Most of what I do is review and analyze global macroeconomic conditions. I fancy myself as a “big thinker” probably due to my upbringing in the proprietary side of the institutional investment game. I tirelessly pontificate upon long-term themes and find companies that are most likely to benefit from that trend taking shape. I read countless earnings reports, CEO transcripts, cash flow statements and balance sheets. Basically, I try to pick the right names in the right trends at the right time and select them for the portfolios that I manage. When investors embrace that logical path beautiful things happen. My stocks’ earnings expand, margins grow seemingly unabated, regulatory policies gently bow away in the name of advancement, and fellow market participants allocate gleefully to the trend.
But every so often we get a good scare in the markets. Perhaps a hedge fund collapse, or a credit crisis, or a taper tantrum, or even a global pandemic. Yet policy makers always find a way to ease our fears and support the common man. And as investors we get much solace knowing that the Fed has our backs. The theme is simple: when unexpected bad things happen in the investing world, the Federal Reserve comes galloping in on the white horse and showers us with easy money to topple the wall of worry and get us back on track. Wall Street, the Fed knows, is paramount in the process of bolstering solid growth for Main Street.
Our latest scare is that we have an old Charybdis in our midst, the kind of which we have not seen since the days of Federal Reserve Chairman Arthur Burns and the easy money policies of the 1970s. The story of Dr. Burns is etched into our investing minds, and for that matter into every subsequent Fed Chair’s brain. The 1970s was a period where politicians were struggling to keep the populace happy, with a protracted Vietnam War coming to an unceremonious conclusion, the US dollar being debased, global competition appearing to overtake American ingenuity, an Oil Embargo driving inflation, and a challenging foreign policy driven by the Cold War. The solution to some of these problems was believed to be the easy money policies of Arthur Burns, who was to a great degree politically influenced by the White House.1 The Federal Reserve kept an expansive monetary policy to maintain a low level of 4% unemployment and left Nixon to control inflation through wage and price controls. The result we now know was a colossal inflationary mistake that required newly appointed Fed Chairman Paul Volker (1979-1987) to undo the mess by aggressively introducing contractionary interest rate policies.
Most Gen X’ers and all Baby Boomers remember the uncomfortable 1970s and 1980s, where price increases and recessions were as common as Bazooka Bubble Gum. The grand lesson learned by the Federal Reserve was that when it comes to inflation you must act early to nip it at the bud before the field is swarmed with the dandelions of distress. This is exactly why the Federal Reserve has embarked on an aggressive path towards eradicating the inflationary impulse. There is absolutely nothing worse for Main Street than an inflationary cycle and negative real wages. It corrodes the soul of advancement and forces consumers to suffer difficult trade-off decisions in their daily lives as their purchasing power is pummeled. “Regular folks,” as former President Obama used to refer to us, loath it when our money is devalued because of inflation. We just feel poorer from day to day, and it seems that every adult conversation we have is interrupted at some point with the obligatory disbelief as to how much things cost more from the previous shopping experience. Chairman Powell has thus entered his “not on my watch” period in his second five-year appointment. In his remarks after the May 4th 50 basis point rate hike, Powell stated that, “the labor market is extremely tight, and inflation is much too high.” He added that the Fed will “move our policy rate expeditiously back to normal” because they have observed that “price pressures are broadening.” The Federal Open Markets Committee (“FOMC”) expects that “with appropriate firming in the stance of monetary policy, they expect inflation to return to its 2 percent objective and the labor market to remain strong.”2
I for one believe that the Fed will be successful in fighting off inflation. Whether by unintended happenstance or by timing the tightening with a simultaneous fiscal contraction as Biden’s stimulus measures have now expired, the probability of inflation marching ever higher is rapidly tipping the scales back to the good guys. The Fed accurately announced on May 4th that all they can control is demand when it comes to policy efficacy. By raising interest rates and reducing the Federal Reserve balance sheet they will most certainly slow down the pace of aggregate demand (fancy wording for “GDP”). And they also expect that their policy adjustments will manifest itself as tightening financial conditions. The cost of borrowing has risen remarkably quickly, and the price of risk assets has fallen rapidly. Mortgage rates have increased from 2.50% to 5.50%, and personal loans are getting more expensive too. For example, the monthly cost of an average mortgage has increased from $1,818 to $2,612.3 And I suspect that real estate taxes are about to go markedly higher as values are adjusted to reflect the rapid rise in home values. The math is clear – the consumer is simply going to have to slow down. We can already see the effects of higher rates on home sales, as they have slowed down considerably even while homes are still in short supply. In our leveraged society, mortgage rates matter. And when mortgage rates rise, we buy less homes. I envision that we will soon be buying less furniture and appliances to fill those unsold homes.
