• Jonathan V. Bever

A Return of the Bull 3: The Fed Has Very Little Room to Raise Rates



Economic Headwinds Hurricane, Banana, or Coconut? Deflation vs Disinflation vs Inflation


"Justice is to benefit one's friends and harm one's enemies” Polemarchus: Plato’s Republic.

This blog was initially going to be another in the series of the Return of Volatility, however, as volatility is already here, and our opinion the Bull is just around the corner waiting for the storm to pass. So, we will continue our Bull blog series. Further, we want to point out, we do not change our view just because of market volatility. Rather, we look at the numbers and consider the most probable outcome over the next twelve to eighteen months. In our last blog we expected an average return for the S&P. We have not changed our outlook for the year just because there has been a meltdown. We expect inflation to come down and the Fed to pivot, so you don’t want to miss out on a possible melt-up by the end of the year. While we would not be surprised to see a melt-up in the stock market, we do not apply this to the economy, real estate, or commodities. Considering all the headwinds to risk assets we are cautious.


Jamie Diamon recently said what is coming to the economy is a “hurricane”. Paul McCully, when asked about the “hurricane,” answered with a question, “what is a hurricane?” Then stated, he calls it a “banana.” What do we call it? We call it a coconut. Make your favorite coconut drink and keep reading, because things are not as bad as they may seem.


The best part of investing in a bull market is that it feels good. Investing when the market is choppy and bearish, is much more difficult and it does not feel as good. Although, experience teaches us that investing in a market that keeps going up while listening to Doctor Feel Good may not in reality be as good as it feels; conversely investing in a choppy bear market may be much better than it feels. Only time will tell if investing now in a choppy bearish market will reward the investor in the near term; longer-term we have little doubt.


The Current Economic Climate


In 2021 there were no indications of the Fed raising rates and tightening in 2021 or 2022. Yet, in early 2022 the inflation, CPI, CPE, labor costs, and high cost of crude oil indicated so much inflation the Fed had to act. A hawkish fed will raise rates and taper their balance sheet. This is called quantitative tightening or QT. The economy, in addition to high inflation, would now have to absorb rising fed rates and unwinding of their balance sheet, which is almost 9 trillion. The futures market is very efficient and priced in the rate hikes and produced a flattening yield curve. All these variables together make an economic recession highly probable later this year. The market is concerned with the possibility of an earnings recession for the stocks in the market, a general recession for the economy, and overall lack of consumer confidence. As the list of concerns and unknowns grow, equities decline.


What are the unknowns or unanswered questions? Is inflation transitory? How far will earnings on the S&P fall? How will the Russia /Ukraine conflict unfold? How far will the Fed raise rates? How much of their balance sheet will they reduce (QT)? When will the Covid pandemic end? Will the higher cost of capital drive us into a recession and how severe?


The more unknowns, the more significant the stock market decline because the "risk premium" increases. No longer will the S&P be looking at a forward P/E ratio of 30, but rather a P/E ratio of 16.50. Our constant thesis: the Fed money printing is all about fighting deflation. So, reducing money printing should be an easy fix if we have too much inflation. Easy but not without pain. In our opinion, the inflation which looks crippling will roll over; when it does, it will be fast and furious. Deflation is scarier to the money printers than periods of too much inflation (a victory over deflation).


Let us look at two terms to help clarify what we mean. So often, there are only two terms to discuss: inflation and deflation. Yet, another word fits well in our blog: disinflation.



The Fed Fighting High Prices Is Merely Rhetoric


Deflation: is a reduction of the general level of prices in an economy


Disinflation: is a temporary slowing of the pace of price inflation and is used to describe instances when the inflation rate has reduced marginally over the short term.


The temporary pause of money printing leads to the temporary reduction of inflation. This is called disinflation and is not the same as deflation. Deflation is a reduction of the general prices in an economy. Understanding the difference between these two monetary conditions is essential. The Fed is fearful of deflation and uses money-printing as a tool for hedging against it. This tool is used in two ways: to print money thereby adding to the money supply. The second a reduction of the money supply. When the Fed pauses the printing, raise rates, or does QT, we experience it as deflation, but that is not necessarily accurate. What it is: disinflation.


Common measures of inflation are indicated by the Consumer Price Index (CPI) and Personal Consumption Expenditures Index (PCE).


“The Consumer Price Index (CPI) is an index that is often used to measure inflation by tracking the changes over time in the prices paid by consumers for a basket of goods and services.” Investopedia.


Personal consumption expenditures (PCEs) refer to a measure of imputed household expenditures defined for a period of time. Investopedia


The inflation that became worrisome can be easily seen in the charts below. Here are the PCE and the CPI with a steep increase in the past year.


Please see the chart below:


Source data: Bloomberg. Chart created by Jonathan V. Bever


We find this chart very helpful, if history is a guide, as it illustrates our thesis that the Fed will not be able to raise rates too much. We have argued in several past blogs that once the path of money printing begins, it is nearly impossible to exit. If we look across the Pacific, Japan has been printing money for a long time. Their 10-year government bond (JGB) yields 0.252-almost nothing. We believe we are on the same path for the foreseeable future.


Please see chart: The top red line is the Japan Government Bond 10-year yield. The bottom blue line is the US 10-year treasury yield.


