Economic strength forces the Fed to become more aggressive

Economic strength forces the Fed to become more aggressive

On Tuesday, we learned that US employers had a record 11.5 million job openings in March. This is arguably the clearest sign that the economy is booming, as hiring workers doesn’t come cheap and most employers would only do this if they didn’t already have the staff to respond to the request.

Currently, there are only 5.9 million people unemployed. In other words, there are nearly two job vacancies per unemployed person. The mismatch means workers have a lot of options, which means they have a lot of leverage to demand more pay. Indeed, employers are paying at a historic rate.

But booming demand, record job openings and higher wages…are evil?

The Federal Reserve and many in the economics profession don’t put it so bluntly. But that is indeed their message.

The state of play: The demand for goods and services has greatly exceeded the supply1, which has propelled inflation to high rates for decades. This is partly because higher wages mean higher costs for businesses, many of which have raised prices to maintain profitability. Ironically, these higher wages have helped bolster the already strong finances of consumers, who pay voluntarily and thus allow companies to continue raising prices.

It is important to add that this booming demand has been supported by job creation (i.e. a phenomenon where someone goes from nothing to earning something). In fact, the United States has created 2.1 million jobs so far in 2022.

The Bureau of Labor Statistics has a metric called the Total Weekly Payroll Index, which is the product of jobs, wages, and hours worked. It is an approximation of the total nominal spending capacity of the workforce. This measure was up 10% year-over-year in April and has been above 9.5% since April 2021. Before the pandemic, it was around 5%.

This combination of job growth and wage growth has only exacerbated the inflation problem.

And so the best solution, at this point, seems to be to tighten monetary policy so that financial conditions become a little more difficult, which should lead to a cooling of demand, which should in turn alleviate some of these inflationary pressures persistent.

In other words, the Fed is trying to dampen some of the good news coming out of the economy, because that good news is actually bad2.

The Fed decides to reduce “excess demand” 🦅

In a decision widely anticipated, the Fed on Wednesday raised short-term interest rates by 50 basis points to a range of 0.75% to 1.00%. This is the largest increase made by the central bank in a single announcement since May 2000.

In addition, Fed Chairman Jerome Powell signaled the intention of the Federal Open Market Committee (i.e. the Fed committee that sets monetary policy) to keep rates rising at a steady pace. aggressive.

“Assuming that economic and financial conditions evolve in line with expectations, there is a general feeling within the Committee that additional increases of 50 basis points should be on the table at the next two meetings,” Powell said. “Our main objective is to use our tools to bring inflation back to our 2% target. »

To be clear, the Fed is not trying to force the economy into a recession. On the contrary, it tries to make the excess demand – as evidenced by the number of vacancies greater than the number of unemployed – more closely match the supply.

“There’s a lot of excess demand,” Powell said.

Fed Chairman Jerome Powell (Getty Images)

Fed Chairman Jerome Powell (Getty Images)

Currently, there are massive economic tailwinds, including excess consumer savings and booming investment orders, which are expected to propel economic growth for months, if not years. The economy therefore has the possibility of releasing part of the accumulated pressure of demand without entering a recession.

Here’s more from Powell’s press conference on Wednesday (with relevant links added):

It would be a much riskier situation if consumer and business finances were stretched in addition to the absence of excess demand. But this is not currently the case.

And so, while some economists say the risk of recession is increasing, most don’t have it as a base case scenario for the near future.

Is this bad news for stocks? Not necessarily.

When the Fed decides it’s time to calm the economy, it does so by trying to tighten financial conditions, which means the cost of funding goes up. Broadly speaking, this means a combination of higher interest rates, lower stock market valuations, a stronger dollar and tighter lending standards.

Does this mean stocks are bound to fall?

Well, a hawkish Fed is definitely a risk for stocks. But nothing is ever certain when it comes to predicting the outlook for stock prices.

First, history shows that stocks generally rise when the Fed tightens monetary policy. This makes sense if you remember that the Fed tightens monetary policy when it feels the economy has some momentum.

Nonetheless, the prospect of higher interest rates is certainly a concern. Most stock market experts, like billionaire Warren Buffett, generally agree that higher interest rates are bearish for valuations, like the next 12-month (NTM) P/E ratio.

But the key word is “valuations”, not stocks. Stock prices don’t need to fall to drive down valuations as long as earnings expectations are rising. And earnings expectations have risen. And indeed, valuations have been falling for months.

