Jay Mans Up
A tip of the hat to Fed Chairman Jerome Powell this week. Friday was his day. In just over eight focused minutes on the mic (versus 30 minutes allotted), Jay Powell was clear, candid, and resolute. Straight out of the gate, Powell stated that, “The Federal Open Market Committee’s (FOMC) overarching focus right now is to bring inflation back down to our two percent goal. Price stability is the responsibility of the Federal Reserve, and serves as the bedrock of our economy. Without price stability, the economy does not work for anyone.” The Chairman acknowledged that, “restoring price stability will take some time” and will require the Federal Open Market Committee to use policy tools “forcefully to bring demand and supply into better balance.”
In a much-needed credibility bolstering admission, Powell backed away from any soft-landing talk and conceded that the inflation fight will have consequences. He said, “Reducing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions. While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.”
From Powell on down the line to regional Fed governors, the message from Jackson Hole was hawkish and undeniably consistent. Members of the Fed family uniformly advocate continuing to raise rates into restrictive territory and leaving them there until they are confidant they have broken the back of inflation. At the same time, Powell and the gang pushed back on market suggestions of 2023 interest rate cuts (a policy pivot). Powell said, “The historical record cautions strongly against prematurely loosening policy.”
BNY Mellon senior investment strategist Jake Jolly observed that Powell “closed the door on the idea of a near-term pivot, highlighting that a key history lesson is that policy must avoid loosening too early. Bottom line: rates need to keep going up until they’re firmly in restrictive territory. And then they need to stay there.”
Make no mistake, however, a restrictive policy setting is powerful poison for this structurally fragile, debt-saturated, credit-based economy that’s already slowing significantly. Such policy runs the serious risk of not just subduing inflation, but taking the economy out at the knees as well. In our current perilous predicament, there are no truly good policy options. Nobody expects Chairman Powell to overtly state that the Fed is willing to march the economy and markets right into the teeth of a recession for the sake of restoring price stability. That said, bluff or otherwise, with personal and institutional credibility entirely at stake, his Jackson Hole communique strongly implied nearly as much.
Powell’s blunt bit of shock and awe certainly rattled the cages of those consumed by the Fed-pivot Pavlovian conditioning of the last disinflationary decade. The self-defeating Catch-22 summer rally in equity indexes was instigated by widespread recognition of an increasingly dire “hurricane warning” of an economic outlook. That warning essentially constituted the ringing of Pavlov’s bell. Having heard the bell, markets geared-up for a dovish policy pivot party, got the music started, and rallied over 17% from late June through mid-August. What markets are now grappling with is that despite salivating excitedly for the expected Fed pivot, Powell just unplugged the jukebox and announced, “this is no time for frivolity.” The market’s summer dream, one filled with pleasing visions of a Fed-spiked-punchbowl party, was just replaced by a nightmare.
Accordingly, following Powell’s speech on Friday, heavy selling pressure picked up throughout the day. Market breadth was extremely negative, and down volume represented over 90% of the total. For major market indexes, Friday was a steady one-way trek to the downside that ultimately left the averages lower by between three and four percent. Last week, we had a weekly buying climax in the S&P 500 that reversed into a bearish lower weekly close. This week’s market action started with a gap lower open that fully followed through to close at the bottom tick of the week. This is bearish market action, and it strongly suggests that the summer rally is in the rear-view mirror. We’re now back to assessing a fundamentally sobering reality.
On the week, equities tanked while commodities, especially most energy components, generally faired well. In fact, of all equity sectors, energy stocks were the lone bastion of weekly gains. Precious metals were lower as the dollar continued higher, and Treasury yields were up across the curve. At week’s end, the 2s10s yield curve remained deeply inverted, and continued to aggressively red-flag pending recessionary trouble.
Outside of Jackson Hole, significant news and data this week continued to add important pieces to the mosaic of our emerging economic picture. Following extremely concerning data last week out of a crucially important leading economic indicator—that is, the housing sector—this week the eroding island of economic strength shrank further. Then, on Tuesday, it was S&PGlobal U.S. Purchasing Managers Index (PMI) data that revealed yet more significant weak data chinks in the economy’s armor.
US Manufacturing PMI slowed more than expected to a 25-month low, from 52.2 to 51.3. The US Manufacturing Output Index dropped further into contraction to 49.3 for a 26-month low. US Services PMI unexpectedly collapsed from 47.3 to 44.1 (vs. an expected jump to 49.8) for a 27-month low. Rounding out the data, the US PMI Composite Output Index shocked markets with a deepening contraction at 45.0 in August. The US Composite PMI was the weakest of all the global regions, and marked a fresh 27-month low. Markets had expected a bounce from July’s surprise contraction of 47.7.
Commenting on the PMI data, Siân Jones, Senior Economist at S&P Global Market Intelligence said:
August flash PMI data signaled further disconcerting signs for the health of the US private sector. Demand conditions were dampened again, sparked by the impact of interest rate hikes and strong inflationary pressures on customer spending, which weighed on activity. Gathering clouds spread across the private sector as services new orders returned to contractionary territory, mirroring the subdued demand conditions seen at their manufacturing counterparts (other regions outside of the U.S.). Excluding the period between March and May 2020, the fall in total output was the steepest seen since the series began nearly 13 years ago.
