Key Points: – Investors anticipate a 50 basis point rate cut in September due to weakening job market data. – A larger cut may signal recession fears, not inflation control, spurring market sell-offs. – The current economic “soft landing” could be a temporary illusion as the labor market weakens.
The market is abuzz with speculation that the Federal Reserve might deliver a larger-than-expected interest rate cut in September, driven by recent signs of economic softness. While many investors are hoping for a 50 basis point cut, especially after the latest JOLTS report showing the lowest job openings since 2021, they may want to be cautious. A deeper rate cut isn’t necessarily the good news it might seem on the surface.
The JOLTS data, coupled with last month’s jobs report, has raised concerns that the labor market could be weakening more rapidly than anticipated. Investors are now looking to Friday’s employment numbers with increased apprehension, and Fed fund futures are reflecting expectations of a significant rate cut at the Federal Reserve’s next meeting. But before the market gets too excited about the prospect of lower rates, it’s important to consider the message a large cut would send.
A 50 basis point cut would likely indicate that the Federal Reserve is more worried about a looming recession than ongoing inflation. According to David Sekera, Morningstar’s chief US market strategist, such a cut could trigger an even deeper stock market sell-off. The move would suggest that the Fed sees significant risks to the economy, much like a pilot deploying oxygen masks in mid-flight—hardly a signal of smooth skies ahead.
Other experts are also expressing caution. Citi’s chief US economist Andrew Hollenhorst points out that the market seems to be in denial about the growing signs of labor market weakness, just as it was slow to accept the seriousness of inflation during its early stages. Hollenhorst emphasizes that the unemployment rate has been gradually rising for months now, not just a one-off event. This slow deterioration suggests the labor market is indeed weakening, and a larger rate cut could be the Fed’s acknowledgment of that fact.
While moderating inflation does provide the Fed with some breathing room to focus on supporting the economy, the idea that the economy is still in a “Goldilocks” phase—where inflation is cooling, and the job market remains resilient—might be wishful thinking. Investors should be careful what they wish for when it comes to monetary policy, as the short-term benefits of lower rates could be overshadowed by the reality of a deeper economic slowdown.
Key Points: – S&P 500 and Nasdaq on track for seventh consecutive day of gains – Markets recovering from recent downturn, buoyed by positive economic data – Investors eye Jackson Hole symposium for insights on Fed’s rate cut trajectory
Wall Street is gearing up to close its most impressive week of 2024, with major indices rebounding strongly as concerns about an economic slowdown dissipate. The S&P 500 and Nasdaq are set to mark their seventh straight day of gains, erasing losses from a recent market tumble and signaling renewed investor confidence.
This remarkable turnaround comes on the heels of encouraging economic data that has alleviated fears of an imminent recession. The week’s positive momentum has been fueled by reports indicating that inflation continues to trend downward towards the Federal Reserve’s target, while American consumer spending remains robust.
Oliver Pursche, senior vice president at Wealthspire Advisors, commented on the market’s resilience: “It has been a great week, and it has been a great year. There’s been some volatility, but major indices are all up nicely. What we saw a couple weeks ago was the market blowing off some steam.”
The rally has been broad-based, with the financial sector leading gains among S&P 500 components. However, not all sectors have participated equally, with real estate showing some weakness. This divergence highlights the nuanced nature of the current market environment, where investors are carefully weighing various economic indicators and sector-specific factors.
Looking ahead, market participants are eagerly anticipating the upcoming Jackson Hole Economic Symposium. This annual gathering of global central bank officials, scheduled for next week, could provide crucial insights into future monetary policy decisions. Federal Reserve Chair Jerome Powell’s keynote speech on Friday is expected to be a focal point, potentially setting expectations for the U.S. interest rate trajectory.
Austan Goolsbee, President of the Federal Reserve Bank of Chicago, has already set a dovish tone, cautioning against maintaining restrictive policy longer than necessary. This sentiment, coupled with recent economic data, has led to increased speculation about potential rate cuts. According to CME’s FedWatch tool, there’s a 74.5% probability that the Fed will implement a 25 basis point cut at its September meeting.
The market’s optimism is reflected in the performance of major indices. As of early afternoon trading, the Dow Jones Industrial Average was up 0.27%, the S&P 500 gained 0.21%, and the Nasdaq Composite added 0.25%. These gains put all three indices on track for their most substantial weekly percentage increases since October.
Despite the overall positive sentiment, some individual stocks faced headwinds. Applied Materials saw its shares decline by 1.7% despite forecasting stronger-than-expected fourth-quarter revenue. Similarly, packaging company Amcor’s U.S.-listed shares dropped 4.9% following a larger-than-anticipated decline in fourth-quarter sales.
As the trading week draws to a close, the market’s resilience in the face of recent volatility has been noteworthy. The shift from recession fears to recovery hopes underscores the fluid nature of investor sentiment and the importance of economic data in shaping market narratives.
With the Jackson Hole symposium on the horizon, investors will be keenly watching for any signals that might influence the Fed’s approach to monetary policy. The coming weeks could prove crucial in determining whether this rally has staying power or if new challenges lie ahead for Wall Street.
