Slowing Inflation

March 2023 - The market moving headlines of late have been record inflation, Federal Reserve rate hikes and failures within parts of our banking system. Continued market volatility should be expected in the near and midterm. The January inflation report earlier this month showed prices rose at the hottest rate in several months, from December to January. But, the year over year number came down. Although the headline inflation number remains high, it is calculated against the very low base of January 2022. We should expect inflation to be high for a few more months, but there are indications that it may be slowing. The FED has already built in market expectations for a few more hikes, and the coming hikes will likely be lower than those of 2022.

Despite the FED’s efforts, the job market remains tight. Several large companies have announced layoffs and those continue to be the trend. Workforce security is good for consumer confidence, and we have seen consumer confidence coming back from record low levels, reminiscent of the early 80’s. This job security and consumer confidence will play a big role in equity markets once the interest rate adjustments have ended, and asset class returns trend toward more historical rates.

Since the FED began raising interest rates, the short term rates have been adjusting, but the long term rates have lagged significantly. The FED is currently projecting that its terminal rate will be 5.1%-5.25%. The 10 year Treasury bond has been yielding as low as 3.32% over the past month. Why? Because the government bond markets have been actively manipulated by the central banks globally, suppressing interest rates for over a decade. Especially impacted are the long-term bonds, which should yield more than their short-term brethren. This “inverted” yield curve is particularly dangerous for banks, including those of the Federal Reserve, holding large amounts of U.S. Treasuries.

On February 22, the minutes from the February FED meeting were released and the markets went down. The past six months were spent “talking the stock market down” and it worked. Proclaiming to bring job openings down to align with job seekers was a key part of the “forward guidance” strategy. And it was effective, crushing the enthusiasm in the market about interest rates not going any higher.

Jamie Dimon (Citi Bank Chairman) said the FED “lost control of inflation for a bit,” and he was right. What he meant was inflation expectations. The FED fears consumer and business inflation expectations more than inflation itself. So, where does the FED go from here? Powell and two FED presidents have said we have a “little” to go. Translation, we haven’t lowered inflation enough and we will continue to raise rates a little at a time until we are satisfied.

In September of 2020, Powell made an official policy change in the way they view the 2% inflation target. Because inflation had been too low for too long he told us he would let inflation run up, to bring inflation back to 2% average over time. And inflation has run hot. But, if we look at the average rate over the past fifteen years, inflation remains below the FED’s 2% target. While inflation has been below that target for several years, the government debt has ballooned as a result. We have had a lot of fiscal programs that have doubled our debt since 2008. Since then, the GDP has been growing at about 9% per year. So, inflation is disproportionate to the growth we have had.

With the damage to the economy of excessive spending, the FED’s challenge has been to take away the threat of hyper- inflation but leave the economy with hotter than average inflation. This may have been accomplished, but they have to continue to maneuverer future rates and manipulating the debt and spending along the way to stability.

Apart from the FED’s latest moves and their focus, the stock market is pushing on hoping the rate hikes will end and some normalcy will return. The S&P is trading at roughly 18X earnings. This means that the market is fairly valued and not cheap. We are still seeing a lot of “hope trading”, meaning that traders are hoping for a quick end to interest rate increases and earnings will go up.

We are nearing the end of Q4 earnings reporting and so far, a trend is developing. The percentage of companies beating their estimates has fallen to 69.3%, down from 76% over the prior four quarters, but above the long-term average (since 1994) of 66%. The recent increase in debt service and cost of new equipment has taken a toll on corporate earnings.

Companies have been “lowering the bar” for target earnings and profits, so this magnifies the “misses” when compared to projected earnings in years past. As analyst look into the future, they are pushing higher earnings estimates to the end of 2023. This is in anticipation of rate stabilization. It is unlikely that we will see a “pop” in the stock market unless rates stabilize very quickly and earnings can rise.

A silver lining on this dark cloud is that short term interest rates are very high compared to long term rates. While we are seeing above 4% yields on short term funds, the mid to long term funds are still paying less than 4%. This inversion in yields can’t last forever, but is an opportunity to stay safe from the volatility of the stock market as the FED finds its way to rate stabilization.

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