On September 30, 2022, after the Fed raised interest rates 75 basis points (0.75%) and markets were near the bottom. Since then, the Fed followed up on its promise to hike rates another 125 basis points (1.25%) for a full 500 basis points raise since it began its restrictive monetary policy in November 2021. Last week in mid-June 2023, the Fed chose to pause rate increases after 10 consecutive hikes. Markets moved higher, taking this pause to mean that rate hikes are over. We disagree; Powell made it clear that he anticipates two more rate hikes by the end of 2023, then the Fed will pause and lower rates from a terminal rate of 5.6% after these next hikes to 4.6% by the end of 2024 and 3.6% by the end of 2025.
June’s Stock Market Increase Is Temporary
One of the reasons we think the market rise will be short-lived is that the core Consumer Price Index (CPI) has remained at 5.3% YOY even after 500 basis points of hikes. The cost of shelter dropped briefly but is back on the rise. The CPI does not include new homes, but it does include rental properties. Prices are rising again on new homes and rentals because we do not have enough supply. In fact, we need another 2 to 7 million homes to be built to meet the demand, and home builders are forecasting constructing only 846,000 new homes in 2023. They will begin to build more homes when they know the Fed is done raising rates, so we anticipate they will build more in 2024, but housing prices will not likely come down for some time, making core inflation sticky. We are also seeing some commodity prices coming off the bottom with oil and gas down $40 a barrel from last year, but OPEC+ has committed to continue its production cuts. If oil prices rise, that puts more pressure on the Fed. The Fed still has work to do.
Factors Affecting Direction in This Stock Market Update
With that in mind, it is important to review what could go right with the economy and what could go wrong and how that will impact the timing of less-restrictive Fed policy. We will look at past and future situations that could cause the Fed to start a new Fed cycle or maintain its current restrictive policy.
Banking Woes
In late March, it became evident that the swift and prolonged rate increases of the last year and a half have caused some structural weakness in the regional banking system, and the Federal Deposit Insurance Corporation (FDIC) had to seize (through receivership) Silicon Valley Bank and Signature Bank. Depositors lost faith that the banks still had their money; in one case this was due to social media posts that caused depositors to take $42 billion of their money back in less than a day. To prevent the fear of contagion to other regionals like BB&T, PNC, First Republic. and so on, the FDIC shut the banks down and guaranteed deposits. These concerns seem like distant memories, but nothing has changed; risks are still there and likely the Fed didn’t raise last week to wait and see what might happen next.
Commercial Real Estate in the Post-COVID Era
The next potential shoe to drop — the commercial real estate market — has been in decline since the pandemic and has only gotten worse as employees continue to work from home part of the work week if not all of it. Many thought this behavior would be transient and everybody would return to a normal work week at the office. In a job market where we still cannot find enough labor for the jobs available, it appears that remote work at least 2 to 3 days per week is the new norm. We are starting to see the effects of this phenomenon in the form of commercial real estate bankruptcies as their tenants no longer need the space. Companies in the commercial real estate industry are facing both lower occupancy rates and the higher cost of credit — a double whammy. This is a substantial market, and the Fed doesn’t want to create a condition like it did in the regional banks. These bankruptcies are likely to impact the municipal bond market as cities aren’t collecting as many tax dollars from an eroding tax base. The Fed really doesn’t want to create that dynamic.
Supply Chain Improvements
The process of regionalizing supply chains continues in earnest, and as a result supply chain reliability has improved and double ordering to meet demand has been reduced substantially. Less friction in the supply chains reduces inflation and helps the Fed do its job. This is a multi-year process that seems to have legs.
Spending Hangs Tough
People continue to spend on experiential pleasures and other discretionary purchases, but some of that liquidity will be taken out of the system as students resume paying their loans down. And as is the case with the previous three items, lower demand and less liquidity work in favor of the Fed keeping rates where they are now and potentially start lowering.
Residential Real Estate
Now we will consider the forces that will keep the Fed at higher rates for a longer period, which is generally not good for stock markets. Likely, the stickiest inflation problems facing the Fed come in two forms: a lack of supply of homes and rental properties termed “shelter” in the CPI and wages, which came down just slightly since hiking started with no clear indication that that will change anytime soon. We don’t have enough available housing supply to meet the demand. Housing inventory has not kept up with the population increase over the last 15 years and now we have to catch up so the cost of “shelter” remains sticky and will continue to be so for the foreseeable future. This is a real problem for the Fed.