Source data: Bloomberg. Chart created by Jonathan V. Bever


Regarding our stock market, one of the chief concerns the bears point out is that the Fed will have to raise rates well above three percent to fight robust inflation. We argue the bears simply don’t see the big picture. As you can see, since the 1980’s, the Fed rate has had a series of lower highs and a series of lower lows until they got to about zero. The Fed rate has fallen since 1985. The economic conditions have not changed. Therefore, we don’t believe the Fed will be able to raise rates of 2.50. We expect a 25-75 basis point hike in July, and possibly no rate hike at all. July could mark the end of this tightening cycle.


To further add to our conviction this conviction, there is a new Fed tool called Quantitative Easing implemented during our great financial crisis. Rather than wiping out bad debt, new debt would be created to bail out the banks. So, if we consider all the debt essentially backed by our treasury, raising rates too much becomes more crippling than inflation affecting the consumer: CPI or PCE. If you think this all sounds like a circular argument, we agree.


How then can the Fed fight inflation? The adage “the cure for high prices is high prices”. We can hear our readers say, wait, the Fed is saying they will keep raising their rates and tapering their balance sheet. Rhetoric too is a tool of the Fed.




When the internal combustion engine was created, crude oil became invaluable. The heavy lifting crude oil could do in conjunction with an engine was a game-changer.


Likewise, crude oil prices are doing some heavy lifting for the Fed. We have argued from the beginning that high crude prices are the Achilles Heel to money printing because it is not the type of inflation that can be outsourced. Currently, there is no viable substitute for crude oil, and it is settled in US dollars (so, no currency hedge).


According to The Atlantic: “Each 50-cent increase in the price of gasoline adds almost $60 billion to annual consumer bills…”


See link:

https://www.theatlantic.com/business/archive/2012/03/the-110-effect-what-higher-gas-prices-could-really-do-to-the-economy/254386/


Labor inflation would be a problem for money printing. However, labor inflation can be outsourced to other countries with a weaker currency and lower labor costs such as China and Mexico. The Fed, with extremely low rates and the vast amount of money printing will have a tough time raising rates or reducing its balance sheet (quantitative tightening) to fight inflation.


How then can they fight inflation? They can raise rates and do QT for a while, then must take them back. We argued lightheartedly in our last blog, Return of the Bull: Blog II, the only thing transitory is the Fed rate policy. We find it ironic that the high crude oil price, the Achilles Heel, is doing the heavy lifting for the Fed. From foe to friend; from fear to desire. So, if high crude prices help the Fed put the brakes on the economy when the Fed pivots and want to stimulate the economy, then crude prices will need to come down. A reduction in gas prices is a big stimulus to the consumer. So, long before the Fed pivots from a Hawk to a Dove, we would not be overweight energy. Why? Please see the chart below:


The top line is the Fed balance sheet, and the red line on the bottom chart is the crude oil price. When the Fed needs to print money the price of crude tends to go down. In 2020 at the beginning of the pandemic, the Fed would put about 4 trillion on its balance sheet. Crude oil declined to around $20 per gallon and was even negative at one point in April.


Source data: Bloomberg. Chart created by Jonathan V. Bever



How To Invest to Fight Inflation


While we talk about inflation, deflation, and disinflation as time marches on the cost of living goes up regardless. One of the best hedges against inflation is common stocks. From the perspective of an opportunity to prepare for long-term inflation (also known as the erosion of purchasing power of one’s money) a bear market and a recession should be looked at as a great opportunity to invest in stocks with increasing potential to fight long term inflation.


To help illustrate our optimism, please see the pessimism in the University of Michigan Consumer Sentiment. It is at an all-time low; since 1978, it has never been lower.



Source data: Bloomberg. Chart created by Jonathan V. Bever


When the sentiment is negative the market is low. So, when the sentiment is at its high, so is the market; it is probably time to get the most defensive. Conversely, when sentiment is low, and the market is low, it is perhaps time to invest for the better days ahead. The red pillars above show periods of recession. Likewise, they are opportunities for the long-term investor to find bargains. Happy hunting!



DISCLOSURES:


SPX INDEX: S&P 500, or simply the S&P, is a stock market index that measures the stock performance of 500 large companies listed on stock exchanges in the United States. It is one of the most commonly followed equity indices, and many consider it to be one of the best representations of the U.S. stock market. 


Quantitative easing (QE) is a monetary policy whereby a central bank buys government bonds or other financial assets in order to inject money into the economy to expand economic activity. Wikipedia The Fed Balance Sheet


In the United States, the federal funds rate is the interest rate at which depository institutions lend reserve balances to other depository institutions overnight on an uncollateralized basis. Reserve balances are amounts held at the Federal Reserve to maintain depository institutions' reserve requirements. Wikipedia


“The Consumer Price Index (CPI) is an index that is often used to measure inflation by tracking the changes over time in the prices paid by consumers for a basket of goods and services.” Investopedia.


The term personal consumption expenditures (PCEs) refers to a measure of imputed household expenditures defined for a period of time. Personal income, PCEs ...Investopedia


The Fed balance sheet is a weekly report that lists the Federal Reserve's assets and liabilities. The report outlines what the Fed is doing to expand or contract its balance sheet as it implements its monetary policy.


The University of Michigan Consumer Sentiment Index is a consumer confidence index published monthly by the University of Michigan. The index is normalized to have a value of 100 in the first quarter of 1966. Each month at least 500 telephone interviews are conducted of a contiguous United States sample. Wikipedia


“The views stated in this piece are not necessarily the opinion of Cetera Advisor Networks LLC and should not be construed directly or indirectly as an offer to buy or sell any securities. Due to volatility within the markets, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.”.


“Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing.”.


“Cetera does not offer direct investments in commodities (such as crude oil).”

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