The market beatings will continue until inflation improves 🥊
Renewed concerns about inflation have the Fed triggered 📉
It’s a bear market.
On Monday, the S&P 500 tumbled 3.9% to close at 3,749.63. That put the index down 21.8% from its January 3 all-time closing high of 4,796.56. This was the first time the S&P closed down by at least 20% from its high, confirming that we’ve been in an official bear market.
By the end of the week, the S&P had fallen to 3,674.84, down 23.4% from its high.
Historically, bear markets have come with more pain. According to Howard Silverblatt of S&P Dow Jones Indices, the average bear market has lasted 18.6 months and has seen the S&P 500 fall 38.3% before bottoming.1 The ones that came with economic recessions tended to be worse. Though, it’s not crazy to think this could be a bear market without a recession.
While the stock market is likely to generate healthy returns in the long run, there’s good reason for investors to manage expectations in the short run as the Federal Reserve gets increasingly aggressive with monetary policy.
‘The worst mistake we could make‘ 🦅
The stock market’s recent sharp declines came in the wake of the May consumer price index report — released on June 10 — which was much hotter than expected. The news intensified worries about inflation persisting and renewed calls for a more hawkish Federal Reserve.2
And the hits kept coming last week.
The New York Fed’s May Survey of Consumer Expectations released Monday confirmed that the inflation we’ve been experiencing today has folks increasingly convinced that inflation is likely to remain elevated down the road. The median expectation for inflation one year ahead was 6.6% in May. This tied the highest reading (March) since the survey’s inception in June 2013.3
On Tuesday, we learned that producer price growth in May accelerated to 0.8% from April. This reflected a worrisome 10.8% gain from a year ago. Excluding food and energy prices, which tend to be much more volatile in the short-run, core PPI was up 0.5% for the month and 8.3% for the year. Prices for both goods and services rose at an increasing rate.
Also on Tuesday, the National Federation of Independent Business reported that its small business Optimism Index in May fell to its lowest level since April 2020 as inflation concerns persisted. From the report: “The net percent of owners raising average selling prices increased 2 points from April to a net 72% seasonally adjusted (the same as March 2022 and a record high reading).“
To be clear, none of these metrics reflect sudden and sharp deteriorations. They’ve been trending unfavorably for months.
The issue right now is that they continue to show little or no improvement despite months of tighter monetary policy from the Fed. We’re not close to seeing “clear and convincing” evidence that inflation is cooling, which the Fed needs to see before it will let up on tightening monetary policy.
This is why on Wednesday, the Fed unleashed a very aggressive 75 basis point interest rate hike, the biggest rate hike since 1994.
“We have to restore price stability,” Fed chairman Jerome Powell said on Wednesday. “It’s the bedrock of the economy. If you don’t have price stability, the economy is not going to work as it's supposed to.”
"The worst mistake we could make would be to fail [on lowering inflation],” he said. “We have to restore price stability. We really do."
The stock market’s conundrum 😵💫
None of this is great news for those hoping for a sustained recovery in the financial markets to begin soon.
The Fed wants tighter financial conditions, and a robust stock market rally would be the opposite.
Powell all but confirmed that the Fed was hoping for a bear market.
“Over the course of this year, financial markets have responded and have generally shown that they understand the path we're laying out,” he said Wednesday.
Vickie Chang, global markets strategist at Goldman Sachs, explained this dynamic on Tuesday (emphasis added):
“The recent market correction has been a Fed-driven one, as equities have steadily priced in more tightening this year while simultaneously worrying that such front-loaded tightening will ultimately lead to a policy reversal. Our US economists also do not see major financial imbalances of the sort that led to the retrenchment episodes of the 2000s. So, for equities to recover in a sustained way, history suggests that this kind of monetary tightening-induced contraction is most likely to end when the Fed shifts policy direction. While a shift towards Fed easing is unlikely without an outright move into recession, as in late 2018, a clear signal that tightening risks are receding may be sufficient.”
And so until inflation shows signs of letting up, investors should manage their expectations for near-term returns. (Read more about the stock market’s conundrum here.)
The good news is we continue to get bad news about the economy 🙃
In recent weeks, we’ve been getting lots of evidence that economic growth has been decelerating. Notably, there’s been some indications that the labor market is a little less hot than it used to be. It’s the kind of bad economic news that should be good news for the effort to bring down inflation.