Meanwhile, on the consumer front, University of Michigan reported that consumer sentiment bounced modestly off of all-time (more than 60-year) lows due to lower gasoline prices. Nevertheless, sentiment readings remain deeply recessionary, and this week other consumer news was alarming. On Wednesday, data from the National Energy Assistance Directors Association (NEADA) revealed that at least 20 million households—or about 1 in 6 American homes—are behind on their power bills. According to Bloomberg, this is said to be the worst crisis in late utility payments NEADA has ever recorded. Jean Su, who tracks utility disconnections across the US, warned of a coming “tsunami of shutoffs” as the highest consumer price inflation in 40 years outpaces wages. Across the country, power companies reported a surge in non-payment customers, and New Jersey’s Public Service Enterprise Group said customers at least 90 days late have risen 30% just since March. Mark Wolfe, NEADA’s executive director, said simply, “People on the bottom, they can’t pay.” The report is especially troubling considering that, beyond food and shelter, electricity is as essential a basic cost as there is.
So, with the combination of a fundamental economic downturn gaining momentum and a Fed that’s now committed to a restrictive policy setting “for some time,” the economy and market prices appear firmly in the crosshairs. With that said, while Jackson Hole dramatically increased the threshold for triggering a policy pivot, the Fed’s infamous “put” still remains very much alive and in play. Perhaps the most consequential difference now is that the put (or pivot back to an economy- and market-supportive stimulative policy setting) has gone from preventative and proactive to reactive. In other words, Fed action won’t preemptively ride to the rescue at the first sign of trouble. Rather, the Fed will respond only to actual pain already incurred. The unofficial Fed mandate of the prior era was crisis and pain prevention; it’s now emergency response. Realized pain is now a prerequisite to a pivot. In order to be patched up in the emergency room, the patient will now require an actual broken bone. That couldn’t be more consequential for financial markets. It’s a fundamental sea change that, for markets, will take time to adjust to. The game has changed.
Presently, even with the Fed’s credibility chips decisively all-in on a firm hawkish policy trajectory, the futures market continues to price in 2023 rate cuts. Interestingly, this may not be a rejection of the Fed’s hawkish assertions, but rather an affirmation of them. The aggressive ongoing yield curve inversions and futures markets’ 2023 rate-cut signatures appear to give credit to the negative compounding impact of a determinedly hawkish Fed policy setting amid a rapidly deteriorating economic backdrop. In other words, futures markets’ pricing-in of 2023 rate cuts is a reflection of expectations that the Fed’s hawkishness will contribute to unfolding recessionary crisis dynamics sufficiently intense to surpass the threshold necessary to trigger the emergency response of a reactive Fed put.
This week, Morgan Stanley chief investment officer, Mike Wilson described the shifting sands investors are facing. He said, “I think the big change this time versus prior periods when markets got excited about a Fed pivot is, this time, they’re not going to get one unless something really bad happens, which of course won’t be good for stocks.” This fact reintroduces the stick to a market that was previously all carrot. Once fully recognized by the market, it is key to reintroducing two-way market price action and more authentic price discovery. If pain in markets is allowed, and the pressure to pivot is resisted by the Fed to a much greater degree than in the recent past, fundamentals will again dictate market pricing. After Chairman Powell’s best Volker impersonation to date, market expectations appear to have been somewhat reset. As a result, the perverse yet popular “bad news is good news” Wall Street trading strategy may, at least for now, be shelved until a lot more fundamental reality gets priced into markets.
What reality needs to be priced in? Well, according to highly respected economist David Rosenberg, from the current crazy 18x forward earnings multiples on the S&P, markets need to grapple with the idea that “we’re in the early stages of what is probably at least a six-quarter recession.” In contrast to the idea that we’re only heading for a soft landing or a short and shallow recession, Rosenberg says, “I’m wrapping my head around this. The recession is starting, and the Fed is still tightening policy, and the peak impact is not going to be until the mid-part of next year. So, we’re locked-in right now and there’s no going back.”
For famed investor and economist Lacy Hunt, what needs to be priced-in is what he describes as our current “pre-recessionary environment” and what shortly follows. According to Dr. Hunt, we’re in an economic landscape that closely resembles the conditions that directly preceded the most significant market calamities of old. As he sees the set-up, “this is very similar to 2008, very similar to 2000, it’s similar to several of the recessions since the end of WWII.”
While Fed Chairman Powell rightly deserves praise for this week’s commitment to the inflation fight and his efforts to reintroduce discipline and sanity back into financial markets, the overall predicament remains as daunting as ever. As Dr. Hunt observes, if the Fed maintains their current approach, “they will have difficulty in containing the recession and fostering a recovery.” Alternatively, if in the face of such difficulties, the monetary maestros pivot all the way back to a pandemic-style policy response, “the economy might recover temporarily, but the expansion would be interrupted by another cost-of-living crisis and the Fed would not achieve either of its mandates for employment or inflation.” As HAI suggested last week, hope mightily for a best possible Goldilocks outcome, but keep your seatbelt fastened and reserve any bets for gold.
Weekly performance: The S&P 500 lost 4.04%. Gold was off 0.74%, silver dropped by 1.68%, platinum was hit by 3.68%, and palladium was lower by 0.45%. The HUI gold miners index was down 1.16%. The IFRA iShares US Infrastructure ETF was off 2.22%. Energy commodities were mostly stronger. WTI crude oil gained 2.90%, while natural gas shed 0.72%. The CRB Commodity Index was higher by 2.42%, and copper was up 1.09%. The Dow Jones US Specialty Real Estate Investment Trust Index was down 3.45% on the week, while the Vanguard Utilities ETF (VPU) was down 2.49%. The dollar ripped higher by 0.60% to close the week at 108.75. The yield on the 10-yr Treasury gained 6 bps to end the week at 3.04%
Best Regards,
Morgan Lewis
Equity Analyst & Investment Strategist
MWM LLC
