The Fed is acting aggressively to control inflation, which came in far above expectations yesterday at an annualized 9.1% for the month of June. By raising interest rates in amounts larger than expected, they are hoping to cool off the economy by aggressively slowing it. This bodes for a lower stock market in the third quarter.
Unfortunately, the inflation we are experiencing is a supply issue, which the Federal Reserve cannot control. Even former Fed Chairman Bernanke said recently that “factors beyond the Fed’s control can contribute to inflation… Supply side forces are, indeed, important today – not only the increases in global energy and food prices...but also pandemic related constraints, like the disruption of global supply chains. Unfortunately, the Fed can do little about the supply side problems”.
At this point, dislocations in the oil and gas market, food and fertilizer markets, constraints in shipping and trucking routes, and distortions in Chinese supply/demand due to Covid, are the major drivers of inflation. There is little the Fed can do but constrain the economy through much higher interest rates. It’s quite possible that the Fed Funds interest rate will exceed the 10 year yield in the near future which disincentivizes banks from lending any money at all.
The popular theory that a recession will serve to bring prices down may be premature until the aforementioned global problems are resolved. 40 years of inflation credibility at the Fed is now on the line, and it portends much higher interest rates from the Fed.
The futures market predicts peak short term interest rates of 4% next June, and then an eventual lowering of interest rates, when inflation begins to taper. This expectation is likely to be revised upward after yesterday‘s very hot inflation numbers.
The first half of 2022 was the worst first half for stocks in 52 years. Stock declines of 20% + occurred over concerns about inflation and recession, while the US government bond market lost 10% of its value simultaneously.
The “everything bubble “, so named because most asset classes were at record levels due to rampant speculation, is unwinding just as the Fed is raising interest rates to intentionally cool off the economy.
While it is tempting to begin bargain hunting for value in the stock market at this point, it is likely that we will see lower levels first.
The narrative of the first half of 2022 focused upon inflation, and it seems to now be turning more toward concerns over corporate earnings and recession. S&P 500 companies have strong balance sheets and generally fixed rate debt. Nonetheless, higher interest rates are still increasing their borrowing costs. A 1% rise in interest rates is expected to reduce overall earnings by 3%. Add to this 5% wage inflation and significantly higher raw material and transport costs, and it’s easy to understand where this pessimism comes from.
Anticipation of higher US interest rates is driving up the US dollar to 20 year highest. US multinational corporations that do large amounts of business abroad will face earnings headwinds as their foreign profits translate back into less dollars.
Earnings season begins next week for the second quarter.
“Leading “economic indicators are concerned with future changes in economic activity. Among the most important leading indicators are GDP, employment, industrial production, consumer spending, inflation, and housing.
On July 1, the Federal Reserve Bank of Atlanta lowered its Q2 GDP projection to -2.1%. Coupled with the first quarter decline of -1.6%, they are now officially forecasting a recession. This would argue in favor of a “hard” economic landing.
US consumer confidence is now at a 16-month low, which translates into a decline of real consumer spending in May for the first time this year by 0.4%. This collapse of consumer sentiment suggests that corporate margins are likely to soften going forward, especially when we consider that manufacturers face much higher costs of capital, raw materials, and wages.
Both manufacturing and services indices are oriented lower (see ISM charts below):
Source: Blooomberg
