The Fed is stuck, so are stocks

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Roula Khalaf, editor-in-chief of the FT, selects her favorite stories in this weekly newsletter.

Good morning. Unhedged is very happy to be back after a week and a half of absence. I was in Switzerland most of last week attending a Bank for International Settlements conference. (Unhedged is just me, until I find a replacement for the irreplaceable Ethan.) There, I learned a lot about how the Basel Global Banking Standards are negotiated. The short version: It’s hard, but it’s done because everyone involved has a pressing interest in a banking system that doesn’t break down all the time. On Friday, I will publish an interview with Agustín Carstens, head of the BIS and central banker of central bankers. In the meantime, send me an email: [email protected].

The Fed is stuck, so are stocks

I wouldn’t flatter myself that Unhedged is its readers’ only source of financial information. It’s still worth summarizing what happened over the last ten days while the letter was pending. Over this period, the big picture has not so much changed direction as consolidated significantly, in a way that will inform what we hear at the Federal Reserve meeting today.

There is now even stronger evidence that the U.S. real economy is growing at an above-trend pace and that inflation is stuck above target. Expectations of a reduction in interest rates have therefore fallen further, which has made the stock markets lose their dizziness.

The first quarter gross domestic product report released last Thursday showed growth of 1.6 percent, suggesting a slowdown. It was misleading. The trade deficit and inventories weighed heavily, but demand remained unchanged. Final sales to domestic buyers grew at an annual rate of just under 3 percent, only slightly slower than the previous quarter. Real personal consumption expenditures (last Friday) confirmed the signal.

Investments also contribute to demand. Real private investments, both residential and non-residential, are experiencing a significant increase. The manufacturing sector, as we noted earlier, is finally expanding, albeit slowly. This is all great, except that the Fed’s preferred measure of inflation is simply old and going in the wrong direction:

A measure of wage inflation that the Fed is interested in, the Employment Cost Index, was released yesterday, and it also rose sequentially.

Markets saw the outlines of this picture before recent data completed it. The furious stock market rally that began last October ended like the beginning of April, and except for a brief rebound marked by technology stocks, it has been sideways down ever since:

It has been suggested that the market malaise is due to concerns about growth, or even stagflation. I don’t think the data supports this reading. NatAlliance’s Andrew Brenner suggested that a poor Conference Board consumer confidence number and a poor Dallas Fed staff survey, both released yesterday, are evidence of creeping sluggishness. But the majority of data points in the opposite direction. Yes, businesses that cater to low-income households continue to report weakening demand, as the FT reported yesterday. But as Unhedged has previously pointed out, the plight of low-income, heavily indebted consumers is consistent with an overall strong U.S. economy.

More importantly, if markets were responding to increasing downside risk, we would expect this to be reflected in corporate bond yield spreads relative to Treasuries, which respond to even small changes in the probability of recession. But unwanted spreads remained stuck at levels not seen since 2007:

What we are seeing is the stock market moving from valuing based on a strong economy and falling rates to valuing on a strong economy and high, stable rates, at least in the short term (for an argument measured in favor of lower inflation and rates in the medium term, look at Chris Giles’ latest central bank newsletter his main argument, in my opinion, is that the US labor market continues; to relax).

The Fed has no choice but to wait for improving data before cutting rates, and stocks could remain stuck in a sideways trend until that happens. Making predictions about the short-term behavior of stocks is, of course, folly. But it’s not just the reduced likelihood of a rate cut that’s putting downward pressure. Stocks remain expensive and earnings haven’t been great, despite the strong economy. On Friday, S&P 500 stocks that reported first-quarter earnings reported 3.5 percent earnings growth and 4 percent revenue growth on average, according to FactSet. Margin expansion has been difficult to achieve due to persistent inflation. Right now, stocks are facing fundamental headwinds.

What could break the Fed’s impasse? The obvious candidate, given where the current strong growth is coming from, is a slowdown in consumer demand. There is reason to think this could happen because – as almost everyone agrees – America’s excess pandemic savings are exhausted. Below, for example, is a chart from Nancy Vanden Houten of Oxford Economics. Excess savings are difficult to measure. It follows the more or less standard methodology, calculating excess savings as the actual level of savings (accumulated income minus expenses) minus what savings would have been if pre-pandemic trends had persisted.

Vanden Houten notes that “consumers continue to spend at a reasonable pace” despite the reduction in the stock of savings. That is to say, the savings rate is low, a sign of confidence. I asked him whether this risks making consumer spending vulnerable to a confidence shock. She replied:

The question is how long consumers will maintain such a low savings rate. We believe for now that a healthy job market and wealth gains from stocks and real estate will boost spending, but we see a risk that households will start to increase their savings. I think there is a risk that low-income households will cut back on spending – perhaps they already have. They are more likely to have exhausted their savings and have also not benefited from the same increase in wealth as other households.

In other words, the stress and parsimony that we see in a small minority of poorer households risks rippling upwards. This will help solve the Fed’s inflation problem, but not in a way that will please shareholders.

A good read

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