Key Points: – The VIX spiked to its highest level since March 2020, indicating high market volatility. – Major indices, including the Dow and Nasdaq, suffered significant losses amid recession fears. – Experts urged the Federal Reserve to consider emergency rate cuts to stabilize the economy.
In a significant development for global financial markets, the Cboe Volatility Index (VIX), commonly known as Wall Street’s “fear gauge,” surged to its highest level since the pandemic-driven market plunge in March 2020. This increase in volatility comes amid a sharp sell-off in equities, driven by mounting concerns about a potential U.S. recession and disappointing economic data.
The VIX briefly soared above 65 on Monday morning, a dramatic rise from about 23 on Friday and roughly 17 just a week ago. It later cooled to about 42 shortly after 10 a.m. ET, reflecting ongoing market turbulence. The last time the VIX reached such heights was in March 2020, when it climbed as high as 85.47 following the Federal Reserve’s emergency actions during the Covid-19 pandemic.
The VIX is calculated based on market pricing for options on the S&P 500 and is designed to measure expected volatility over the next 30 days. It is often used as an indicator of investor fear and market uncertainty. Historically, spikes in the VIX have coincided with significant market sell-offs, although they can also precede swift recoveries.
Monday’s market rout saw the Dow Jones Industrial Average drop 854 points, or 2.1%, while the Nasdaq Composite lost 3.1%, and the S&P 500 slid 2.5%. The decline was part of a broader global sell-off, with Japan’s Nikkei 225 plunging 12%, marking its worst day since the 1987 Black Monday crash.
The sell-off was triggered by a combination of factors, including fears of a U.S. recession, disappointing July jobs data, and concerns that the Federal Reserve is not acting quickly enough to cut interest rates to support the economy. The Fed recently chose to keep rates at their highest levels in two decades, exacerbating investor anxiety about economic growth.
Tech stocks were among the hardest hit, with Nvidia falling more than 5%, Apple dropping nearly 4.6% after Warren Buffett’s Berkshire Hathaway halved its stake in the company, and Tesla down 10%. Other major losers included Broadcom and Super Micro Computer, down 7% and 12%, respectively.
The bond market also reflected heightened fears, with U.S. Treasury yields tumbling as investors sought safe havens. The yield on the benchmark 10-year note fell to 3.7%. Meanwhile, Bitcoin experienced a sharp decline, falling from nearly $62,000 on Friday to around $52,000 on Monday.
In Asia, the Nikkei 225’s 12.4% loss underscored the global nature of the sell-off. The index closed at 31,458.42, its worst day since 1987, with a record point drop of 4,451.28. The decline was exacerbated by the Bank of Japan’s decision to raise interest rates, which ended the yen “carry trade” and increased the yen’s value against the U.S. dollar.
The sharp increase in the VIX and the corresponding market declines have prompted calls for urgent action. Jeremy Siegel, Wharton professor emeritus and chief economist at Wisdom Tree, urged the Federal Reserve to implement an emergency 75 basis point cut in the federal funds rate and to consider another cut at the September meeting. Chicago Fed President Austan Goolsbee also acknowledged that current interest rates might be too restrictive and suggested that the central bank would take necessary actions if economic conditions deteriorate further.
As markets continue to digest these developments, investors are closely monitoring economic data and Federal Reserve communications for signs of stability. The interplay between economic indicators, Fed policy, and market reactions will be crucial in determining the trajectory of the financial markets in the coming weeks. With three more Fed meetings scheduled for this year, there remains ample opportunity for the central bank to adjust its policy stance in response to evolving economic conditions.
The dramatic rise in the VIX serves as a stark reminder of the market’s vulnerability to economic uncertainties and the importance of vigilant policy responses to maintain stability and investor confidence.
Hopes for an imminent pause in the Federal Reserve’s interest rate hiking campaign were dashed on Tuesday as new data showed consumer prices rose more than forecast last month. The stubbornly high inflation figures make it likely the central bank will extend its most aggressive policy tightening cycle since the 1980s.
The Consumer Price Index climbed 0.4% from January and 3.2% annually in February, according to the Bureau of Labor Statistics. That exceeded all estimates in a Bloomberg survey of economists who had projected a 0.3% monthly gain and a 3.1% year-over-year increase.
Stripping out volatile food and energy costs, the core CPI accelerated to 0.4% for the month and 3.8% from a year ago, also topping projections. The surprisingly hot readings marked an unwelcome re-acceleration after months of gradually cooling price pressures had buoyed expectations that the Fed may be able to begin cutting rates before year-end.
The data landed like a bucket of cold water on hopes that had been building across financial markets in recent weeks. Investors swiftly repriced their bets, now seeing around a 90% chance that the Fed’s policy committee will raise interest rates by another quarter percentage point at their March 22nd meeting. As recently as Friday, traders had been leaning toward no change in rates next week.
“After taking a step back the last couple of months, it appears inflation regained its footing in February,” said Rubeela Farooqi, chief U.S. economist at High Frequency Economics. “A re-acceleration could mean a longer period of policy restrictiveness is required to bring it down on a sustained basis.”
The biggest driver of February’s price spike was housing, which accounts for over 40% of the CPI calculation. Shelter costs surged 0.4% for the month and are now up a sizable 5.7% versus a year ago. While down from their 2022 peaks, those increases remain far too hot for the Fed’s comfort.
