany’s business expectations index (ZEW) fell to its lowest level since 2008. Here in the U.S., the new orders component for the Institute of Supply Management (ISM) dropped into contraction territory as well (below a 50 index reading). Add the past two quarters of negative growth in domestic GDP readings, and the economy may “possibly” be in official recession territory. Whether that will have much of an impact in any way other than recordkeeping is the unknown and more likely a function of how aggressively the Fed continues to dampen today’s headline inflation.
From a “glass half full” perspective, however, last week’s Philly Fed Manufacturing Index reading was an improvement this month from the prior month’s cycle low: new orders improved (although still negative growth) and the employment outlook continued to improve. One component that also stood out and should interest the Fed was the “prices paid” component which has begun reversing course, given the slowdown in economic growth.
The most recent Consumer Price Index (CPI) also suggests that inflation may have peaked a month earlier, as July posted a slight year-over-year decline in the inflation rate to 8.5%, owing significantly to a decline in fuel prices (-4.6%) from the month earlier. Of course, one month does not make a trend, but it was noteable that several key categories such as used cars, clothing, and household appliances all reported price level declines. And increasing inventory levels for a number of retail giants suggest that in the near future, more companies will be discounting excess inventory, a plus in the effort to rightsize pricing.
Against this backdrop, it is noteworthy that consumers are lowering their inflation expectations as well. Recent New York Fed data shows the consumer inflation outlook has dropped to 6.22% for one year ahead and 3.18% for three years out.
State of the consumer and the job market countertrend
Consumers have a somewhat mixed perspective regarding their future. Many certainly look at inflation levels declining over the next one- to three-year period but are concerned about today’s inflation impact. The July Conference Board’s Consumer Confidence Survey index declined for the third straight month as respondents raised concerns over inflation, gas, and food prices. Of the respondents, 17% said business conditions were good (versus 19.5% the prior month) and 24% said business conditions were bad (versus 22.8% the month before). Just as interesting—and encouraging—though, was their six-month outlook with slight upticks in job availability and their anticipation of increasing wages.
Also interesting was the American Association of Individual Investors (AAII) poll released August 17. The poll highlighted a 20% increase in the market bullish camp to 33.3% of those surveyed having a positive outlook. While well below the historical average of 38%, from an investor perspective, retail investors are now a bit more intrigued with current market valuations. In the meantime, while falling gas prices are positive, those prices still remain roughly 23% (+/-75 cents) above levels last year. Unfortunately, the consumer is still looking at higher mortgages (home prices and interest rates), higher rates on their credit cards, and escalating costs at the grocery store.
Job market countertrend
Despite weakening in certain sectors of the economy, the labor markets remain a bright spot and certainly one anchor that potentially dampens the risk of a “hard economic landing” from overly aggressive rate hikes. The unemployment level still remains at a historic decades’ low of 3.5%, providing an interesting context. In every prior post-war recession, unemployment levels have always increased ahead of the economic downturn, providing a glimpse of what was just around the corner. This year has been the exception. Of course, data can change on a dime, but the labor markets today still appear relatively sound despite slight upticks in initial jobless claims in recent months, and continuing claims have similarly remained sound.
Meanwhile, against the backdrop of July’s nonfarm payrolls jumping by 528,000, the small business NFIB survey reported that 50% of the small business owners surveyed had job openings still available, and another 19% planned to create new jobs over the next three months. Again, the job backdrop can certainly change quickly if business conditions deteriorate, but that signal remains absent from today’s data.
The housing industry has been the most visibly impacted, taking the brunt of rising interest rates and the industry’s prior two-plus years of upward spiraling home prices. This sector has also demonstrated how quickly situations change. While mortgage rates have taken a breather (as buyer demand has slowed), the markets have not adjusted yet to the year-over-year increase in rates, and the still-high home prices remain detached from homebuyer incomes. This past month we witnessed housing starts fall for the second time in the past three months: Single family starts fell to a June 2020 low, and building permits fell to a September 2021 low. On a year-over-year comparison, home sales were down 20%.
Add to those numbers a 5.9% drop in existing home sales (the lowest level of sales since 2014, ex-Covid) and a National Association of Home Builders (NAHB) confidence index level falling to a contraction reading of 49, and this is a key economic industry to monitor. The good news, though, is that housing inventories continue to rise from their lows earlier this year (although still below pre-Covid norms) because of slowing sales. This growth in inventory should provide relief from escalating housing prices and more opportunities for future homeowners. In the meantime, Fed policymakers are closely watching the impact of rising rates on the housing markets and the corresponding impact to the broader economy.
