23 May 2022
The May meeting of the US Federal Reserve Board saw an interest rate increase of 0.5% and the Fed Chair making clear the intention to get US inflation down to the desired 2% level signalling two further 0.5% rate increases were on the table for both June and July. The Fed stated that ongoing interest rate increases would be appropriate and, in this environment, the key question for investors is ‘How aggressive will be the Fed be in pursuing its inflation goal?’.
At the post-meeting press conference, Chair Jay Powell spoke directly to the American people stating, ‘Inflation is much too high, we understand the hardship it is causing and we’re moving expeditiously to bring it back down’. He emphasised the Fed had the tools and resolve to achieve this. Powell also reiterated the view of the Fed that it is necessary to bring inflation down to have a sustained period of strong labour market conditions and a lengthy economic cycle.
The Fed, unlike many central banks, has a dual mandate to promote both price stability and maximum employment. There is no doubt that the Fed were too lax in ignoring inflationary pressures and as a result the labour market is now extremely tight and inflation too high. The Fed also announced they were beginning the process of significantly reducing the size of the central bank balance sheet. Today, households and business spending continue to expand in the US and the economy remains strong with the recent negative first quarter GDP number distorted by swings in inventories and net exports. During the first three months of the year, employment rose by nearly 1.7 million jobs. In March, the unemployment rate hit a post-pandemic and near 5-decade low of 3.6%. Labour force participation has increased slightly but has lagged economists’ expectations, adding to tightness in the labour market and resulting in wages rising at the fastest pace in many years.
Against this backdrop of a robust economy, inflation remains well above the Fed’s longer-run goal of 2% with their favoured indicator, the PCE, showing prices rising 6.6% in the year to end March and core PCE price rises, excluding volatile food and energy, rising by 5.2% as outlined in the Fed minutes. With aggregate demand strong and supply side disruption still present, it is difficult for production to respond quickly, and this is what is meant by the economy suffering a supply shock. Powell acknowledged these disruptions to supply had lasted longer than anticipated with price pressures spreading to a broader range of goods and services, and anecdotal evidence suggesting that both the service sector and certain sticky inflation components within the CPI basket are now seeing upward pressures. This was already occurring before the invasion of Ukraine which saw prices of crude oil, food, and additional commodities spike upwards. Powell also mentioned how Covid-19-related lockdowns in China might further disrupt supply chains.
The invasion of Ukraine will only add to inflationary pressures and Powell reiterated that high inflation would impose significant hardship for many of the population in his statement, adding that the Fed remained strongly committed to restoring price stability. The Fed is now moving policy rates to more normal rather than emergency levels, but even after the recent rise and the two forecast 0.5% increases at the next meeting, policy will remain accommodative with real rates negative. Balance sheet run off will be in line with achieving the Fed’s dual policy goals.
Powell also acknowledged that there could be a need to be nimble in response to incoming data and the evolving outlook, with further surprises likely. The Fed believe that the economy in the States is strong enough to handle tighter monetary policy.
During Q&A, Powell acknowledged that the 3.6% unemployment rate was at its lowest level in 50 years, but also that the Fed members expect some additional labour force participation which would of course help ease wage pressures. He also expects job creation to slow from the very strong half million per month and, therefore, while unemployment will fall further, it will do so at a slower rate.
Powell stated that wages were running at such a high level because of an imbalance between supply and demand in the labour market and the Fed seemed to be banking on higher labour force participation to help ease these imbalances which would see wage inflation moderate.
Powell was asked how optimistic he was and if he could slow the economy and especially the job hiring market without causing a recession. Powell discussed the extremely high vacancy rate of 1.9 people for every unemployed person and that he was hopeful that, by moderating demand, the vacancies would come down. His optimistic scenario was one where inflation and wages were down, and inflation fell without having to dramatically slow the US economy and rely on a recession to reduce inflationary pressures. Powell commented that the Fed believed there was a good chance of achieving a soft or softish landing or outcome and that this was a change in language from previous Fed statements which only referred to soft.
Households and businesses generally have strong balance sheets so are in relatively good financial shape. Powell continues to expect inflation to flatten out, including core PCE inflation – a key indicator for the Fed.
Powell discussed the neutral rate - the rate of interest that neither pushes economic activity higher, nor slows it down. He admitted that this could not be identified with any precision, so was estimated within broad bands of uncertainty. Today, the Fed estimates the figure being somewhere between 2% and 3% for an economy that is at full unemployment and 2% inflation. Powell also admitted that this could involve higher than previous estimates of the neutral rate of interest.
Powell discussed inflation expectations and noted that, to date, long-term expectations have been reasonably stable only rising to the levels they were in 2014. The Fed does not see a wage price spiral but stated that it’s a risk that couldn’t be allowed to happen, and neither could inflation expectations become unanchored.
