Inflection Point

Inflection Point

The Federal Reserve cannot continue to ignore the evidence of a deteriorating economy. Moreover, a growing number of FOMC members are acknowledging the emerging currency crisis.

The ECB has raised its rate 75 basis points to 1.5% and a change in leadership in Great Britain has already occurred, taking pressure off the pound. The yen remains above 145, which was the level that prompted intervention.

On the domestic front, the rate increases continue having their negative effects. As discussed in previous commentaries, housing activity is declining. Builders are reporting significant cancellations and rising inventories. The Case Shiller Index shows housing prices falling 1.32% in September for a second consecutive monthly decline. Home prices feed into the CPI with a lag, so the inflation effect should be felt in coming months. Also, home buyers become reluctant to commit when values are falling. If they feel that prices are moving in the downward direction, the prospect of equity erosion will constrain activity.

At the November 2nd FOMC meeting, the 75 basis point increase in the Fed funds target from 3.25% to 4% was announced, an increase expected by market participants. A 4% rate is viewed by some Fed members as a positive real interest rate (a rate higher than the underlying inflation rate). Expectations about future rate increases were vague but suggest a 50 basis point increase is likely at the December meeting.

A significant change in policy implementation was part of the policy statement. There was a recognition of the cumulative effects of the rate increases and the lagged impact on the economy. The Fed is moving back to a pre-2019 model, going from data dependence to forecasting the impact of policy. This important change was more than overshadowed by Chair Powell’s press conference. The rhetoric was harsh and lacked adequate acknowledgement of the weakening economy and the currency risk. He referred to the strong labor market with the gains in monthly employment. However, in the ADP report, all gains were in leisure and entertainment, while manufacturing and goods production experienced decline (on the other hand, the labor department recorded an increase in manufacturing). However, the unemployment rate moved up 0.2% to 3.7%, with the participating rate falling. Reality will alter expectations on future interest rate changes, particularly as the Fed acknowledges the cumulative tightening of monetary policy and the lags with which monetary policy affects economic activity.

Another consequence of rising rates is the increasing burden of debt service. The higher rates are placing a greater burden on interest costs for servicing federal, state and local government debt. The burden will continue to spread to developing nations, many of which have currencies tied to the dollar. Currency instability is a risk that will add to financial instability.

In the weeks ahead, markets will be assessing the likely path of future rate moves. When will they stop and stabilize? The tradeoff between inflation and recession will be the biggest consideration, complicated by world economic and financial stability. Inflation is moderating, maybe not fast enough for some, but moderating. At the same time, recession signs are emerging more broadly. As another indication, the leading indicators are down two months in a row and an inverted yield curve is persisting throughout the maturity spectrum. The Wall Street Journal reports labor pressures are easing across some sectors of the economy. Global demand for some durable goods has slowed sharply. For example, Whirlpool indicated that it had cut global production by 35% this month to reduce inventories.

The inventory cycle is still working its way through the economy as supply shortages turn into surpluses due to declining demand. The consumer’s position is diminishing as income growth remains below inflation and declines in the stock and bond markets cause significant balance sheet destruction. Also, rising credit card debt, now at the pre-pandemic level, will become even more problematic with rising rates.

What is constantly overlooked during this tightening phase is the money supply. The explosive growth between 2020 and 2021 is in part responsible for the inflationary cycle we are experiencing. Over the last year, M1 and M2 have slowed to a growth rate of 2.0% to 2.5%. More importantly, M1 has not increased since November of 2021 and M2 since December. The implications are favorable for reducing inflation but problematic for growth.

In the face of all these cross currents, along with Ukraine, China’s COVID policy, and the upcoming election, equity markets managed to deliver a strong performance in October. The Dow was up 14.07%, the S&P 8.8%, and NASDAQ 4.06%. This rise occurred even though some big tech companies reported disappointing earnings and guidance. In general, earnings have held up despite the effect of the strong dollar on multinational companies.

Against this backdrop, high cash positions, investor sentiment levels, the end of tax-loss selling by mutual funds, and the strong dollar should provide some upside impetus. Although a potential source of financial instability, the strong dollar continues to drive foreign funds flow into the US markets. The level of interest rates (4.72% for the 2 year and 4.17% for the 10 year) is an added incentive. At the same time, the market reacted harshly to Chair Powell’s press conference and the hawkish tone that was conveyed, offsetting the beneficial change to a forecasting model. The valuations being generated from the market’s decline are providing opportunities for stock buybacks and mergers and acquisition activity. While M&A activity in the biopharma sector has recently picked up, we suspect a broader recovery in activity across many sectors will materialize in the coming months as buyers and sellers fully recalibrate their business and valuation expectations.

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