Rents rose 0.5% in February while the owners’ equivalent measure, which tracks costs for homeowners, jumped 0.4%. Both measures are watched closely by policymakers, as housing represents the heaviest weight in the index and tends to be one of the stickier components of inflation.
David Tulk, senior portfolio manager at Allianz Global Investors, said the latest shelter prints mean “the Fed’s path to restoring price stability is going to be a tough one.” He added that debate among central bankers over whether to raise rates by a quarter percentage point or go for a more aggressive half-point move now seems “settled in favor of 25 basis points.”
Energy and gasoline prices also contributed heavily to February’s elevated inflation figures. The energy index rose 2.3% last month, fueled by a 3.8% surge in gas costs. Those pressures could intensify further after recent OPEC production cuts.
Food prices were relatively contained last month, holding steady from January levels. But overall grocery costs are up 10.2% versus a year ago as the battered supply chains and labor shortages stemming from the pandemic continue to reverberate.
While this latest inflation report dealt a significant blow to hopes for an imminent pivot toward easier Fed policy, economists are still forecasting price pressures to ease over the year thanks to cooling pipeline pressures from housing and wages.
However, reaching the Fed’s 2% inflation target is likely to require a measure of demand destruction and labor market softening that could potentially tip the economy into recession. It remains to be seen if central bank policymakers will be able to orchestrate the elusive “soft landing” they have long aimed for.
The latest inflation data released Tuesday shows consumer prices rose more than expected in January, defying forecasts for a faster slowdown. The Consumer Price Index (CPI) increased 0.3% over December and rose 3.1% over the last year, down slightly from December’s 3.4% pace but above economist predictions.
Core inflation, which excludes volatile food and energy costs, also came in hotter than anticipated at 0.4% month-over-month and 3.9% annually. Shelter prices were a major contributor, with the shelter index climbing 0.6% in January, accounting for over two-thirds of the overall monthly increase. On an annual basis, shelter costs rose 6%.
While used car and energy prices fell, persistent strength in housing and services indicates inflation remains entrenched in the economy. This could complicate the Federal Reserve’s plans to pivot to rate cuts this year after aggressively raising interest rates in 2023 to combat inflation.
Markets are currently pricing in potential Fed rate cuts beginning as early as May, with around five quarter-point decreases projected through end of 2024. However, Tuesday’s inflation data casts doubt on an imminent policy shift. Many Fed officials have signaled a more gradual approach, with only two or three cuts likely this year.
The hotter CPI print pushed stocks sharply lower in early trading, with the Dow Jones Industrial Average falling over 250 points. Meanwhile, Treasury yields surged higher on expectations for sustained Fed tightening.
Inflation-adjusted wages also fell 0.3% month-over-month when factoring in a decline in average workweek hours. While inflation may be peaking, price increases continue to erode household purchasing power.
Shelter costs present a tricky situation for policymakers. Rental and housing inflation tend to lag other price moves, meaning further gains are likely even if overall inflation slows. And shelter carries significant weighting in the Fed’s preferred core PCE index.
While annual PCE inflation has fallen below 4%, the six-month annualized rate remains near the Fed’s 2% target. Tuesday’s data provides a reality check that the battle against inflation is not yet won.
To tame housing inflation, the Fed may have to accept some economic pain in the form of job losses and supply chain stress. So far, the resilience of the labor market and strong consumer demand has kept the economy humming along.
But the cumulative impact of 2023’s aggressive tightening is still working its way through the economy. Eventually, restrictive policy normally triggers a recession as demand falls and unemployment rises.
The Fed is walking a tightrope, trying to curb price increases without severely damaging growth. But persistent inflationary pressures leave little room for a swift policy reversal.
Rate cuts later this year are still possible, but will depend on compelling evidence that core inflation is on a sustainable downward path toward the Fed’s 2% goal. Until shelter and services costs normalize, additional rate hikes can’t be ruled out.
Markets cling to hopes that falling goods prices and easing supply chain strains will open the door for Fed easing. But policymakers remain laser-focused on services inflation, particularly in housing.
Overall, the January inflation data signals the Fed’s inflation fight is far from over. While markets may yearn for rate cuts, persistent price pressures suggest a longer road ahead before policy can substantively turn dovish.
US economic output grew at a faster pace than initially estimated in the third quarter, according to revised GDP data released Wednesday by the Commerce Department. The upgraded third quarter growth paints a picture of resilient business and government spending offsetting slowing consumer demand.
GDP expanded at an annualized rate of 5.2% during the July to September period, topping the advance reading of 4.9% growth. Upward revisions were fueled primarily by fixed business investment and government expenditures proving stronger than expected.
Corporate Investments Defy Recession Fears As rising rates threaten housing and construction, many economists feared companies would pull back on equipment investments amid an uncertain outlook. However, nonresidential fixed investment, encompassing structures, equipment, intellectual property and more, rose 1.3% in Q3.
While this marked a steep decline from 6.1% growth in Q2, business spending has moderated far less than feared. Companies seem focused on funding promising productivity enhancements even as they trim costs elsewhere. Tech and machinery upgrades that drive efficiency and cut costs over the long term remain attractive.
