Market Turmoil: Is Fed Tightening a Policy Mistake?
The market moving headlines this week involved a stronger than expected Q4 GDP growth print and a much more hawkish Fed (Powell) than the markets had priced in. “Volatility,” a word normally used by floor traders when markets have huge sell-offs, truly fulfilled its meaning this week as swings in market indexes were crazy wild up and down, both day to day and especially intraday.
Let’s start with GDP. The Q4 GDP growth of +6.9% Q/Q beat the consensus 5.5% view, but the number, by itself, is quite misleading, as 71% of the growth, or 4.9 of the 6.9 percentage points, came from inventory accumulation.
- As we have pointed out in several recent blogs, the “shortage” narrative pulled demand forward, and much of the holiday buying occurred in October and November. In the GDP data, Q4 retail sales fell -1.9%. How healthy is that?
- As a result, both wholesale and retail inventories skyrocketed as 2021 came to a close.
- Some of these inventory spikes may be desired, as manufacturers and retailers move away from the “just-in-time” inventory model, as it broke down during the pandemic. So, at least for a while, higher desired inventory levels may be in place.
- Nevertheless, it is likely that a significant portion of the inventory spike is unwanted, and we expect Q1/22 to show inventory drawdowns. This will be a negative in the Q1 GDP growth report, just like it was a positive for Q4.
- There are implications here for inflation, as, at least on the retail side, the fastest way to reduce bloated inventories is through price reductions (i.e., “on sale”).
- We also question the continuation of the “shortage” narrative. How did inventories get so bloated if “shortages” continue to be the order of the day? The chart below shows a time series of the number of container vessels at California’s two largest ports (LA and Long Beach). While still higher than “normal,” the downtrend is very clear.
The Fed: Dovish to Hawkish
Just as it appears that shortages are ending and, perhaps, the current bout of inflation will begin to moderate, the Fed, or at least its Chair (Powell), has decided to deploy all the weapons in the Fed’s arsenal to fight it. In the immediate post-Fed meeting environment, markets have now priced in the possibility of five (5) 25 basis point (bps)(0.25%) rate hikes, and Powell, himself, did not rule out the possibility of 50 bps hikes. Could it be that the Chair is talking tough on inflation because it is politically expedient to do so? We think so. After all, the official policy statement wasn’t near as hawkish as was the Chair in the post-meeting press conference.
A Soft Q1/2022
Past blogs have cataloged the slowdown occurring in the economy, especially post-Thanksgiving. Our expectation is that the January payroll report will be very weak, and some economic forecasters are now calling for a significant decline in the Payroll Survey (maybe even -200K!) when the January data are released (on February 4).
It should also be noted that the trade deficit exploded in Q4, up 33% with December showing a record -$101 billion. Imports led the way (see chart). This is a subtraction from GDP. In addition, the latest Regional Fed Surveys all showed declining orders and employment indexes in December. Same for most other business and consumer surveys.
In the post-meeting presser, Powell characterized the labor market as “very very strong.” This is debatable. If looked at only from the demand side (i.e., unfilled jobs and the official unemployment rate), such a characterization may seem valid. But, the economy is still 2.3 million jobs short of where it was pre-pandemic, and now we have a 9% absenteeism rate among those who are employed.
While most of those who are absent from work do get paid, about 20% do not. That could put a small crimp in Q1 retail sales! It is clear to anyone paying attention to the data that Q1 GDP growth will be lucky to avoid a negative sign. The chart at the top of this blog, for example, shows that since Thanksgiving, there has been a dramatic fall in restaurant patronage. The strong correlation between workers and diners foretells of a dive in the food and beverage employment data.
Recent “volatility” in the financial markets has occurred because the future has become even more cloudy than it was in 2021. Will the economy strengthen in Q2? The answer to that, as it has been for the past two years, is: It depends on the path of the pandemic! Will there be more Covid variants? Will they be as contagious as Omicron? As virulent as Delta? Because the immediate future is so uncertain, the financial markets are in a tizzy.
The Fed, on the other hand, appears to think that “normalcy” will return in Q2. While they could be correct, our view is that is a low probability event. The path to “normal,” we think, will be slow and rocky. Take, for example, the spike in absenteeism shown in the chart above. Just like the sluggishness in the return to “normal” in the Labor Force Participation Rate, we think that higher than “normal” rates of absenteeism will not just disappear by Q2.
It is true that the Fed can lower inflation, but they do so by reducing demand, not creating supply. And the demand reduction is an inexact art, not a science. Unfortunately, the Fed, over its history, has proven to be a poor artist. Normally, it begins to tighten monetary policy when the economy is strongly expanding. At the start of this tightening cycle, the economy is slowing, and, as we said above, Q1 GDP growth will be weak, if not negative. The market volatility we see is a function of market fears that the Fed will overtighten and cause a recession.
- The Fed’s tools act on the economy with long and variable lags, and the Fed does not know when to stop its tightening process, so, normally, they would have a bias on the side of less tightening.
- Today, because of the political issue of inflation, they may not be able to stop the tightening process, especially if inflation doesn’t immediately react to higher interest rates.
- For context, in the post-WWII era, the Fed has embarked on 13 rate hiking cycles, all of which began when the economy was strongly expanding; 10 of those 13 resulted in recession!
To be fair, we note that while Powell came off as quite hawkish, the post-meeting Fed communique was much less so. And while sounding hawkish, the Fed chair only committed to ending QE as scheduled and that the FOMC was of a mind to begin to raise rates soon. So, while the markets interpreted that as a sure 25 bps rate hike in March, and then four more for the rest of the year, that is not written in stone. Powell appears to still be willing to let the incoming data dictate the course of Fed policy.
Other Market Worries
Other big issues for the equity markets include the record high valuation metrics, especially in the face of such growing uncertainty. From the March 2020 market lows to the recent record highs, 75% of the run-up in the S&P 500 has been the expansion of the Price/Earnings (P/E) multiple. Only 25% of the rise in the index levels can be attributed to rising corporate profits.
One can argue that record low interest rates have been responsible for the P/E expansion. That is, the future cash flows are being discounted with lower rates which makes those cash flows more valuable. But, now that rates are rising, those P/E ratios should be contracting. That means lower valuations.
But, perhaps, the biggest impact the Fed has on markets has to do with market liquidity. The Fed reduces the amount of liquidity in the market when it starts reducing the size of its balance sheet, which Powell has now said is under consideration. To do this, the Fed sells its balance sheet assets into the market and takes the resulting funds it gets out of circulation. Markets always contract when liquidity is withdrawn.
Then there are the geopolitical issues. The most imminent one is the threat of a Russian incursion into the Ukraine – markets always react poorly when such military type events occur. Furthermore, lurking in the background is China’s ultimate intention regarding Taiwan.
All we’ve talked about here is now weighing on investor sentiment and, because of all the uncertainty about the outcomes, markets have become volatile with large moves, both negative and positive, not only day to day, but intraday. The volatility will calm when the clouds part, i.e., when there is a clearer picture of the economy’s growth path and when the inflation genie is put back into the bottle. Could be a while.
Robert Barone, Ph.D.
(Joshua Barone contributed to this blog.)