Equity investors need to answer one simple question: Will Jerome Powell follow through?
Weeks of increasingly hawkish rhetoric and an intimidating diagram suggest markets face a determined Fed, taken aback by its own lack of foresight and perhaps even a bit angry at having fallen so far behind in the inflation fight.
Note that the situation wouldn’t be as vexing if it were possible to suggest the Fed’s belated response to a persistent inflation overshoot contributed to big gains in labor force participation. But the Fed miscalculated on that front too. With the exculpatory caveat that hindsight is 20/20, they should’ve realized very early that participation wasn’t likely to be the best guide given the tectonic shifts triggered by the pandemic and ensuing surge in household wealth (figure below).
So, here we are, with Wall Street economists rapidly marking their Fed calls to a hawkish bent that took far too long to materialize. For its part, the Committee is effectively marking its own predictions to yesterday’s market pricing. Market pricing, in turn, has moved on to anticipate easing starting as early as mid-2023 on the apparent assumption that Powell’s front-loaded tightening cycle is virtually guaranteed to dead end in a recession the yield curve is already predicting.
That’s where we are. “The question for equity investors at this point is whether they believe the Fed will actually tighten this much and what will be the impact on the economy from a growth standpoint,” Morgan Stanley’s Mike Wilson wrote, in a Monday note, on the way to saying the Fed appears to be “very committed to doing whatever it takes to quash inflation given it is now public enemy number one.”
The familiar figure (below) speaks to the “public enemy number one” characterization of price pressures.
At the end of the day, Americans only care about one thing: The outlook for their personal finances. And in real terms, that outlook isn’t great.
Wilson cited extraordinarily elevated consumer angst and the read-through for buying conditions on the way to addressing the narrative that says stocks are attractive because they’re an inflation hedge — a claim on nominal growth. Wilson doesn’t disagree with that, but he did offer some thought-provoking nuance.
First, he said the ERP is too low considering mounting headwinds for corporate profits. Corporate bottom lines are at risk “from rising cost pressures, payback in demand and a war that has structurally increased the price of food and energy,” he wrote.
Implicit in Wilson’s assessment was the notion that not all inflation is bullish for stocks. He subsequently made it explicit.
“We agree with the view that stocks are a good hedge from inflation [but] keep in mind that inflation from food and energy is bad for most companies as it acts as a tax on consumers,” he wrote, adding that energy and materials companies are the only real, unequivocal beneficiaries in these kinds of conjunctures, “and they make up a very small slice of the index.”
What about tech? Well, tech companies are likely to be less affected, but “less” doesn’t mean not at all. Wilson described Morgan’s US equity team as “skeptical” of the notion that tech will come away unscathed from America’s bout with inflation, given that the sector will “feel it on the top line if consumer (and corporate) spending fades.”
Moreover, Wilson worries that the market isn’t out of the woods yet when it comes to the potential for exogenous shocks to dent investor sentiment. He cited the war, ongoing “stress” in China’s property sector and the pandemic, which isn’t really over.
Although markets may have mostly priced in a hawkish Fed, stocks likely aren’t priced for “headwinds to growth from this policy shift, still historically high inflation, payback in demand and the war in Ukraine,” Wilson said.
I’ve always wondered about the extent to which Jerome Powell is fully knowledgeable about his role, the extent to which he understands the variables in the economy (some of them wildcards) that affect economic outcomes, and the extent to which he is comfortable with the tools at his disposal to address issues or challenges in the economy. He is no Alan Greenspan, and neither is he any version of Ben Bernanke.
That said, I think Powell does know how to wet his finger and hold up in the wind and gain a sense of which way it is blowing. I’m just a back-seat driver, but we all are back-seat drivers when it comes to the Fed. And we’re all impacted by it. Sometimes, simply getting a sense of wind direction is actually the best approach.
Is public enemy number one behind a conspiratorial plot to engineer a Fed plumbing crisis, or destroy world order? Hmmm, who can say?
However, things don’t smell right, but maybe the smoke filling the room had just been getting thicker for a few decades, and maybe Powell, like that Bob Dylan lyric, can’t help that he’s lucky.
I’ve spent at least a decade reading Jeffery Snider at Alhambra, an exercise not unlike shining a dim flashlight in a foggy night. Sometimes I grow disenchanted by the collateral dollar thing, which sometimes connects to Zoltan s Fed plumbing lectures.