Surprisingly resilient corporate investment provided vital ballast for growth last quarter. Coupled with still-healthy consumer spending, albeit revised down slightly, business capital outlays appear sufficient to keep the US out of recession territory for now.
Government Spending Spikes In addition to business investment, government expenditures at the federal, state and local levels increased 5.8% in Q3, meaningfully higher than early readings. Surging defense spending as well as state investments in education drove elevated government consumption.
With Democrats in control of Congress and the White House, pandemic-era support programs also continued stimulating significant public sector demand.
Consumer Engine Slows but Remains Solid Although personal consumption spending fell short of initial 4% growth estimates and instead rose a still-strong 3.6%, households continue underpinning US growth. A super-tight jobs market, rising wages and abundant savings for higher-income Americans seem sufficient to maintain solid consumer demand.
However, with borrowing costs jumping and inflation eating away at incomes, an evident slowdown in spending ahead of the crucial holiday season presents economic risks. Any further erosion of consumption could spur layoffs and trigger recessionary conditions. For now at least, consumers appear positioned to continue carrying the torch.
Strong Growth But Uncertainty Lingers Thanks to business and government resilience, Q3 expansion topped already lofty expectations. This provides a sturdy launching pad heading into year-end. But with the Fed aggressively tightening policy and key trading partners teetering on the brink of recession, clouds linger on the horizon. Another quarter of solid growth could be the high water mark before a challenging 2024.
Against the odds, the US economy appears poised to stick the landing from a period of scorching inflation without plunging into recession. This smooth descent towards more normal inflation, known as a “soft landing”, has defied most economists’ expectations thus far.
Just months ago, fears of an imminent downturn were widespread. Yet October’s inflation print showed consumer prices rising 3.2% annually – down markedly from a 40-year high of 9.1% in 2022. More importantly, core inflation excluding food and energy eased to 2.8% over the last 5 months – barely above the Federal Reserve’s 2% target.
This disinflation is occurring while job gains continue and economic growth rebounds. Employers added a solid 204,000 jobs per month over the past quarter. GDP growth also accelerated to a robust 4.9% annualized pace in Q3, its fastest since late 2021.
Such resilience has led forecasters like Oxford Economics’ Nancy Vanden Houten to now predict, “What we are expecting now is a soft landing.” Avoiding outright recession while taming inflation would be a major feat. In the past 80 years, the Fed has never managed it without sparking downturns.
Cooling inflation gives the central bank room to moderate its fierce rate hike campaign. Since March, the Fed lifted its benchmark rate range to a restrictive 5.25%-5.50% from near zero to squash rising prices.
Investors are betting these tightening efforts have succeeded, with futures implying rate cuts could come as early as May 2023. Markets rallied strongly after October’s consumer price report.
Risks Remain However, risks abound on the path to a soft landing. Inflation remains well above the Fed’s goal, consumer spending is softening, and ongoing rate hikes could still bite.
“It looks like a soft landing until there’s some turbulence and things get hairier,” warns Indeed economist Nick Bunker.
While consumers powered the economy earlier in recovery, retail sales just declined for the first time since March. Major retailers like Home Depot and Target reveal shoppers are pulling back. If consumers continue retreating, recession odds could rise again.
The Fed likely needs more definitive proof before declaring victory over inflation. Chairman Jerome Powell still stresses the need for “sufficiently restrictive” rates to hit the 2% target sustainably.
Further shocks like energy price spikes or financial instability could also knock the economy off its delicate balancing act. For now, the coveted soft landing finally looks achievable, but hazards remain if inflation or growth falter.
Navigating the Descent Amid this precarious environment, how should investors, policymakers and everyday Americans navigate the descent?
For the Fed, it means walking a tightrope between overtightening and loosening prematurely. Moving too fast risks recession, while moving too slowly allows inflation to become re-entrenched. Gradually slowing rate hikes as data improves can guide a gentle landing.
Investors should prepare for further turbulence, holding diversified assets that hedge against inflation or market swings. Seeking prudent VALUE rather than chasing speculative growth is wise at this late stage of recovery.
Consumers may need to budget conservatively, pay down debts, and boost emergency savings funds. With caution, America may yet stick an elusive soft landing during this perilous inflationary journey.
Major stock indexes posted modest gains Friday, but new data reflects growing unease among consumers about the state of the U.S. economy.
The University of Michigan’s preliminary November reading on consumer sentiment fell to 60.4, below economist expectations and the lowest level since May. This marked the fourth straight monthly decline for the index, highlighting continued erosion in economic optimism.
“Consumers cited high interest rates and ongoing wars in Gaza and Ukraine as factors weighing on the economic outlook,” said Joanne Hsu, director of Surveys of Consumers.
Inflation expectations also edged up to 3.2% over the next five years, levels not seen since 2011. This suggests the Federal Reserve still has work to do in getting inflation under control after aggressive interest rate hikes this year.
Earlier this week, Fed Chair Jerome Powell reiterated that further rate increases may be necessary to keep inflation on a sustainable downward trajectory. Other Fed officials echoed Powell’s sentiments that policy may need to become even more restrictive to tame inflationary pressures.
