The Shallows

The Credit Strategist August 2022

Stocks rallied strongly again after the Fed raised rates another 75 basis points on July 27th, leaving no doubt that investors are wading through the shallows.  It would be one thing if investors truly based their decisions on long-term considerations but we know that isn’t the case.  We are only four months into this tightening cycle and investors are already rushing to discount a Fed pivot.  Our last inflation reading (June) was 9.1% and some respected observers like Rob Arnott think it could be even higher – not lower – by year end. My friend Peter Boockvar reminds me that if inflation is zero month-over-month for the rest of the year (the odds are it will be significantly higher than that), it will still be up +7% year-over-year in December.  So investors are making a huge if not irresponsible leap of faith betting on a relatively quick pivot by the Fed.  The Fed is unlikely to stop raising rates if inflation is still in the high single digits at the end of the year; it will have to do more to get it even close to its 2% target or lose whatever scraps of credibility are still hanging from the rafters of the Eccles Building like crepe at a funeral.  Investors read into Mr. Powell’s words what they wanted to hear rather than listening to what he said, which was:  “[A]nother unusually large increase” of 75 basis points “could be appropriate at our next meeting” in September.  He added that at some point, the Fed will want to slow its pace of increases to assess how cumulative rate rises are affecting the economy.  There is nothing in those comments to suggest any change in policy.  The best it suggests is 50 basis points in September.  That is not the type of news that justifies the type of post-meeting hoopla we saw.

Markets are driven by short-term momentum trading and flows.  Investors want to convince themselves that the short-term outlook for equities is attractive because they’ve been programmed by a dozen years of easy money and vapid thinking, but they are ignoring 40-year high inflation, rising interest rates, deteriorating earnings and credit quality, a strong dollar, a weakening consumer, geopolitical instability, and political incompetence and corruption on all levels.  One would think such problems would influence investors’ judgment but apparently they don’t (which is a reflection on their judgment, not on the facts on the ground).  They ignored disappointing earnings reports from TSLA, MSFT, GOOG, INTC, WMT and others (and reports from AAPL and AMZN that were less than stellar), suggesting that speculation abides in a world of negative real rates.  It’s not as though stocks are cheap. S&P 500 earnings are heading lower (even with all the phony non-GAAP adjustments pumping them up), leaving them trading at ~20x forward earnings.  A more appropriate multiple is ~15x (at most). 

David Rosenberg reminds us (thanks to my friend Peter Boockvar who reported this in the July 29th issue of his excellent newsletter The Boock Report (www.boockreport.com)) that it is extremely premature to start drawing conclusions about how stocks will ultimately react to Fed hikes.  That was the import of Mr. Powell’s comments that the Fed will have to pause and assess the efficacy of its rate hikes in the future (which is not a policy change).  The Fed needs to wait and see if the economy slows like it expects and if it doesn’t it will probably have to tighten more than expected.  Mr. Rosenberg says:

“Remember this:  the Fed went on hold in February 1989, and while there was a nice tradable rally, the reality is that the low in the equity market wasn’t turned in until October 1990 – twenty months after the pause.  The Fed stopped tightening in May 2000, and the market low didn’t come until October 2002, over two years later.  And the Fed moved to the sidelines in June 2006, and the lows didn’t come until March 2009.” 

Mr. Boockvar added two other examples: the Fed started cutting rates in January 2001 and the market didn’t bottom until October 2002, and the Fed started slashing rates in September 2007 and markets didn’t hit their lows until March 2009.  This time, the Fed only started tightening four months ago and we’ve barely had time to digest any of the effects.  Investors are exhibiting the patience of gnats (baby gnats actually) but they’d do well to understand that monetary policy works on a delay and their desire for instant gratification could get them into trouble.  Their impatience is why the narrative (reflected in bond futures prices) that the Fed will pivot and start cutting rates next year is so crucial to any bull case for stocks.  Some want the Fed to tighten faster so it can switch to easing faster which shows a lack of understanding of the negative consequences of the stop-and-go approach that failed in the 1970s. A quick pivot is important to those seeking another bull market, but they are ignoring the likelihood that such an approach would leave real interest rates – which fuel inflation, speculation, wealth inequality and other noxious consequences - deeply negative and further confirm doubts about the Fed’s inflation fighting credentials.

I also believe rallies like the ones that followed each of the four rate hikes this year reflect the Fed’s low credibility with respect to imposing even a modicum of monetary discipline since the Great Financial Crisis.  Investors have every right to believe the Fed won’t keep its word with respect to fighting inflation.  Inflation is a toxic force that extracts a terrible cost from all economic actors but particularly from the most vulnerable.   Failing to squash inflation (even at the necessary cost of an economic slowdown) renders it that much more difficult to address the disparities in income and opportunity growing increasingly embedded in society.  The market is telling us it doesn’t take the Fed at its word when it comes to fighting inflation or inequality or speculation.  And if the market is correct and the Fed bails on its inflation fight sooner rather than later, the system will grow more fragile.  If the market is wrong, stock market investors will get slammed with the S&P 500 heading down toward the ~3000 level (15x earnings of $200).  That seems a long way away from where we sit right now but the market should not be trading at ~4000 with all the headwinds blowing in its face at gale force.