In the wake of the November FOMC meeting, Fed Chair Jerome Powell summarized Fed policy very clearly with two statements: “We will stay the course until the job is done”. He added, “It is very premature to think about pausing (rate hikes)”.
It was a hawkish message, though Fed Funds expectations were largely unchanged after the meeting and press conference.
Stock prices reacted by skidding badly. The S&P 500 ended the day -2.5%. The Fed has made it clear that it wants to tighten monetary conditions by engineering an equity bear market. How far can the bear market run? Here is a roadmap.
Where are we in the equity cycle?
Where are we in the equity cycle? This helpful analysis from Michael Cembalest of JPMorgan Asset Management provides some clues. Stock prices are forward-looking, and they have bottomed before GDP, payroll, or reported earnings in past recessions.
While stocks have bottomed before reported earnings, the historical evidence also indicates that stock prices move roughly coincidentally with forward 12-month EPS estimates, which are falling.
Assessing the economic outlook
Where are we in the economic cycle? New Deal democrat uses a discipline of analyzing the economy using coincident indicators, short leading indicators that look forward six months, and long leading indicators that look forward 12 months. His latest update makes for grim reading. 2 of his long leading indicators are positive and 12 are negative. The short leading indicators are a little better. 3 are positive, 5 neutral, and 6 negative. Reading between the lines, a recession is likely to begin in either Q4 2022 or Q1 2023.
All three timeframes of indicators remain negative, and there was further deterioration in the long leading index, as the 10 year minus 3 month Treasury yield inverted; and also railroads in the coincident data. Consumer spending remains weakly positive, and now staffing also has weakened significantly.
What about the inflation outlook, which will strongly influence Fed policy? While reported inflation is still hot, forward-looking inflation indicators are cooling. Goods inflation, as measured by ISM prices paid, is pointing to an imminent deceleration.
What about the services inflation? J.W. Mason observed that roughly two-thirds of excess CPI over the Fed’s 2% target is attributable to shelter.
The Owners’ Equivalent Rent component of shelter inflation is deflating. Apartment List reported that October effective asking rents fell -0.7% sequentially, though they are still up 5.7% on an annual basis. This was the third deepest decline in its history, which was only exceeded by the COVID era of April and May 2020.
There is also good news on wages. Small businesses are especially sensitive barometers of the business cycle because of their lack of bargaining power, and some small business indicators are pointing to slowdowns. Wage growth, as measured by NFIB wage pressures, is nosediving. NFIB wage intentions has historically led the Atlanta Fed’s wage tracker by about three months.
As further evidence of an economic slowdown, Bloomberg reported that about 37% of small businesses were unable to fully pay their rent in in October.
A resilient consumer
While forward-looking indicators are pointing to an economic slowdown, the Fed’s main focus on CPI and PCE inflation isn’t slowing. In fact, bottom-up reports from companies tell the story of a resilient consumer. Real retail sales adjusted by population has historically peaked before past recessions, but consumer spending has slowed, but not collapsed despite strong monetary tightening.
The strength in consumer spending can be attributed to the flood of fiscal stimulus during the COVID pandemic era. Jason Furman observed that households saved about $2.2 trillion of pandemic stimulus. but they’ve only spent about $0.7 trillion. This may mean that the Fed will have to tighten even further before “the job is done”.
Employment will be a key determinant of Fed policy. Initial jobless claims normalized by population has been rising, but readings are nowhere near levels seen during past recessions.
The stronger than expected October Employment Report also underlines the continued tightness in the jobs market. In addition, leading indicators of Non-Farm Payroll, such as temporary jobs and the quits/layoffs ratio from the JOLTS report, are still strong.
That said, the more volatile household survey differed from the establishment survey by showing a decline in jobs. As well, average hourly earnings are decelerating, which should provide relief to Fed officials concerned about a wage-price spiral,
An orderly or disorderly pivot?
In summary, the Fed is determined to slow the economy and the economy is slowing into a recession that will likely begin in Q4 2022 or Q1 2023. Forward-looking indicators of inflation are falling, though reported inflation indicators will remain strong for a few more months. The consumer is still resilient, which means that the Fed will stay hawkish until unemployment spikes.
There are two ways this tightening cycle could end. The first is an orderly slowdown which allows the Fed to stabilize interest rates and ease gradually. The other is a disorderly slowdown and financial crisis that forces global central bankers to act.
The initial sentences from FOMC press conferences offer clues of when the Fed might actually pivot and ease. Here is an excerpt from the May 2022 press conference when the Fed began to raise rates.
Inflation is much too high, and we understand the hardship it is causing, and we’re moving expeditiously to bring it back down. We have both the tools we need and the resolve that it will take to restore price stability on behalf of American families and businesses. The economy and the country have been through a lot over the past two years and have proved resilient. It is essential that we bring inflation down if we are to have a sustained period of strong labor market conditions that benefit all.
From the standpoint of our Congressional mandate to promote maximum employment and price stability, the current picture is plain to see: The labor market is extremely tight, and inflation is much too high. Against this backdrop, today the FOMC raised its policy interest rate by ½ percentage point and anticipates that ongoing increases in the target rate for the federal funds rate will be appropriate.
Powell repeated the “inflation is much too high” and “the hardship it causes American families” mantras at the June 2022 press conference.
I will begin with one overarching message: We at the Fed understand the hardship that high inflation is causing. We are strongly committed to bringing inflation back down, and we’re moving expeditiously to do so. We have both the tools we need and the resolve that it will take to restore price stability on behalf of American families and businesses.