For investors, the deteriorating consumer outlook and stubborn inflation signal more churn ahead for markets after October’s volatile swings. While stocks have rebounded from last month’s lows, lingering economic concerns could spur renewed volatility ahead.
This uncertain environment calls for careful navigation by investors. Maintaining discipline and focusing on quality will be key to weathering potential market swings.
With slower growth on the horizon, investors should emphasize companies with strong fundamentals, steady earnings and lower debt levels. Searching for value opportunities and dividend payers can also pay off as markets turn choppy.
Diversification remains critical to mitigate risk. Ensuring portfolios are balanced across asset classes, market caps, sectors and geographies can smooth out volatility when conditions invariably shift. Regular rebalancing to bring allocations back in line with targets is prudent as well.
Staying invested for the long haul is important too. Bailing out of the market can backfire if it recovers and gains are missed. A buy-and-hold approach with a multi-year time horizon allows compounding to work its magic.
Of course, maintaining some dry powder in cash provides flexibility to scoop up bargains if stocks retreat again. Dollar-cost averaging into new positions can limit downside risk.
Above all, patience and discipline will serve investors well in navigating uncertainty. Sticking to a plan and avoiding emotional reactions to market swings can help anchor portfolios for the long run.
While the path ahead may be bumpy, historic market performance shows long-term returns can overcome short-term volatility. Bear markets eventually give way to new bulls. Maintaining perspective and focusing on the horizon can guide investors through uncertain times.
Of course, there are no guarantees in investing. Stocks could see more declines before recovery takes hold. But diversification, quality tilt and balanced allocations can help smooth out the ride.
And investors with long time horizons can actually take advantage of market dips. Regular investing through 401(k)s means buying more shares when prices are depressed, which will pay off handsomely when markets rebound.
The key is tuning out the noise and sticking to smart principles: diversify, rebalance, emphasize quality, maintain perspective and stay the course. This disciplined approach can serve investors well in volatile times.
Though the path forward may remain bumpy, patient investors focused on the long view stand to be rewarded in time.
The bond market is sounding alarm bells about the economic outlook. The yield on the 2-year Treasury briefly exceeded the 10-year yield this week for the first time since 2019. Known as a yield curve inversion, this phenomenon historically signals a recession could be on the horizon.
While not a guarantee, yield curve inversions have preceded every recession over the past 50 years. Here is what is happening in the bond market and what it could mean for investors.
Why Did Yields Invert?
Yields on short-term bonds like 2-year Treasuries tend to track the Federal Reserve’s policy rate. With the Fed aggressively hiking rates to combat inflation, short-term yields have been rising quickly.
Meanwhile, long-term yields like the 10-year are influenced by investors’ growth and inflation expectations. As optimism over the economy’s trajectory wanes, investors have been driving down long-term yields.
This dynamic inversion, where short-term rates exceed longer-duration ones, reflects mounting concerns that the Fed’s rate hikes will severely slow economic activity. Markets increasingly fear rates may cause a hard landing into recession.
The yield curve has flashed the most negative signal since the lead up to the pandemic recession. This suggests investors see a lack of catalysts for growth on the horizon even as inflation remains stubbornly high.
Ongoing supply chain problems, the war in Ukraine putting pressure on food and energy prices, and fears of a housing market slowdown are all weighing on outlooks. There is a sense the Fed lacks effective tools to bring down inflation without crushing the economy.
Meanwhile, key economic indicators like manufacturing surveys have weakened significantly. This points to activity already slowing ahead of when rate hikes would take full effect.
Implications for Investors
The risks of a recession are rising. Yield curve inversions have foreshadowed every recession since the 1950s. However, they have also sometimes occurred 1-2 years before downturns start.
This suggests investors should prepare for choppiness, but not panic. Rotating toward more defensive stocks like healthcare and consumer staples can help portfolios better weather volatility. At the same time, cyclical sectors like tech and industrials could face more pressure.
In fixed income, short-term bonds may offer opportunities as the Fed potentially cuts rates during a downturn. But credit-sensitive sectors like high-yield bonds and leveraged loans could struggle if defaults rise.
While uncertainty abounds, the inverted yield curve highlights the delicate balancing act ahead for the Fed and concerns over still-high inflation. Investors will be closely watching upcoming data for signs of how quickly the economy is slowing. For now, caution and safe-haven assets look to be in favor as recession worries cast a long shadow.
Jan Hatzius Thinks the U.S. Will Avoid a Recession
The July hike in rates will be their last, according to a new forecast by Goldman Sachs’ chief economist, Jan Hatzius. In an analyst note dated July 17, Mr. Hatzius reduced his forecast for a recession over the next 12 months to only 20% from an already lower tha peers 25%, citing inflation that has dropped precipitously over the past year.
“We are cutting our probability that a US recession will start in the next 12 months further, from 25% to 20%,” Hatzius wrote. “The main reason for our cut is that the recent data have reinforced our confidence that bringing inflation down to an acceptable level will not require a recession.”
