What Is The Fed Trying To Prove?

The Trifecta: The Fed, The Economy, The Earnings

The Fed

• The February increase in the federal funds rate to a 4.50 to 4.75% range was accompanied by Chair Powell exhibiting a dovish tone and emphasizing “disinflation” and the lagged effects.
• The 10-year Treasury rate at 3.60% tells a compelling story about inflation and future short-term rates.
• The federal debt will be burdened with increasing debt service cost.

 

The Economy

• Inflation peaked and continues to fall; money supply is confirming the decline.
• The consumer is stretched thin, with rising debt and low savings rates.
• The U.S. economy is experiencing a rolling recession, from housing, to computer chips, to durable goods, to retail.
• Commercial construction and autos are at risk.
• Services are helping to sustain growth and China’s reopening is an added element.

 

The Earnings

•  Earnings reports are generally better than expected, as many companies adjust to the changing environment. Big tech has disappointed.
• Buybacks are increasing. The Chevron announcement is an eye opener, followed by Meta.
• The rate on the 10-year Treasury, at the 3.50 to 3.75% range, places a strong foundation under the equity market and is biased toward growth.
• In our judgment, the equity market is looking beyond the weaknesses in the economy.
• Stocks appear to have made their lows in October 2022 and seem to be in the early stages of a new, but different, “bull” market.

 

The Federal Reserve raised the Fed funds target rate 25 basis points at the February 1 FOMC meeting to the 4.5 to 4.75 range, a rate that a number of Fed members has coalesced around in recent weeks. Vice Chair Lael Brainard suggested that such an increase was most likely. In a recent speech, she highlighted the tempering of inflation, expecting the PCE deflator, the Fed’s preferred inflation measure, to rise 4.75% year-to-year in December and 3.1% annualized over three months.

As discussed in a prior commentary, the composition of the FOMC meeting in February took a dovish tilt, with three new rotating members. There appears to be a growing recognition of the lagged effect of the intensely restrictive Fed policy which manifested itself again in the absence of monetary growth for over 13 months for M1 and 12 months for M2.

Despite the absence of broad-based deterioration of employment and the surprise January report, the underpinnings of the economy are softening. Rising consumer debt (and the accompanying increase in financing costs), low savings rates, and falling “real” income, are placing the consumer in an increasingly precarious position. The wealth effect has in part been affected by the consumer’s declining balance sheet (equities and real estate) and adds an element of conservatism. Retail sales are reflecting the slowdown and many retailers are in the midst of an inventory cycle. The goods sector of the economy is experiencing a rolling recession—housing, computer chips, durable goods, and manufacturing in general. The ISM Survey also points toward a contraction in a number of areas—manufacturing, prices paid, and new orders, with readings below 50.

The Challenger Report shows job cuts rose over 400% year-to-year and the proxy for capital spending declined for the second month in a row. The employment report for January, which showed a 517,000 gain in nonfarm payroll employment, calls into question the extent of the weakness that has been evident elsewhere. The data has been subject to many adjustments that influenced the outcome—population control, new seasonal adjustments, and others. A high correlation typical of the relationship between the ADP data and the Labor Department results has failed miserably. ADP only showed a 106,000 gain in January.  Who’s right? It will be a matter of time before we know the nature of the dichotomy.

The long lagged effects of monetary policy suggests continued weakness is likely. What has been encouraging was productivity at 3.0% and unit labor costs at 1.1%, both better than anticipated.

Even Powell recognized the progress made on the labor front from the better-than-expected employment cost index and the disinflationary forces underway.

Against this background, the equity market has been resilient, recovering from the October lows and exhibiting strong performance in the new year. Despite weakness among big tech, earnings reports have been better than expected, with companies adjusting their cost structures given the changing environment. Guidance has also provided some upward bias. As we have often said, many enterprises are constantly adjusting to their individual supply/demand dynamic.

This “recession” has probably been the most discussed and most anticipated, with many companies preparing for the prospect. Most certainly, equity market participants have discussed the prospect of recession ad nauseam. Not much of a surprise. Stocks appear to be looking beyond the economic weaknesses, discounting future developments. Within the market, the huge company cash hoards are manifesting themselves in a proliferation of buybacks. Chevron announced a program to reduce 20% of its market capitalization and Meta indicated a $40 billion buyback is coming. The current rate structure presents a favorable background for equities in general, and growth stocks in particular. The lows reached in October could well mark the end of the bear market and the beginning of a new “bull” market; one that will be quite different from the last one. In an environment with nominal short-term rates, the no-road-to-profitability stocks, the meme stocks, and those stocks without adequate cash flow are the ones to avoid.