Reading the market tea leaves
Reignited investor fears were again obvious last month with July’s fund outflows. Domestic growth fund strategies bled $7.2 billion in assets, adding to the year-to-date withdrawals of nearly $50 billion. This outflow was in tandem with investors pulling funds from all equity categories, except value strategies. Also interesting was that in this environment of rising rates, investors seeded approximately $12 billion last month into intermediate-and long-term bonds while pulling roughly $12 billion from short and ultrashort bonds.
Aside from nervous investors sitting on the sidelines, there was sufficient market support to drive a partial recovery for the broader equity categories from their June 16 lows. As we might expect, the more growth-oriented, the better the two-month returns. Growth and small cap stocks fared best, ranging from +/- 19% to 20%. All S&P sectors were positive over that period, with consumer discretionary stocks leading the charge, up approximately 25%. The laggard, not so surprisingly with recent gasoline price declines, was the energy sector, up a more modest 3.5%.
The overseas markets were mixed. One of the star performers was India, up 11.6%, followed on the downside by China, off -3.78%. All commodities except natural gas were negative over the same period. Surprisingly, gold tracked negative despite inflation concerns while natural gas was positive (up nearly 24%) as Europe begins facing the prospect of a chilly winter without Russian supplies of natural gas. An honorable mention also goes to the fixed income markets, with the broad bond markets posting positive over the two-month period. Unfortunately, this was not the case for the year-to-date returns for longer maturity Treasurys (20+ years) which shared last place (and negative returns) with growth stocks.
While the markets did provide some reprieve, the sell-off earlier in the year was significant. Using Sector SPDR’s as a market sector proxy, the following chart highlights the recovery required for each indicated sector to move back to its prior 52-week high. Closest to a prior one-year “recovery” was the utility sector, now almost back to par. Countering this more defensive sector was the more growth-oriented communication services sector, still down nearly 33% from its one-year high. Also, in contrast, is the more diversified S&P 500 ETF, which despite a nearly 16% rally over the past two months, remains off nearly 12% from the prior 12-month high.
Now, with more hikes ahead and the acknowledgement that at some point a recession will be called, the question is, where is the market headed from here and were the last two months a bear market recovery? In answer to the last part of the question, these last two months were most likely a bear market rally. And it’s a greater likelihood that more volatility is ahead. But I also think we have seen a bottoming in equity trading ranges from the June lows, based on factors such as the breadth (the number of stocks) participating in the recent rally; the number of stocks above their 50-day moving average; the participation by small caps; and the significant percentage of stocks making new 20-day highs. Although more technical in nature, this market positioning generally represents institutional investors looking for opportunistic valuations. However, I expect to see continuing market volatility until the evidence is in that the Fed has completed its monetary tightening, inflation is under control, and just as importantly, corporate earnings have once again turned the corner. Until then, the markets will indeed provide great entry points.
Whether we have fallen into a recession or not, the economy did post negative growth for the first half of the year. But as mentioned in the past, tomorrow’s headlines are already history. What we have learned from history, however, is that the second year in a presidential cycle is generally the worst market year, but the good news is that the third year is generally the strongest. Whether or not that will apply this year and the next remains to be seen, but I expect that the market damage this year will be repaired next year. It’s the market timing that’s difficult.
Also known is that supply chains are unplugging, and shipping/freight costs (to/from China) have significantly declined. Inflation will continue to slow as economic activity trends downward. Housing is on the forefront of the slowdown as prices and mortgage rates must find that equilibrium where new homeowners can afford their first house. Demand will continue to trend downwards as the global economy slows. And the fall in demand helps inflationary pressures—caused by the quick post-Covid economic recovery—to fall.
I am also trusting that the second half of the year will be less eventful (from a market perspective) than the first half. The Fed’s monetary policy goals are well telegraphed, inflation has (hopefully) peaked, and I would expect the inevitable recession, when called, will be mild. In the meantime, the job markets will likely remain intact, despite an inevitable uptick in the unemployment rate. Most businesses remain well grounded, having learned valuable lessons during the Covid economic lockdown. And a number of those companies that needed extra liquidity raised debt through last year when rates were still extremely attractive. Meanwhile, Congress approved two bills this month—the Chips and Science Act of 2022 and the Inflation Reduction Act of 2022—that may also lead to increased capital outlays over the next few years (jobs, targeted economic growth, increasing domestic research, and development and corporate profits). Only time will tell the full impact of the two bills’ passage, but they should provide additional economic stimulus over the next several years.
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