The forecast follows the previous weeks CPI and PPI reports that show both had decelerating price increases from previous periods, with consumer prices up just 3% from a year ago. The report pointed to a faster-than-expected decline in core inflation, which showed to a 4.8% increase from a year earlier. Core inflation readings don’t include food or energy prices that may be up or down based on factors unrelated to economic strength or weakness.
With inflation on the run, economists don’t expect the Fed to stop short of finishing the job. On July 25-26 next week the Federal Reserve is widely expected to adjust rates up another quarter-percentage point. Goldman’s Hatzius wrote he expects this will be the final increase in the Fed’s tightening cycle.
“We do expect some deceleration in the next couple of quarters, mostly because of sequentially slower real disposable personal income growth — especially when adjusted for the resumption of student debt payments in October — and a drag from reduced bank lending,” he wrote.
Monetary policymakers have raised interest rates sharply over the past year, approving 10 straight rate hikes in the span of one year to lower inflation that was as high as 9%. In a little over a year, the base overnight bank lending rate was pushed up from near zero to near 5.25%, the fastest pace of tightening since the 1980s. If Hatzius and many other economists are correct, Officials are expected to approve an 11th rate hike at the conclusion of their two-day meeting next week, the FOMC did not raise rates at the June meeting, choosing to assess the economy for a longer period before deciding.
Increased interest rates elevates costs on consumer and business loans, which then slows the economy by forcing employers to cut back on spending. Higher rates have helped push the average rate on 30-year mortgages above 7% from half that level a couple of years back. Borrowing costs for everything from home equity lines of credit to auto loans and credit cards have also spiked. This helps slow demand, less demand is less inflationary.
The labor market has remained strong despite the Fed’s assault on business conditions. Taken all together Goldman Sachs is more bullish on a soft landing for the US economy.
“The main reason for our cut is that the recent data have reinforced our confidence that bringing inflation down to an acceptable level will not require a recession,” he wrote. For context the average recession expectation has been 15% since WWII. Hatzius’ adjusted forecast is still above the average of 15%, but well below the median forecast on Wall Street, of 54%.
According to the note, encouraging CPI data is not a trend set to fizzle out, as fundamental signals highlight further disinflation to come, “Used car prices are sliding on the back of higher auto production and inventories, rent inflation still has a long way to fall before it catches up with the message from median asking rents, and the labor market has continued to rebalance with an ongoing downtrend in job openings, quits, reported labor shortages, and nominal wage growth,” wrote Goldman’s Hatzius.
Take Away
No economist has a crystal ball, but when Goldman Sachs issues a note, the markets pay attention. In its note this week it reports expectations that the odds of a recession in the next year have fallen to just 20%, citing encouraging economic data, including, employment, consumer sentiment and slowing inflation. Goldman’s senior economist expects just one remaining interest rate hike in the Federal Reserve’s tightening cycle, and that is expected in July.
Why Diversify Your Portfolio Into Smaller Government Contractors
Will there be a recession, or will the Fed orchestrate a rare soft landing? Coming off a down year last year, with the stock market now up mid-year by 7%, which is the average expected return for a full year of the broader indexes, many investors find themselves straddling a fence. On one side of the fence is the fear of missing out (FOMO), and on the other is a money market rate that is higher than it has been in decades. In a weakening economy, investors don’t have to exit the stock market completely to find stocks that are not expected to be negatively impacted. Until there is more clarity, perhaps it is worth taking a portion of your holdings on a side trip, to look at government contractors.
When company earnings are dependent on the consumer, its stock price may be tied to the pace of the economy – it’s likely to at least be correlated to activity within its industry. While many investment options are available, one often overlooked but potentially rewarding segment is companies that generate revenue through government contracts, not consumer sales or business-to-business. Let’s explore the benefits of investing in such companies, particularly smaller ones where a new contract is most impactful to the bottom line. These company’s still have above average growth potential but can be quite resilient during economic downturns.
Stable Revenue Streams
Companies that secure government contracts often enjoy stable and predictable revenue streams, they also are billing an entity that can tax and is not reliant on stable earnings itself. Government contracts typically involve long-term agreements that provide a consistent flow of income for the duration of the contract. This stability can be particularly beneficial for investors seeking reliable returns on their investments. Aerospace companies, for instance, often receive substantial contracts for the production and maintenance of military aircraft, providing a steady stream of income.
Reduced Vulnerability to Recessions
One of the key advantages of investing in companies with government contracts is their potential indifference to economic downturns. During recessions or periods of economic uncertainty, government spending has even been known to increase as a means to stimulate a weak economy. This increased spending often benefits companies with government contracts, as governments prioritize projects related to defense, infrastructure development, and public services. This makes aerospace and dredging companies, which are heavily involved in such projects, relatively impervious to recessions.
Long-Term Growth Opportunities
Government contracts often involve large-scale projects that span several years or even decades. This long-term nature provides companies with ample opportunities for growth and expansion. For example, aerospace companies may secure contracts to develop advanced military aircraft, including drones, or provide satellite-based communication systems. Similarly, dredging companies might be contracted for extensive port development projects. These opportunities allow companies to invest in research, development, and innovation, positioning them for sustained growth and profitability.