He moved away from the “I feel your pain” message but the focus on the inflation message was clear at the July 2022 press conference.
My colleagues and I are strongly committed to bringing inflation back down, and we’re moving expeditiously to do so. We have both the tools we need and the resolve it will take to restore price stability on behalf of American families and businesses…
Skip ahead to the November 2022 press conference, and the message remains the same.
My colleagues and I are strongly committed to bringing inflation back down to our 2 percent goal. We have both the tools that we need and the resolve it will take to restore price stability on behalf of American families and businesses.
While growth has slowed, the Fed is focused on the employment picture.
Despite the slowdown in growth, the labor market remains extremely tight, with the unemployment rate at a 50-year low, job vacancies still very high, and wage growth elevated. Job gains have been robust, with employment rising by an average of 289,000 jobs per month over August and September. Although job vacancies have moved below their highs and the pace of job gains has slowed from earlier in the year, the labor market continues to be out of balance, with demand substantially exceeding the supply of available workers. The labor force participation rate is little changed since the beginning of the year.
Until the focus of the opening statement of the FOMC press conference changes from an inflation focus, the Fed will not pivot and ease.
The one exception to the orderly pivot scenario is a financial crisis. A recent BIS bulletin raised concerns about USD strength and global financial stability.
- A sequence of major shocks to the global economy has led to substantial exchange rate adjustments, notably a strengthening of the US dollar against most currencies, reflecting cross-country differences in shock exposure and in the pace of monetary tightening.
- Given the central role of the US dollar as an invoicing currency, a dollar appreciation tends to raise foreign import prices. Unlike in the past, recent dollar appreciation has coincided with a surge in commodity prices, compounding the impact on inflation. Dollar appreciation has also been associated with a tightening of global financial conditions.
- FX intervention may help mitigate dislocations arising from exchange rate swings, but is likely to be effective only if it is part of a consistent macroeconomic policy stance that ensures macro-financial stability. In particular, a coherent fiscal-monetary mix is essential to avoid disruptive exchange rate movements that may arise from fears of fiscal dominance.
Callum Thomas of Topdown Charts observed that the central banks of smaller and emerging market countries have begun to pivot to easing, as they can be sensitive barometers of monetary policy. Within the developed markets, the RBA has hiked rates consecutively by less than expected quarter-points, and the Bank of Canada also raised rates by a half-point, which was less than the expected three-quarters, and cited financial stability concerns in its statement. Norges Bank slowed its rate hike to 25 bps despite upside inflation surprises, which was less than expected.
A Fed pivot is on the horizon. The only questions are timing and the trigger.
Investment implications
Here is what all this means for equity investors. Financial markets are forward-looking. If the economy enters a recession in Q4 or Q1, the most likely historical outcome shows that it will emerge within about six months. This puts the timing of an ultimate market bottom in Q4 or Q1.
As for the level of stock prices. the last time the 2-year Treasury yield was at these levels, the S&P 500 was trading at a forward P/E of 14 to 16. The S&P 500 is trading at a forward P/E of 16.1. Assuming a typical 15-20% cut to forward earnings estimates in a recession, this puts the downside potential at 2600 to 3200.
Historically, equities have struggled in the first year of fast tightening cycles, which this is. Stocks are likely to find a bottom when it begins to discount an improvement in the macro picture.
Cam, please clarify this statement: “If the economy enters a recession in Q4 or Q1, the most likely historical outcome shows that it will emerge within about six months. This puts the timing of an ultimate market bottom in Q4 or Q1”
Because the market is usually 6 months ahead, and if the low is usually 6 months before recovery…the 6 month shifts cancel….usually.
Exactly
One of the things that bothers me a lot, which is my own selfish bias of course, is if we revert back to the PEs or market cap to GDP ratio or Tobins Q of the 70s or earlier. Should that happen, the S&P will look like the Nikkei since 1990. But I wonder if the debt and growing fiscal deficits are playing a role. Is the debt to GDP predicting future debasement of the currency?
Maybe the calculation of Tobin’s Q is off because actually it would cost a lot more than expected to replace on account of all this debt, I don’t know.
When something breaks, what will the Fed do? Will this be the Tyson Moment when the Fed’s plan goes awry?
What will the gov’t do? The pandemic response was stimulus checks , the Spanish flu pandemic , the Great Depression and WW2 what happened? Times have changed, the most palatable response short term will be more money somehow. Whether by low interest rates or taxes I have no idea.
We don’t actively worry about unfunded liabilities, but they are there and to a large extent quantifiable, is the secular rise in PEs related to some kind of discounting going on? The next 30 years sees how many trillions unfunded for SS and medicare? It’s huge, and it’s in 2022 dollars….how big an impact will COLA have on the numbers? Likely huge squared. So maybe an inevitable debasing of the currency means that PEs rise because the E of today gets inflated tomorrow.
When the bottom is in, buy. To know when the bottom is in I think we need to wait for prices to show us and if one ends up buying at 10% above the final bottom, you still get a good price….you know the advice about leaving the top 10% and bottom 10% to others.
Market cap to GDP is analogous to Price to sales
Remember P/E = Price / (Sales x net margin)
Net margin has risen because tax rates are much lower, and so is interest expense. So doing P/S or market cap to GDP comparisons aren’t very relevant. Even Charlie Munger made that comment about market cap to GDP re: Buffett’s ratio.
As for Tobin Q, it’s based on replacement value. But what’s replacement value on IP in asset light companies these days? Similarly not as relevant.