Sometimes Occam’s razor can cut painfully.
The analysis of financial markets can involve an endless array of variables, requiring rocket scientists running supercomputers. Yet Occam’s principle that the simplest explanation is often the best can often clarify an investor’s thinking.
To wit: Inflation is too high, which means interest rates are too low. And while price/earnings ratios have come down to reflect the rise in rates to date, earnings expectations underlying P/E calculations have not adjusted appreciably. The product of lower P/E multiples and lower earnings forecasts is lower stock prices.
On inflation, there is no dispute. Friday’s report that consumer prices shot up an annualized 8.6% in May from a year earlier exceeded economists’ forecasts but came as no surprise to the public. The University of Michigan’s consumer confidence survey showed the most downbeat sentiment on record, mainly because of soaring prices and despite historically low unemployment.
This is what the Federal Reserve confronts as its Federal Open Market Committee meets this coming week. Central bank officials from Chairman Jerome Powell on down have been indicating one-half percentage-point increases in the key federal-funds target rate were likely at this confab and the next one in late July.
Fed-funds futures have also been pricing in an additional half-point hike at the September FOMC meeting, according to the CME FedWatch site, plus quarter-point rises in subsequent FOMC meetings in November and December. The futures market was also looking for two additional quarter-point boosts in early 2023, bringing the Fed’s key policy rate target to a peak of 3.5% to 3.75%.
Such expectations contrast sharply with the last projections published by the FOMC at its March meeting. The committee’s median expectation was that its preferred inflation measure, the personal consumption deflator, adjusted for food and energy costs, would recede to just a 2.6% year-over-year rate of increase by the end of 2023.
This heavily massaged inflation number was running at nearly twice that pace, 4.9%, in its most recent reading for the 12 months ended in April. Yet it was expected to ease gently with just a mild rise in the fed-funds rate to 2.8%, and with no increase in the unemployment rate, which was expected to end 2023 at 3.5%, versus the May jobless rate of 3.6%. Those rosy projections might as well have had a “bridge for sale” sign attached to them, this column observed at the time.
Given the high probability that the FOMC will hike its fed-funds target by a half-point, from the current 0.75% to 1% range, when it winds up its two-day meeting on Wednesday, its updated summary of economic projections may be more instructive. These estimates ought to be more realistic—higher projected interest rates would logically include an uptick in unemployment, but also a smaller reduction in inflation.
One possible surprise could be a three-quarter-point hike in the fed-funds target to demonstrate the Fed’s urgency to rein in inflation after Friday’s hot consumer-price-index report. June fed-funds futures priced in a 19.1% probability of such a supersize rise, a tenfold increase in the odds from a week earlier. Meanwhile, the yield on the two-year Treasury note—the coupon maturity most sensitive to Fed rate expectations—moved above 3%, topping its previous peak in late 2018 and the highest since November 2007, according to St. Louis Fed data.
Nomura economist Robert Dent has been among the most hawkish of Wall Street Fed watchers, projecting the fed-funds target to hit 3.75% to 4% next year, a quarter-point higher than the market consensus, to rein in inflation. The Fed’s economic projections need to reinforce the need to slow growth, including a rise in unemployment, he says. Instead of inflation being a supply problem, which Fed officials dismissed as transitory last year, it has become demand-driven, most notably in housing costs, he adds.
Official inflation statistics also understate the price pain felt by most Americans. A National Bureau of Economic Research paper published this past week by Marijn Bolhuis, Judd Cramer, and Lawrence Summers looked at changes in CPI calculations in recent years. To bring down core CPI to the 2% range, as presently calculated, would require the same extreme monetary restraint exerted by former Fed Chairman Paul Volcker, which resulted in back-to-back early 1980s recessions. If that sounds familiar, it’s what former AllianceBernstein chief economist Joseph Carson has been contending here for over a year.
As for stocks, the
S&P 500senger
P/E has corrected by about five points, to about 16 times projected earnings, from over 21 late last year. But that’s based on aggregate earnings estimates that have barely budged, despite the squeeze on profit margins from rising costs, and slowing sales growth in some cases. According to Refinitiv, S&P 500 earnings are expected to rise 11.3% in the 12 months from the first quarter of 2022. Consensus S&P 500 earnings estimate for calendar 2022 remain at a peak, which Bleakley Advisory Group Chief Investment Officer Peter Boockvar doesn’t see as possible.
If interest-rate expectations are still too low and earnings forecasts too high, don’t be surprised if stocks get sliced further.
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