Competitive Advantage of Being Established
Government contracts typically involve rigorous bidding processes and stringent eligibility criteria. Companies that successfully secure these contracts gain a competitive advantage over their peers. Once established, they often become preferred suppliers for subsequent projects, further solidifying their market position. This advantage can translate into increased market share, higher profitability, and enhanced investor confidence, making these companies attractive for long-term investments.
Great Lakes Dredge & Dock Corporation (GLDD) would seem to fit the above criteria. It is the largest provider of dredging services in the United States, and is engaged in expanding its core business into the rapidly developing offshore wind energy industry. Great Lakes also has a history of securing significant international projects. GLDD has a 132-year history, has a market-cap of $542 million, and is up 37% year-to-date.
The most recent research note from Noble Capital Markets on GLDD is available here.
Kratos Defense & Security Solutions, Inc. (KTOS), a military contractor that has admirable specialties compared to the large names that typically come to mind. Kratos is changing the way transformative breakthrough technology for the industry is rapidly brought to market through proven approaches, including proactive research and streamlined development processes. KTOS treats affordability as a technology that needs to be considered. It specializes in unmanned systems, satellite communications, cyber security/warfare, microwave electronics, missile defense, hypersonic systems, training, combat systems and next generation turbo jet and turbo fan engine development. KTOS has a $1.72 billion market-cap and is up 31% year-to-date.
The most recent research note from Noble Capital Markets on KTOS is available here.
Technological Advancements and Spin-Off Opportunities
Working on government contracts often requires companies to push the boundaries of technology and innovation. Aerospace companies, for example, are at the forefront of developing advanced defense systems, satellite technologies, and commercial aircraft. Similarly, dredging companies and those involved in wind energy may invest in state-of-the-art equipment and techniques to execute complex infrastructure projects. These advancements can lead to spin-off opportunities in commercial markets, expanding the company’s revenue streams beyond government contracts.
Take Away
Investing in companies that recieve revenue primarily through government contracts, particularly those that are small cap companies, may provide a recession-fearful investor with some comfort that the stock(s) they are investing in are less likely to suffer from consumers tightening their wallets, yet they have potential to grow.
As with all investing and forecasting the future, if it was easy, everyone would already be doing it. But, the two examples listed above may be a good start to help inspire discovering stocks that are situated differently than traditional consumer or business-to-business companies.
The Difficult Reality of Rising Core and Super-Core Inflation
While many market participants are concerned about rate increases, they appear to be ignoring the largest risk: the potential for a massive liquidity drain in 2023.
Even though December is here, central banks’ balance sheets have hardly, if at all, decreased. Rather than real sales, a weaker currency and the price of the accumulated bonds account for the majority of the fall in the balance sheets of the major central banks.
In the context of governments deficits that are hardly declining and, in some cases, increasing, investors must take into account the danger of a significant reduction in the balance sheets of central banks. Both the quantitative tightening of central banks and the refinancing of government deficits, albeit at higher costs, will drain liquidity from the markets. This inevitably causes the global liquidity spectrum to contract far more than the headline amount.
Liquidity drains have a dividing effect in the same way that liquidity injections have an obvious multiplier effect in the transmission mechanism of monetary policy. A central bank’s balance sheet increased by one unit of currency in assets multiplies at least five times in the transmission mechanism. Do the calculations now on the way out, but keep in mind that government expenditure will be financed.
Our tendency is to take liquidity for granted. Due to the FOMO (fear of missing out) mentality, investors have increased their risk and added illiquid assets over the years of monetary expansion. In periods of monetary excess, multiple expansion and rising valuations are the norm.
Since we could always count on rising liquidity, when asset prices corrected over the past two decades, the best course of action was to “buy the dip” and double down. This was because central banks would keep growing their balance sheets and adding liquidity, saving us from almost any bad investment decision, and inflation would stay low.
Twenty years of a dangerous bet: monetary expansion without inflation. How do we handle a situation where central banks must cut at least $5 trillion off their balance sheets? Do not believe I am exaggerating; the $20 trillion bubble generated since 2008 cannot be solved with $5 trillion. A tightening of $5 trillion in US dollars is mild, even dovish. To return to pre-2020 levels, the Fed would need to decrease its balance sheet by that much on its own.
Keep in mind that the central banks of developed economies need to tighten monetary policy by $5 trillion, which is added to over $2.50 trillion in public deficit financing in the same countries.
The effects of contraction are difficult to forecast because traders for at least two generations have only experienced expansionary policies, but they are undoubtedly unpleasant. Liquidity is already dwindling in the riskiest sectors of the economy, from high yield to crypto assets. By 2023, when the tightening truly begins, it will probably have reached the supposedly safer assets.
In a recent interview, Bundesbank President Joachim Nagel said that the ECB will begin to reduce its balance sheet in 2023 and added that “a recession may be insufficient to get inflation back on target.” This suggests that the “anti-fragmentation tool” currently in use to mask risk in periphery bonds may begin to lose its placebo impact on sovereign assets. Additionally, the cost of equity and weighted average cost of capital increases as soon as sovereign bond spreads begin to rise.
Capital can only be made or destroyed; it never remains constant. And if central banks are to effectively fight inflation, capital destruction is unavoidable.