Powell also acknowledged that much of today’s inflation at a global level is due to supply shocks that central banks cannot influence but added that, in the States, there is a job to do on demand and in the labour market, demand is substantially outstripping the supply of workers, and this is also true of the product markets. Powell was asked if the Fed would look to reduce demand further to get it into line with the reduced supply evolving from Covid-19 and the crisis in Ukraine. Powell responded saying that the Fed was focused on doing the job needed on demand for now and with 2:1 vacancy to unemployed people, there’s a lot of excess demand. With ‘more than five million more (currently) employed, plus more job openings than the size of the labour force’ there is an imbalance that the Fed will need to work on which he described as ‘A very difficult situation’. The Fed continue to believe that the US is a strong economy and not close or vulnerable to a recession, although they expect economic activity to slow.
After the tougher rhetoric at the recent Fed meeting, the key question for investors is how aggressive will the Fed be in pursuing its inflation goal? While rate rises have captured the attention of investors, it is important to remember at the outset that all the Fed is doing for now is removing the emerging settings put in place to counter the impact of the pandemic. The reality is that the Fed is belatedly taking its foot off the accelerator, not hitting the brakes. The Fed Funds rate just prior to Covid-19 was 1.5-1.75% and factoring in two further 0.5% increases by July, the rate will be 1.75-2.0%, leaving interest rates below the long-term neutral range indicated by the Fed of 2-3%. So, by the summer, monetary policy, although tighter, will still be accommodative.
Notwithstanding this observation and its impact on the real economy, it is still highly significant for investors as it represents a material change from the ultra-easy monetary conditions to which markets have become accustomed and investors have benefitted from. When 10-year US Treasury yields hit 3%+, there was an alternative for investors to equities, especially if there is still belief that the Fed’s long-term inflation goal of 2% will be met. Furthermore, a higher discount rate now needs to be applied to corporate earnings, thus lowering the fair value PE valuation for shares. The US stock market has reacted negatively to this changing landscape with the S&P 500 at 4010. It is down around 17% from its January 2022 high of 4820.
Looking ahead, over the remainder of the year, it is likely that both the rate of economic growth and inflation will show some signs of deceleration. A key question for markets will be which of these falls faster and furthest. The US delivered negative first quarter GDP, but this was distorted by technicalities including the trade position and de-stocking, so it is likely that there will be a rebound in the second quarter to a positive number. Most recent data from the Atlanta Fed Nowcast suggests growth of around 2%. The most recent employment numbers emphasised how tight the labour market remains. Other more forward-looking indicators such as the recent ISM manufacturing survey were not as strong as expected and, looking at new home sales, there are signs of declining sentiment in the housing market which isn’t surprising given that the mortgage rate has risen from around 3.0% at the end of last year, to around 5.4% today. These limited signs of economic deceleration are unlikely to deter the Fed from raising rates over the next three months in line with Powell’s comments. Investors should therefore focus on what will happen after this.
If by the summer there are tentative signs of economic slowdown, how will the Fed react? A positive surprise for markets will be if the Fed blink and deter from raising rates as aggressively as the market expects. However, if inflation remains sticky, even if growth slows, the Fed may press on with rapid monetary tightening. For the Fed to back off from raising rates, they will need to see indications that supply-side inflation factors are starting to ease materially and upward wage pressure in the employment market is moderating. Even if the economy shows a marked pace of slowdown but inflationary pressures remain too strong with labour markets often a lagging indicator, the Fed. for its own credibility, may feel forced to press on with monetary tightening. Then the question of what is politically more important may come into play which, in present circumstances, is the cost of living.
Fed rhetoric is tough today but in recent weeks, the Bank of England has undermined its commitment to battle inflation at all costs in the face of a likely significant UK economic slowdown. Fed commentary to date has continued to emphasise their belief that they can thread the needle and get inflation down without causing a recession or major economic slowdown. At some stage the Fed may be forced to choose which in the short term is the most important component of its dual mandate; full employment or price stability.
At this point in time it is impossible to forecast with conviction which scenario is the more likely. These outcomes will have vastly different implications for stock markets, so investors may be forced to act quickly as required. Changing market structures with more mechanistic, or in other words quantitative decision making, means short-term volatility is high by historic standards. Volatility can occur on the upside as well as the downside and encouraging data could allow significant trading rallies in a short space of time. If the Fed did decide to pause rate increases in the light of slowing growth, even if inflation remained sticky, there would likely be a short-term positive market response. However, over the longer-term, a Fed less committed to getting inflation down and risking losing its credibility would lead to higher 10-year Treasury yields and a consequent negative impact for equity market valuations.