The real conundrum is whether this tighter money environment will cause an early and painful recession. Whether rightfully or wrongfully, the Fed believes that they can avoid a recession and thusly are confident that they are embarking on the proper path. The central bank is banking on the fact that consumers and businesses have never been flusher with excess savings and gainful employment. At one point in Wednesday’s press conference, Powell claimed that the ratio of job vacancies to unemployed persons has never been higher, with nearly two jobs open for every unemployed person. Furthermore, he informed us that the job quits rate is also at historic highs, implying that labor is so undersupplied that people can voluntarily leave their jobs and easily find new employment. This points to rapidly growing wages, which the Fed fears will provide a feedback loop to even higher prices – the dreaded wage-price spiral. The data is clear that lower wage employees have seen strong wage gains as companies have been forced to compete with government stimulus checks to get people back to work. Now that those stay-at-home couches are vacant and schools are fully post-Pandemically reopened, the labor force is gainfully and fully employed again. So how come we continue to see job openings at record levels? Quite simply, people are still eager to consume and spend their higher pay checks and excess savings. Now that financial conditions have tightened, I expect that consumption will soon slow down to more normal levels. We will get a slower pace of GDP, and thus we should expect a slower pace of job growth, and that will translate to a smaller amount of job openings. And voila, the recipe for lower wage inflation will again be in place.
Add to that a dash of supply chain resolution, and a helping of an end to a regional military conflict and you wind up with decreased demand (because of Fed actions) meeting increasing supply (because of China reopening) and lower commodity prices (because of resolution to the Russia-Ukraine War). This is a classic case of patience winning the day. I expect the Fed will be true to its words of raising rates an additional 50 basis points in each of the next two FOMC meetings. That would bring us to September 21st, a mere six weeks ahead of the November elections. At that point the dye is cast for probably either a pause in the hiking cycle or a smaller increase of just 25 basis points. Fast forward to what appears to be a likely shift in the political balance of power in the US House and Senate – and you might very well be setting up for a memorable end of year rally. “A recent report, entitled “Asset Prices, Midterm Elections, and Political Uncertainty,” was published last July in the Journal of Financial Economics by Kam Fong Chan of the University of Western Australia and Terry Marsh of the University of California, Berkeley. Among other revelations, they found that, between 1871 and 2015, annualized U.S. stock-market returns were 15.41% higher in the winter months following midterms than during all other months.”4
I took it upon myself to analyze price performance of stock markets during bond bear markets and found some interesting observations. Since 1993 there have been five major bond bear markets. In each of those bear markets, defined as an increase in 5y rates of at least 150 basis points, the stock market rallied an average of 27.7%! Also of note was that at the end of the bond bear market, the average forward P/E ratio for the SP500 stood at 22.20. Today’s bond bear market is now 272 basis point in scope and the forward P/E of the SP500 is at 17.66.5 Since the start of the current bond bear market which began in January 2021, the SP500 has returned only 8.0%. Relative to historical performance, the overall stock market is somewhat underpriced relative to other bond bear markets. I believe that if we can avoid a recession (as the Fed believes) perhaps it might be a good idea to begin accumulating some solid names during this uncomfortable period. The pandemic has introduced us to so many new businesses which are now being woven into our daily lives, from work-from-home solutions to mRNA vaccines, to modern EVs and new mobility solutions. The world continues to move toward warehousing solutions and at home consumption. All these new technologies prove to me that the American economic spirit is strongly built upon innovation. It is my belief that we are just at the precipice of a technological period that will redefine how we transport ourselves, communicate with one another, and work with one another. In a word, there will be plenty of trend trains to hop on board.
My advice is to be patient … but begin to lose your patience a little bit soon.
1 How Richard Nixon Pressured Arthur Burns: Evidence from the Nixon Tapes, JOURNAL OF ECONOMIC PERSPECTIVES VOL. 20, NO. 4, FALL 2006 (pp. 177-188)
2 Federal Reserve issues FOMC statement May 4, 2022
3 Based on a $460,000 average balance of new 30y fixed rate mortgage
4 Barron’s, A Strong Stock-Market Rally Could Be Coming Later This Year, By Mark Hulbert April 27, 2022
5 Based on FactSet research of $230.09 2022 earnings projections