The prevalent bullish claim is that because central banks have learned from 2008, they will not dare to allow the market to crash. Although a correct analysis, it is not enough to justify market multiples. The fact that governments continue to finance themselves, which they will, is ultimately what counts to central banks. The crowding out effect of government spending over private sector credit access has never been a major concern for a central bank. Keep in mind that I am only estimating a $5 trillion unwind, which is quite generous given the excess produced between 2008 and 2021 and the magnitude of the balance sheet increase in 2020–21.
Central banks are also aware of the worst-case scenario, which is elevated inflation and a recession that could have a prolonged impact on citizens, with rising discontent and generalized impoverishment. They know they cannot keep inflation high just to satisfy market expectations of rising valuations. The same central banks that assert that the wealth effect multiplies positively are aware of the disastrous consequences of ignoring inflation. Back to the 1970s.
The “energy excuse” in inflation estimates will likely evaporate, and that will be the key test for central banks. The “supply chain excuse” has disappeared, the “temporary excuse” has gotten stale, and the “energy excuse” has lost some of its credibility since June. The unattractive reality of rising core and super-core inflation has been exposed by the recent commodity slump.
Central banks cannot accept sustained inflation because it means they would have failed in their mandate. Few can accurately foresee how quantitative tightening will affect asset prices and credit availability, even though it is necessary. What we know is that quantitative tightening, with a minimal decrease in central bank balance sheets, is expected to compress multiples and valuations of risky assets more than it has thus far. Given that capital destruction appears to be only getting started, the dividing effect is probably more than anticipated. And the real economy is always impacted by capital destruction
Philippe Petit walks Tightrope between buildings one and two of WTC, Manhattan, 1974 – Robert.Dearie (Flickr)
Analyst Team Point Out Asset Classes that Slingshotted in the 1970s
While the traditional fine print usually says, “past performance is no guarantee of future results,’ we all know trading decisions, whether the stocks are to be held for seconds, or decades, are based on probabilities. And market probabilities are rooted in past performance. What does past performance tell us about the chances that the markets can survive high inflation and low growth? Well, if the stagflation of the 70s repeats, there may be a small section of the markets to keep a solid footing.
Michael Hartnett is the chief investment strategist at Bank of America/Merrill Lynch. Hartnett sees in our current economy the ingredients in the macroeconomic picture that lead to the difficult economic combination of high inflation and low growth. His team, in their Flow Show note on Friday, wrote: “Inflation and stagnation was ‘unanticipated in 2022…hence $35 trillion collapse in asset valuations; but relative returns in 2022 have very much mirrored asset returns in 1973/74, and the 70s remain our asset allocation analog for 2020s.”
If the conditions of the 1970s are being mirrored and we are creating a foundation similar to 1973/74, Hartnett and team have a list of assets that could springboard off the stagflation cycle.
The assets with potential include taking long positions in small-caps, value, commodities, resources, volatility, and emerging markets. The group also highlights the short positions that worked well in the 1970s, the note indicates these are larger stocks, bonds, growth, and technology.
Why Small-Caps
As it applies to the smaller companies, the note points out that stagflation persisted through the late 1970s, but the inflation shock had ended by 1973/74, when the small-cap asset class “entered one of the great bull markets of all-time.” The Hartnett team sees small-caps set to keep outperforming in the “coming years of stagflation.”
The current year-to-date status has the Russell 2000 small-cap stock market index (measured by iShares ETF) down 19.8% in 2022. At the same time, the Dow Industrials are down 11%, S&P 500 lost 21%, and the Nasdaq Composite gave back 33%.
The current state of the Fed and Chairman Powell is they continue to be adamant about tightening, Powell said he’d prefer to overdo withdrawing stimulus than do too little. He also knows that until the market believes this, his tightening efforts will have a lower impact.
The BofA team isn’t helping market expectations as they noted, despite Powell’s clear signal that the Fed isn’t ready to declare even a slight victory from its raising rates; the analyst team says, don’t give up on that pivot.
After tightening interest rates through 1973/74 amid inflation and oil shocks, the central bank first cut in July 1975 as growth turned negative, Hartnett points out. A sustained pivot began in December of that year, and importantly, the unemployment rate surged from 5.6% and 6.6% that same month.
The “following 12 months, the S&P 500 rose 31%. The note suggests the lesson learned is that job losses when they occur, will be the catalyst for a 2023 pivot,” said Hartnett and the team.
We’re not there yet. Today’s economic release on jobs showed the U.S. added a stronger-than-expected 261,000 jobs during October. This is a slower pace than the prior month’s 315,000 job gains but still shows the Fed can comfortably notch rates up more and continue reducing its balance sheet.
Take Away
The team of analysts at BofA/Merrill Lynch, reporting to Michael Hartnett, drew conclusions from the stagflation and financial markets’ performance of the 1970s. They shared their thoughts in a research note with investors. Looking at past performance, their expectation is that the Fed will pivot away from aggressively raising rates when it begins to negatively impact job creation. At this point, many markets will have already reacted to inflation expectations and would then react to a more accommodative monetary policy.
The asset sectors to avoid or short are larger stocks, bonds, growth, and technology. The preferred sectors that, in past situations, have done well are small-caps, value, commodities, resources, volatility, and emerging markets.
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