Stocks Tumble on (alleged) Powell Pivot

 Stock indices fell a notable 5 to 6% the past 2 days due to the alleged Powell Pivot. Fed Chair Jerome Powell noted that “Fifty basis points will be on the table for the May meeting” on May 3-4 when the Federal Reserve meets to approve a possible rate hike. He also expressed the need for continued rate hikes that would be a challenge in avoiding a Recession. None of this should be remotely surprising for money managers since traders in the overnight federal funds rate had already priced in that the Fed will raise the Fed lending rate from 0.25% to a range of 2.75% and 3% this year. They expect this pace translates into half-point hikes or greater at the next three meetings (every 6 weeks).

We acknowledge the Fed’s predictable comment was the news that led to this weeks sharp reversal and assume Institutional Sell programs used this narrative to bust Stop orders and create panic among investors and analysts. The Fed’s urgency to raise rates and drain bank reserves are required until there are signs of reduced consumer demand which decelerates inflation from its current 40-year highs. Now that the Bullish investors have been scared away, it appears we have entered a Sell the Rumor and Buy the News mode on rate hikes until yield expectations peak. While AAII small investor sentiment has registerd two consecutive weeks of extreme oversold Bearishness, indicative of a near term low, it’s unlikely the market can rally before the May 3rd Fed meeting when Powell will determine the degree of rate hike and pace of bank reserve removal.  Until then, there is a risk of new lows for the year.

The stock market is a discounting mechanism valued upon where consensus expects corporate earnings and the economy to be in the future, not the current condition.  High confidence expectations of rapid interest rate hikes have raised the cost of capital and compressed forward price/earnings multiples back to pre-pandemic levels for Large Cap stocks and near decade lows for Small Cap stock Indices. With the stock market now discounting a weaker economy, the drumbeat of Recession has just risen an octave with the major investment houses elevating the odds a Recession to 35% within two years. Investor concerns for a recession in a year or two could be premature in the current robust and highly unusual economic environment. It’s difficult to find another period in history where demand for goods, services and labor were so far above supply that the economy slows down from the historic shortages. According to Datasembly, 31% of grocery products consumers browsed for were out of stock in early April. Ford and GM recently instructed cars to be shipped to dealers without some of their less critical computer chips (today’s vehicles contain over 3,000 chips).  Most manufacturing companies are seeing their order backlogs grow to record levels without the commensurate increase in production. Dealer inventories remain at depleted levels that are usually seen at the start of economic recoveries, not at the end of an expansion cycle.

Thanks to Government stimulus and one of the strongest labor markets in history, consumers continue to mob the stores and order online at record levels as illustrated by Redbook’s same store sales data. Overall Retail Sales for the US reached record highs each of the last three months and continue above historical trend growth rates.

The pandemic stimulus bypassed the travel and leisure industry entirely until now due to Covid restrictions, but the future looks sunny despite the 50% inflation of ticket prices and more than 100% rise in Jet fuel costs since last year. Consumers spent 28% more in March this year than in March 2019, pre-pandemic. This summer, Airlines are expecting record revenues and full flights. Even Global passenger traffic was up 55% compared with February 2019 levels. Despite soaring inflation, it appears air travel will continue to soar ever higher this summer, before cooling off.

With a record number of unfilled jobs and very low unemployment, consumers are flush with borrowing capacity and the ability to spend. When we see these robust quit rates and job openings flatten out or edge lower for a year, then we know a more protracted economic slowdown is upon us. For now, a slower economy due to rising interest rates can be tolerated as labor supply and demand start to converge.

In just 6 months, 15-year mortgage rates have more than doubled to 4.4%, with the 30-year rate over 5.1%. Debt service and housing affordability had been excellent for much of the past decade until recently. The Atlanta Fed data reflects this period as the worst time in over 14 years to buy a home due to price increases combined with mortgage rates that have made homes about 25% less affordable than just a year ago.

Housing costs have triggered a notable drop of over 10% in new and exisitng home sales as well as a corresponding rise in inventories that warns of weakness in homebuilders later this year. Home builder stock prices have already discounted a major slowdown. For now, single family homes and aprtment buildings are still surging as builders have yet to satisfy demand.

Housing is an important 15 to 18% component of the economy and its eventual correction will help ease some of the record supply chain inflation in the system. With real wages shrinking and home affordability at 14 year lows, the outlook in this sector remains dismal despite strong construction trends to date.

The economic picture is strong near term  as healthy consumer balance sheets combined with a backlog of post-Covid demand for travel and a severe shortage of products, services and labor provide a nice buffer against the credit tightening efforts underway by our Central Bank. It’s a certainty that the Fed will keep applying the brakes until the economy slows enough to sharply lower inflation. This credit tightening cycle may not engender a painful slowdown or outright GDP contraction given the extreme shortages and buffer of pent up demand in the system. For investors, corporate profit margins will soon fall from their current record highs and stock prices may remain vulnerable until the market perceives peak momentum in the interest rate hiking cycle. Once there is a hint that too many rate hikes have been priced into stock market valuations, that is when the market should embark on another run  to record highs.

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