The chart below by Credit Suisse’s Jonathan Golub captures this dynamic. As you can see, the NTM P/E has been trending lower since late 2020. However, stock prices have mostly risen over this period. Even with the recent market correction, the S&P 500 is higher today than it was when valuations began to fall. Why? Because revenues for the next 12 months have only increased.

To be clear, there is no guarantee that stocks will not continue to fall from their January highs. And it is certainly possible that future earnings growth will turn negative if the business environment deteriorates.

But for now, the earnings outlook continues to be remarkably resilient, which could provide some support for stock prices, which are currently experiencing a fairly typical sell-off.3

More TKers:

Mirror 🪞

📉📈📉📈 Stocks go haywire: The S&P 500 fell just 0.20% to end an incredibly volatile week. On Wednesday, the S&P jumped 2.99% in what was the index’s biggest one-day rally since May 18, 2020. The next day, it fell 3.56% in what was the second index’s worst day of the year.

(Source : <a href="https://twitter.com/JillMislinski/status/1522714967023095809" rel="nofollow noopener" cible="_Vide" data-ylk ="slk : @JillMislinski" classe="lien ">@JillMislinski</a>)” data-src=”https://s.yimg.com/ny/api/res/1.2/w3reUeu62hPgXJgI6dYVSw–/YXBwaWQ9aGlnaGxhbmRlcjt3PTk2MA–/https://substackcdn.com/image/fetch/w_1456,c_limit,f_auto ,q_auto:good,fl_progressive:steep/https%3A%2F%2Fbucketeer-e05bbc84-baa3-437e-9518-adb32be77984.s3.amazonaws.com%2Fpublic%2Fimages%2Ff5544db4-66d8-4202-8942-03cb114af36a_650x415.p”/ ><noscript><img alt=@JillMislinski)” src=”https://s.yimg.com/ny/api/res/1.2/w3reUeu62hPgXJgI6dYVSw–/YXBwaWQ9aGlnaGxhbmRlcjt3PTk2MA–/https://substackcdn.com/image/fetch/w_1456,c_limit,f_auto,q_auto :good,fl_progressive:steep/https%3A%2F%2Fbucketeer-e05bbc84-baa3-437e-9518-adb32be77984.s3.amazonaws.com%2Fpublic%2Fimages%2Ff5544db4-66d8-4202-8942-03cb114af36a_650x415.png” class=” caas-img”/>

The S&P is currently down 14.4% from its January 4 intraday high at 4,818. To learn more about market volatility, read this, this and this.

💼 Job creation: U.S. employers added 428,000 healthy jobs in April, according to BLS data released Friday. This figure was significantly higher than the 380,000 jobs expected by economists. The unemployment rate was 3.6%. To learn more about the state of the labor market, read this.

📊 Service business growth is slowing: According to survey data collected by the Institute of Supply Management, service sector activity slowed in April. According to Anthony Nieves, Chairman of the ISM Survey Committee on Services Companies: “Growth continues for the services sector, which has grown for all but two of the past 147 months. The composite index fell, mainly due to the tight labor pool and slowing growth in new orders. Commercial activity remains strong; however, high inflation, capacity constraints and logistical challenges are obstacles, and the Russian-Ukrainian war continues to affect the costs of materials, including fuel and chemicals.

Up the road 🛣

There is no bigger story in the economy right now than the direction of inflation. All eyes will therefore be on the April Consumer Price Index (CPI) report, which will be released on Wednesday morning. Economists estimate the CPI rose 8.1% year-over-year in the month, which would be a deceleration from March’s 8.5% print. Excluding food and energy prices, core CPI is expected to have risen 6.1%, from 6.5% in March.

Check out The Transcript’s schedule below with some of the big names announcing their quarterly financial results this week.

1. We’re not going to go into all the nuances of supply chain issues here (for example, how labor shortages in the US, COVID-related lockdowns in China, and the war in Ukraine disrupt manufacturing and trade). However, we know that supply chain issues persist, as evidenced by persistently slow delivery times from suppliers.

2. For those of you new to TKer, I’ve written a bit about how good economic news has been “bad” news. You can read more about it here, here, here and here.

3. Investing in stocks is not easy. This means having to deal with great short-term volatility while waiting for those long-term gains. Everyone is welcome to try to time the market and sell and buy in an effort to minimize those short term losses. But of course, the risk is missing out on those big rallies that happen during volatile times, which can do irreversible damage to long-term returns. (Read more here, here, and here.) Remember, there’s an entire industry of pros out there aiming to beat the market. Few are able to outperform in any given year, and of those outperformers, few are able to sustain that performance year after year.

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