However, as I was looking at ideas related to recent Mr H stories, I ran across the following enlightening rant from Snider, which illuminates the short term funding debacle and suggests that Powell has some transparency issues to sort out:
āDuring times of economic stress, SOFR (unlike LIBOR) will likely decrease disproportionately relative to other market rates as investors seek the safe haven of U.S. Treasury securities.ā
There it is; SOFR, as its own name declares, is a secured overnight rate made up out of repo transactions. LIBOR, as an unsecured rate, must contain some sense of liquidity (and some credit) risks during those times of crisis, or even near-crisis. That it did so to the utter and repeated humiliation of the Federal Reserve …
As usual, my smartphone can’t adjust Fred axis stuff to help fine tune my chart, but I think this type of exploration is a new component of understanding future value measures.
Here’s the 10 year three month spread, using both the secured Fed-backed rate and then the unsecured ameribor 3 month rate.
https://fred.stlouisfed.org/graph/?g=NvKr
The implications for this are interesting, because it’s a way to focus on real-time liquidity volatility. I think the unsecured rate is projecting a them of greater stress than the Fed’s current narrative. Which helps explain why so much money is slamming into super short funding mechanisms.
Furthermore, I’m not sold on the idea that public enemy number one is ready to manage this liquidity shift. Additionally, if the underlying reference rates are not reflective of current conditions, that’s a huge problem in discovery. That concept goes back to Mr H and his recent crypto story referencing self referential narrative that’s distorted. If our Fed is playing the market and jeopardizing our economy, we may want to wake up …
I always looked at buybacks primarily as a way that corporations offset the effect of giving executives options as part of their compensation.
Obviously, cash compensation is reflected as an expense- which reduces earnings. However, the cost of options are not accounted for as a reduction to net earnings.
Instead, the options are included in the ādiluted EPS calculationsā because any options that are in the money get included in shares outstanding (the denominator of the EPS calculation). Since more diluted shares outstanding reduces EPS- a company can offset the equivalent shares from options by buying back shares.
Kind of sneaky- because if a company just paid more cash compensation to the execs, it would simply reduce earnings and EPS. Magic!
More on self referential head in sand with blinders in a fog storm updates. The Fed’s inability to look outside it’s own system is a black swan kinda thing. If various reference rates are telling conflicting stories that night become an issue.
The bank issue is interesting, because there’s uncertainty with reference rates, flowed by a Snider favorite of euro futures. The divergent narrative is becoming a PR battle that connects to a credibility drama:
“Zions and 10 other regional banks signed on to a letter in 2019 to the federal banking regulators arguing that a replacement rate for Libor should have a credit-sensitive rate element in order to accommodate midsize and smaller institutions.
āOur customers are not typically securing their loans with Treasury securities in the way that those in the repo markets do,ā Simmons said.
in relying on the steep slope of the short-term Treasury yield curve to justify possible half-point rate hikes, āis ignoring that forward curves are deeply inverted,ā signaling recession risk, according to Citigroup.
In our view, Powell is putting too much faith in the wrong yield curve” and “doesn’t see everything as clearly as he thinks,” Williams wrote. Partially based on the June 2023 to June 2024 Eurodollar futures curve, which is deeply inverted, Citigroup estimates that the risk of a US recession in the next twelve months has risen to 20%, versus 9% February.
@oldbird, why do some of your comments (like this one) read like A-not-quite-I generated nonsense, even to the point of including plagiarized snippets from articles on similar topics? and other comments, like the first one on this page with references to “Mr H”, seem more hand written, even if replete with hard to parse observations. Is a puzzlement. I do enjoy them, in a way, but not so much for enlightenment.
I’m guilty of being super sloppy with comments today, by not providing clear attribution. I do normally at least attempt to toss quotations around these “tidbits”
I’m incorporating information which I hope adds to Mr. H blog posts and in general, when I go to Bloomberg or Barron’s or some point of reference, they are usually mixing together attribution and incorporating ideas into stories. I did share a few illegal Fred posts recently, attempting to document my thoughts by providing graphical charts.
If the last post seemed like nonsense, that’s because it was poorly edited and part of a chain of recent posts that touched on similar topics.
I’m simply very curious about certain details related to the evolving inflation story and the relationship related to Fed plumbing. As with everyone here, I have opinions and appreciate knowing that I need to slow down and make my thoughts less disorganized.
I’d offer you a full refund but that’s off the table.
thanks, no refund needed, it’s nice to know you’re not a bot š