At the press conference following the recent Fed meeting, Chair Jay Powell emphasised the strength of the US economy in contrast to previous periods entering rising rates and economic slowdown and commented that the strength of the employment market meant a recession in the short-term was unlikely. Also, as well as some preliminary signs of a degree of slowdown in the domestic economy, investors should note that external influences are now much more important. Geopolitical uncertainty has reached heightened levels and the Ukraine war now seems likely to go on for much longer than most investors had originally expected. With both sides in a stalemate situation, investors should refer to the First World War where, with no side losing badly enough to want to accept compromise, the war dragged on for many years, despite the appalling level of casualties.
The Covid-19 situation in China is becoming increasingly difficult to the point where political goals have replaced pragmatism at the top levels of leadership. President Xi determined to stick to a zero Covid-19 policy at all costs and his authoritarian leadership has resulted in no real debate within China. China has been an important element of global growth in the post GFC period and for this year at least this looks certain to change.
On the inflation front, the US Employment Cost Index rose 4.5% year on year and the core PCE numbers remain well ahead of Fed targets. The Atlanta Fed have indicated sticky CPI components are seeing upward price pressures. At present, the most likely outlook is the first scenario where economic deceleration is moderate, but inflationary pressures remain high, so further monetary tightening will remain at the forefront of investor focus.
In this environment, US equity markets are unlikely to rise significantly or on a sustained basis from current levels, even though the market is pricing in some level of rate increases. Looking at PE ratios, market valuations will have to adjust to reflect this. According to Yardeni Data, the average forward PE over the last 10, 15, 20, and 25-year periods has been 16.9, 15.5, 15.5, and 16.5. This year is still likely to be a positive one for corporate profits due to the bounce back from Covid-19. Forward consensus earnings for the S&P 500 are around $235 per share which, at the lower end of valuation estimates, would signal a price target for the S&P 500 of 3,600 and 3,960 at higher valuation levels. These are only consensus estimates and numbers could weaken, possibly significantly, in the second half of this period and on into calendar 2023. A 10% decline in profits in 2023 after this on a lower valuation multiple of 15.5x would suggest the S&P trading between 3,275 and 3,575 but clearly if there was a much more severe profit downturn with earnings declining say 20%, the US stock market could fall below the 3,000 level. It should be emphasised that these are not market forecasts but estimates of where valuations could be heading and what level the market would have to fall to, to trade below historic averages.
The world continues to be dogged by a high level of uncertainty and the Russia/Ukraine conflict has no easy circuit breaker; Putin needs a victory and the Ukrainians, through their unexpected success on the battlefield, are unlikely to permanently cede territory to Russia. Putin may pursue escalation to try and deliver some sort of victory which can be presented as a success to the people at home. The recent commentary from the Fed after its open market committee meeting, as well as apologising to the American people, sounded rather like Draghi’s ‘Whatever it takes’ remarks of July 2012 with emphasis on preventing inflationary expectations becoming embedded.
With no sign at present of a significant slowdown in inflationary pressures, this presents a near term challenging outlook for equity markets. Even if measures by the Fed succeed in easing pressures in the labour market, this may not on its own be enough to lower inflation to its target range. Previous Treasury Secretary, Lawrence Summers, has commented that when inflation has been over 4% and unemployment below 5%, recession has always followed within the next two years. The US economy, after an exceptionally vigorous recovery due to persistently applying over stimulatory measures, even as the post Covid-19 recovery gathered pace, has seen the labour market significantly overheat and with wage growth strong and most US companies reporting pricing power, long-term inflation expectations have already started to edge higher. For the Fed to pull the rabbit out of the hat, supply constraints need to ease and a lengthy conflict in the Ukraine reduces the odds of this happening. With real wages under pressure, workers will be tempted to press for significant increases in a tight labour market in the short term and be happy to change jobs to achieve this.
Fine tuning an economic slowdown is hard to achieve without tipping an economy over the edge. With real incomes under pressure, high inflation will eventually curb demand. These challenging economic circumstances combined with asset prices at historically high levels could be justified when short-term and longer-term interest rates were at zero or below. Most gains in the Post Financial Crisis bull market and especially the post Covid-19 rally have been driven by multiple expansion and significant components of consumer wealth such as residential housing and the stock market trade at relatively rich valuations. Valuation alone is never a catalyst for a severe market downturn but is an important factor in determining when fundamental investors will be prepared to commit money to any particular asset class. If the Fed decides, but understandably cannot publish, a view that a recession is now needed to keep inflationary expectations under control, corporate profits and, therefore, equity market valuations will remain under pressure. Even after the price declines that have occurred in the second quarter, the lack of significant valuation support in the US equity market suggests investors should continue to proceed with caution as better opportunities for attractive entry points look likely to occur as the year progresses.
Graham O'Neill, Senior Investment Consultant
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