Labor Market Troubles
Next is wages, a continuing problem for Fed decision makers and another supply and demand issue. We don’t have enough people for the jobs available. We also have a problem matching skills with the jobs that are needed. This is particularly true in the skilled trades – have you tried to get a plumber lately? This is a problem in many industries. The Fed’s dual mandate requires it to pursue the economic goals of maximum employment and price stability. This means the Fed's main job is that the prices you pay for goods and services remain relatively stable over time and that everyone who wants a job in the U.S. can find one. Unfortunately for the Fed, the economy has not slowed sufficiently to balance the supply and demand for labor. In fact, we continue to create hundreds of thousands of non-farm payroll jobs each month. This requires the Fed to keep rates higher for longer.
Market Momentum in This Stock Market Update
Although not a Fed mandate per se, but watched closely by it, is what is happening in the stock markets in this stock market update. The current momentum in the stock market works against current Fed policy. Wealth generation adds liquidity, which is what they are trying to pull out of the system.
Game-Changing Tech — The Power of AI and Its Effect on the Market
In mid-March, OPEN AI released its ChatGPT generative AI large language programming model, which essentially democratizes programming for all and is readily commercialized by many industries. In late May, NVDA reported fantastic earnings driven primarily by the sales of their new chip that can do all the things AI requires. Jensen Huang, the CEO of NVDA, went through many of the use cases for generative AI on their conference call and this technology is truly game-changing — a change comparable to the advent of the internet. Unlike the dotcom era when companies really weren’t sure what to do with the new technology, the path for AI is much clearer and many companies are already putting it to work. NVDA’s stock price increased $130 since their announcement and the mega-caps above moved up in sympathy.
So in the near term, AI has powered the NASDAQ and S&P back to the highs of the year and beyond in some cases. This move in the market has fueled a renewed desire for speculation that had all but been tamped out since the Fed started raising rates. Any stock that adds AI to its name is catching a bid. The Fed hates speculation. Like the recent CAVA IPO that doubled its first day as a publicly traded company and it is not even profitable yet. The Fed looks at all the data to see if its policies are working and this “data” works contrary to its current objective to reduce inflation.
Ultimately, I feel that in the short term, generative AI has fueled a tech rally that makes the Fed's job harder but in the long run will create efficiencies across most industries that will remove friction and lower costs of goods and services. It is estimated that AI will replace many people in many industries. In a period where there are more jobs than people that can fill them, this helps the Fed's current policy.
Market Direction: Clear As Mud
So, as you can see, the timing of the end of the tightening cycle is about as clear as mud and can literally go either way in the near term. Outside of any exogenous events, Fed policy is unfortunately the primary driver of the markets because it impacts the cost of doing business for all companies but primarily those that have to borrow money to operate. That is why the growth stocks that were in vogue when rates were at zero have suffered the most during this tightening cycle.
An Uneven Market Recovery
The indices suggest that all companies are thriving in this Fed-driven market, but, in reality, up until about three weeks ago, only about ten mega-cap technology stocks like AAPL, MSFT, NVDA, AMZN, GOOG and META were driving markets higher. The indices are market-cap-weighted, so these stocks carry the index higher but underneath very little price appreciation is occurring. This narrow breadth is not typically healthy for the markets. The diversion between the market-cap-weighted S&P and the equal-weighted S&P was at all-time highs until June. Since June 2 the breadth of the market has improved, which makes for a healthier market; however, this isn’t the best news for the Fed because it is trying to remove liquidity and an improving stock market does just the opposite.
Possible Action Items for Cautious Investors
Based on this backdrop, in the short term, investors would be well-advised to remain defensive and continue to sell profitable existing positions and purchase short-duration Treasuries and quality companies that have seen significant price dislocations and represent good value and pay dividends. As the market moves higher, it could be wise to sell some or all shares in profitable positions to raise cash and rebalance portfolios. In the short run, the next 3 to 4 months of September to October, we expect the work the Fed has already done and likely will continue to do will take markets back down to market multiples closer to 15x than the 19x we are currently at. At that time, cash-rich investors will be able to buy equities. The economy is resilient, and we think we are closer to the end than the beginning of this historic Fed tightening cycle.
Kathryn Hauer, a Certified Financial Planner ™, adjunct professor, and financial literacy educator has written numerous articles and several books including the “11-Step, DIY, Comprehensive Financial Plan Workbook” and “Financial Advice for Blue Collar America.” She works to help clients and readers understand and act on complex financial information to keep them and their money safe. She functions as a strong advocate and guiding light for her clients as they move through murky and unfamiliar financial and career worlds. Read more on her website