September 20, 2022

Nolte Notes

September 19, 2022

“Is it done yet?” The anticipation of a delicious treat coming from the oven is sometimes too hard to wait. Is the Fed done yet? Is inflation done wreaking havoc on the economy? Like the baked goods, not just yet. The inflation data earlier in the week was tough for the markets to handle, as they expected the Fed to pivot away from hiking rates. Now, not only is the Fed expected to hike 0.75% this week, but probably another 0.50% just ahead of the November election. The biggest problem is that “core” inflation is still rising at 0.4-0.5% on a monthly rate, or 5- 6% annually. Yes, energy prices coming down has helped the headline inflation rate, but real estate (rents), which are 40% of the index, do not yet show signs of slowing. The weekly jobless claims, likely a better short-term indication of tightness in the labor market, is below the level of the same week in 2019. Financial stresses within the economy remain easier today than nearly any time in history. Finally, the Fed balance sheet is off 1.5% from the peak of six months ago, hardly something (yet) to worry about. The runway is clear for more interest rate hikes that will have an impact on the economy in 2023, when the Fed may start considering slowing/stopping their rate hiking cycle.

The key data point was the inflation report on Tuesday. The markets had rallied into the report, expecting the clear peak in inflation to be in the rearview mirror. Buyers were hot and heavy, signaling a potential bottom was at hand. By the end of the week, the 5% drop only reinforced sellers had the upper hand. What seems to be debated is not how much the Fed hikes, but when the Fed stops. Historically, the Fed funds rate needs to be above the inflation rate to quell the fire. That would mean a Fed funds rate that is still double from where we are today, even after a 3% hike in rates just over the last six months. Expectations are for a moderation in inflation around 4-5%, so maybe rates won’t go as far. However, the Fed is notorious for being late to not only the starting of hiking, but late to stopping. The press release from the Fed this week will not be as important as the comments from Chair Powell at the press conference that follows. Market volatility will be with us for at least another week or two.

Interest rates are rising across the yield curve, especially at the short end, as investors reassess the Fed’s
position on hiking rates. A few signs that are pointing to “we are not done yet” is the difference between junk bond and treasury yields. The stock markets tend to bottom as that “spread” widens to well over six percentage points and sometimes as much as ten. Today, those spreads are still below their recent June peaks and just above five percentage points. The still easy monetary policies of the Fed remain a long way away from being reversed. The winner is short-term treasury bills, which are now yielding over 3% for three-month bills. Cash is, for the first time in over a decade, providing a decent return.

Earnings estimates on the markets are beginning to decline, especially following the FedEx announcement of how rough their markets are and their struggle to make money. Other companies are announcing lay-offs and hiking prices to keep up with inflation. The recent railroad agreement provided a 24% increase in wages over the next two years. The combination of layoffs, higher wages and companies raising prices (to pay for their higher costs) will be hard for the Fed to rein in over the coming year. Those areas of the market that will be able to pass those higher prices along should fare well in the markets. Sectors like basic materials, industrial and some service sectors should be impacted less than others. Higher yields have been a problem for technology stocks, so as rates continue to rise, tech should struggle. As a result, the recent better relative performance from value should continue well through this rate increasing cycle.

The focus of the markets will be squarely on the Fed meeting and press conference that follows on Wednesday. Market volatility is likely to be high both on Wednesday and Thursday as investors digest the comments from Chair Powell. It should be evident afterwards that the Fed’s work is not yet done.

The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable but are opinions and do not constitute a guarantee of present or future financial market conditions.

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