by Peter Jones, CFA
Senior Vice President, Equity Research and Portfolio Management
The major event in the capital markets this week took place Friday morning in Jackson Hole, Wyoming. Every year, Federal Reserve Bank leadership meets for a conference to discuss current and future policy. Ahead of today’s meeting, some investors had been optimistic that Powell would soften his stance on the pace of tightening. The logic behind this optimism is twofold: first, the most recent inflation data showed that prices did not increase compared to the previous month and second, the year-over-year growth rate moderated. Additionally, economic momentum is slowing. As such, investors are wondering if it is necessary for the Fed to continue its rapid pace of interest rate increases to restrictive levels.
Powell’s highly anticipated yet brief, 10-minute speech, silenced those hoping for a dovish pivot. While we are not surprised whatsoever with Powell’s commitment to bringing down inflation, the market reacted poorly, with the S&P 500 declining about 3.4% on Friday. In addition, the implied probability of a 0.75% increase in the September Fed Funds rate increased from approximately 50% to 65%.
There were two main takeaways from Chairman Powell’s speech:
The monetary tightening required to lower inflation will cause economic “pain” to both households and businesses. This can be interpreted as the Fed’s acknowledgment that its plan to continue raising rates is likely to cause a slowdown in economic growth or even cause a recession. For inflation to come down, demand must fall to meet supply and the labor market must soften sufficiently so that wage growth moderates.
The costs of long-term inflation due to pausing rate hikes or reversing course are much higher than the costs of a near-term recession. Here, Chairman Powell is indicating that even if the U.S. economy slips into recession, the Fed will continue to tighten policy until inflation has fallen to an acceptable level. In the last two economic crises (i.e., COVID-19 and the 2008 housing/financial collapse), the Fed was able to ease policy in an unprecedented manner by cutting rates to zero and initiating massive asset purchases through quantitative easing. This time, however, the economy will find no such support, at least until the Fed has achieved its goal of price stability.
With stocks down about 13% this year, a substantial portion of this economic pain has likely been priced into the market. In addition, with unemployment at 3.5% and consumer leverage hovering at generational lows as seen in the chart below, it is difficult to imagine a severe or long-lasting recession.
Source: Goldman Sachs
Furthermore, investing in stocks represents a fractional claim on corporate revenues, cash flows and profits — rising inflation flows straight through to corporate earnings, exemplified by S&P 500 earnings increasing 8.5% in the second quarter this year. At this juncture, while we remain vigilant in our assessment of the macroeconomic landscape, we continue to believe that equities represent a compelling value proposition over the long term, even if the ride will be choppy in the coming months.
Takeaways for the Week
Fed Chair Powell extinguished hopes that recent inflation and economic data would moderate the pace of monetary tightening
An incredibly healthy consumer provides us with confidence that the severity of a potential recession would be limited
Stocks have already priced in a portion of the economic pain that is yet to occur and also represent an attractive hedge against inflation. Stay the course and stick with stocks