- The Fed has increased rates by 2.25% this year, yet inflation remains high.
- Real wages are negative, suggesting additional GDP-busting increases are necessary.
- Stocks have retreated back toward 50-DMA support and the long bond is testing June lows.
A risk-off trend was building last week, and investors hit the sell button hard on Friday after Federal Reserve Chairman Jerome Powell poured water on the “Fed could pivot dovish soon” argument.
In a short, not-so-sweet, 8-minute speech, Powell doubled down on hawkish rhetoric, acknowledging the Federal Reserve’s willingness to accept “some pain to households and businesses” in its bid to “restore price stability.” That’s code for it being OK with an undefined amount of layoffs and bankruptcies caused by its interest rate hikes.
Powell’s comments are harsh, but inflation remains a problem. Sure, inflation measures, including core Personal Consumption Expenditures Price Index (PCE) and core Consumer Price Index (CPI), are falling. However, CPI is still outpacing wages, so real wages are negative.
A war worth waging?
In Morning Recon, Real Money’s Stephen Guilfoyle notes “The [PCE] core print (More important, because, unlike food and energy, the components are actually susceptible to policy.) printed at +4.6% [July], down from +4.8% in June, and well below the apex of +5.3% in February. That's right, peak core inflation, according to the Fed's favored tools for measurement, apexed six months ago.”
Yet, the Bureau of Labor Statistics reports, "Real average hourly earnings [earnings adjusted for inflation] decreased 3%, seasonally adjusted, from July 2021 to July 2022.”
When you factor in cuts in hours worked, real average weekly earnings are 3.6% lower than they were one year ago. As a result, people are tapping credit cards and savings to keep pace with inflation, despite four hikes totaling 2.25% already this year.
According to the Federal Reserve Bank of New York, credit card balances increased 13% in Q2, the most significant jump in over 20 years. Meanwhile, the personal savings rate fell to 5% in July from over 10% the year before.
We’ve already had two consecutive negative quarters of GDP growth because consumers are tapped out. Nevertheless, the Fed thinks more hikes are necessary, and higher rates may stick around longer than many hope.
According to Powell, “July's increase in the target range was the second 75 basis point increase in as many meetings, and I said then that another unusually large increase could be appropriate at our next meeting…Restoring price stability will likely require maintaining a restrictive policy stance for some time. The historical record cautions strongly against prematurely loosening policy…We will keep at it until we are confident the job is done.”
So, Powell is guiding for at least 0.50% and, likely, 0.75% at the September meeting. If so, it will further crimp demand, pressuring corporate profits. According to Action Alerts PLUS, the CME’s FedWatch tool shows, “The market now sees a high probability of the Fed leaving 2022 with the Fed Funds rate between 3.75%-4.00% vs. 3.25%-3.50% a month ago.”
Overall, tightening isn’t bullish for risk-on assets.
That forecast is good for the U.S. Dollar. Still, it’s a headwind for just about everything else, including technology stocks (59% of sales come from overseas), commodities (declining global demand because of slowing economies and the fact they’re dollar-denominated), and cryptocurrencies, which are negatively correlated with the Dollar.
In “A Message Had to Be Delivered and Central Bankers Delivered It,” Real Money Pro’s Peter Tchir writes, “They [The Fed] are fighting expectations as much as anything else and they wanted to hammer home their alleged willingness to hike interest rates in the face of bad economic data. Maybe they have all changed their stripes, but I believe they saw an opportunity to deliver a coordinated message, and they took it.”
Remember, the Fed is trying to tamp down animal spirits. Recently, those spirits reignited because of the rally since mid-June. Perhaps, because the Fed didn’t have a policy meeting this month, they viewed Jackson Hole as the best opportunity to rein enthusiasm in before it rekindles inflation.
Back to Tchir:
“The Fed will watch the economy and markets. It will be slower to respond to economic and market weakness, especially if inflation remains high. But if inflation rolls over, along with the economy, it will still act. It basically has just reset how quickly and aggressively it will act.”
The Fed’s hawkish tone is discouraging, but that doesn’t mean there isn’t room for a friendlier Fed in the future. Consider these quotes from Powell’s speech, followed by my comments:
“The U.S. economy is clearly slowing from the historically high growth rates of 2021.”
Certainly, Powell’s not oblivious to the impact of higher rates. He’s watching the economy for clues to how existing rate hikes are working to quell demand. While he notes we’re coming off a period of rapid GDP growth, he’s not ignoring that GDP clocked negatively during the year's first half.
“Our decision at the September meeting will depend on the totality of the incoming data and the evolving outlook. At some point, as the stance of monetary policy tightens further, it likely will become appropriate to slow the pace of increases.”
This is the most blatantly “positive” comment in his speech because it leaves the door open to a data-dependent, dovish tilt at some point. When that happens, though, is anyone’s guess.