This past week came with more data reflecting an economic slowdown.
Notably, on Tuesday we learned retail sales unexpected fell by 0.3% in May.
Motor vehicle and parts sales declined. Furniture and home furnishings sales declined. Electronics and appliance sales declined. Health and personal care store sales declined. Online retail sales declined. The pattern is clear.
Meanwhile, manufacturing has been cooling.
Industrial production climbed by a slower-than-expected 0.2% in May. Manufacturing output unexpectedly declined by 0.1%.
Regional surveys suggest manufacturing activity continued to deteriorate into June.
According to the Empire State Manufacturing Survey released Wednesday, the report’s general business conditions index came in at -1.2 in June, up from -11.6 in May. Yes, it may be an improvement, but any negative number signals a contraction in manufacturing activity in New York.
According to the Philly Fed Manufacturing Business Outlook Survey released Thursday, the general activity index fell 6 points to -3.3 in June. It was the first negative reading since May 2020.
There were also more signs that the labor market is cooling.
From labor market data firm Linkup: “For the second month in a row, LinkUp data reveals job listings on company websites were down, with overall listings dropping 4.2% in May… At the industry level, companies with the largest drops in job listings in May include those in: Utilities (-8.8%); Information (-7.3%); and Transportation and Warehousing (-6.8%)…“4
The Conference Board’s Leading Economic Index5, which offers a more comprehensive forward-looking view of the economy, fell for the third straight month.
“The index is still near a historic high, but the US LEI suggests weaker economic activity is likely in the near term — and tighter monetary policy is poised to dampen economic growth even further,” The Conference Board’s Ataman Ozyildirim said on Friday.
And while a lot of metrics have begun to turn south, the Fed continues to believe it can tighten monetary policy without sending the economy into recession.
“We’re not trying to induce a recession now,” Powell said on Wednesday. “Let’s be clear about that.”
That said, the deteriorating data is a reminder of what Powell said in May: “There could be some pain involved in restoring price stability.“
The bad news is there’s still good news about the economy
One of the biggest tailwinds in the economy is the massive amount of excess savings that consumers accumulated during the pandemic.
According to Moody’s Analytics’ Mark Zandi, consumers are sitting on about $2.7 trillion worth of excess savings.
Sure, these savings are good in that they’ve helped consumers pay up for goods and services. And they’re helping to prevent any economic slowdown from becoming economic calamity.
Unfortunately, these savings have also been a curse in that they’re enabling businesses to raise prices amid tight supply. In other words, it’s one of the reasons why inflation is so high.
The supply wildcard 🃟
Keep in mind that the Fed’s ultimate goal isn’t to slow the economy. Its ultimate goal is to cool inflation. Using policy tools to slow the economy is just a means to achieve those ends.
This is an important nuance because a slowdown in demand isn’t the only path to lower inflation. An improvement on the supply side can get us there too.
And there have been some signs of improvement in supply.
According to Census Bureau data released Wednesday, inventory levels — as measured by the business inventories / sales ratio — looked a little less depleted as of April.
One of the most intuitive measures of supply chain health is supplier delivery times, which had become very long.
However, this month’s regional manufacturing surveys suggest delivery times have gotten shorter. (H/T @RenMacLLC):
Delivery times appear to be returning to levels seen before everyone started freaking out about supply chains.
If it is the case that supply is catching up, then we should soon see inflation come down. This would be a particularly good scenario because it’d mean demand doesn’t have to come down significantly.
While many corners of the economy are slowing all at once, it’s important to remember that most of the slowing metrics are still near record levels. So a recession right now would bring the economy down from very strong levels to slightly less very strong levels.
And if the economy is indeed slowing down and supply chains are indeed improving, then we should soon see prices cooling off or even coming down. This is key because the Fed has been very clear that it will not let up on tightening monetary policy until it sees “clear and convincing” evidence that inflation is easing.
Until we get that evidence, don’t expect the stock market to go on a sustained rally.
It’s worth remembering, however, that Powell has repeatedly said that the Fed will move “expeditiously” in its fight to restore price stability. That means that the Fed can decide to ease up as quickly as it decided to tighten up last week.
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