In the meantime, Tchir is cautious, but he’s buying some assets for a trade, writing, “I'm still bearish on risky assets, though I am starting to buy a few things to trade in case there is a bounce (because the market got too weak on Friday relative to what Powell will do) or that the economic data will be good (I expect weakness relative to expectations, but it could go the other way).”
His shopping list doesn’t include commodities because he’s “too pessimistic on the economy to be comfortable being long commodities here.”
It also doesn’t include technology stocks. He writes, “I think Bitcoin and disruptive stocks (ARK Innovation ETF (ARKK) as a proxy) will move in tandem, and downside is in store for them. I think that bleeds into the semiconductor space as a whole, which leaves me cautious on Invesco QQQ Trust (QQQ) (I did remove most of my QQQ shorts here on Monday morning and may look for a buying opportunity, but I'm trading QQQ and ARKK generally from the short side here).”
So what is he buying? Bonds.
Tchir writes, “Adding some longer-dated Treasury, high-quality investment grade/muni positions (iShares 20+ Year Treasury Bond ETF (TLT) for Treasuries, iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) for credit, and am using closed-end funds for munis).”
The Smart Play
Given the backdrop, it’s little surprise that stocks sold off. Yet, there’s room for (admittedly tepid) optimism in Powell’s remarks. Here are a few more quotes from Powell’s speech, followed by my attempt to paint a rosier picture.
“While the lower inflation readings for July are welcome, a single month's improvement falls far short of what the Committee will need to see before we are confident that inflation is moving down.”
A single month, no, but that comment begs the question, “how many months would it take to build confidence?” Core PCE has been retreating since February. If we get additional months of decelerating inflation, the Fed could shift to the sidelines.
“The FOMC raised the target range for the federal funds rate to 2.25 to 2.5 percent, which is in the Summary of Economic Projection's (SEP) range of estimates of where the federal funds rate is projected to settle in the longer run.”
The committee participants' projection for the median federal funds rate is closer to 4% exiting 2023, but this quote acknowledges current levels are the longer-term norm. If so, additional increases beginning in September may be more susceptible to future removal.
“A lengthy period of very restrictive monetary policy [post 70s inflation] was ultimately needed to stem the high inflation [Volcker’s rate hikes] and start the process of getting inflation down to the low and stable levels that were the norm until the spring of last year. Our aim is to avoid that outcome by acting with resolve now.”
The Fed is arguably over-aggressive to avoid a period of persistently higher rates later. However, front-loading hikes to hammer inflation this year could mean the Fed overshoots, forcing a future course correction, particularly if unemployment rises. Remember, the Fed’s dual mandate is to maintain stable inflation and employment, and employment is the last domino to fall in a recession.
Admittedly, that’s not a lot of dovishness to hang our hat on, but it’s something.
Ultimately, we’re still talking about higher rates to reduce inflation, then a shift to the sidelines to see what happens. If inflation keeps declining (note: YoY comparisons get easier next year), then a Fed pause allows the negative impact of hikes to roll off. Recall that Zweig’s Fed Indicator removed the negative drag of an interest rate hike after six months.
What’s all that mean for stocks? Since my “Is It A Good Time To Sell Stocks” article on August 17th, the S&P, Nasdaq, and Russell 2000 have all declined to support near the 50-DMA. The NASDAQ 100 QQQ has fallen over 8% since mid-month.
That’s a pretty healthy pullback. The sentiment indicators aren’t screaming buy yet, but they’re getting there. The VIX was above 25 today, and the total put/call ratio was 1.24 at the time of this writing. If indexes undercut the 50-DMA and beeline toward June’s low, sentiment will turn bullishly negative pretty quickly.
Remember, individual stocks bottom before the market, and the market bottoms when economic data is terrible, unemployment rises, and profits fall. Since stocks are a leading indicator, it pays to fade them in the first half of a bear market and buy them in the second half. I think we’re closer to the second half, so my inclination is to be a buyer, particularly in recessionary-resistant groups.
If you're aggressive, risk-tolerant, and a trader, it could be a good time to tip-toe into early cycle stocks, including technology, industrials, and discount retail. They are few and far between, but some technology stocks have recovered and remain above the 200-DMA, so they could be emerging leaders. Perhaps, solar is the most notable example. Some industrials have spending tailwinds accelerating next year because of the infrastructure and 'inflation' bills, and discount retail benefits from consumers trading down to save money. Broadly, focus on stocks above moving averages with double-digit growth rates, rather than badly-beaten down former leaders. Historically, leaders during the last bull market aren't the leaders of the next bull market, so you need to keep watch lists fresh.
Keep downside protection on and use stop losses, though, because when you're fishing for a bottom, you can easily lose your lure.
Increasing the amount you contribute to the S&P 500 index fund via Dollar-cost averaging programs, such as 401k or 403b plans, makes sense if you're a long-term investor. There’s never been a time when it hasn’t paid off long-term to buy a bear market. By dollar-cost averaging, you’ll own more shares at a lower average price, positioning you best to recover drawdown when bulls are back in charge.