August 3, 2022
While markets appear to be putting in a rally, there is very little consensus that the rally will be sustainable. Over the past few days there have been a wide variety of events that caused uncertainty, but markets continue to shrug them off as though there are flies hitting the windshield of a moving car.
Unfortunately, the concerns are long term issues and the shorter term, emotional responses can be laid aside easily, the effects of actions such as raising interest rates to fight inflation and political tension with China are longer lasting. They will impact markets and probably not in a positive way.
Last week, the commentary from the Federal Reserve suggested that, in time, the Fed would stop raising rates. The market took this as a very positive development. Interest rates dropped, markets soared, and investors appear to be buying assets again. The chart below shows the S&P 500, with each bar representing 15 minutes, and the associated move higher.
Just this morning, Mary Daly, president of the San Francisco Fed, was interviewed on CNBC and said that the Fed was “Nowhere near almost done”. Other Fed speakers are working aggressively to inform markets that they will continue to raise rates. Despite all of these warnings investors are clearly not too worried.
The market did worry for a couple of days when it became clear that Nancy Pelosi (third highest ranking US politician after Biden/Harris) would visit Taiwan. Upon her departure from Taiwan yesterday, the market gave a sigh of relief and assumed all was well.
Perhaps it is the short attention span of the modern age, but markets have shrugged off these two events and dozens more, including the ongoing war in Ukraine, serious water shortages, heat, flooding, power interruptions, with a form of excitement which is almost baffling. To be fair, there is plenty of room for confusion. Some of the best financial managers in the world are all predicting that the Federal Reserve will have to reduce interest rates to prevent a recession.
During the market reset over the past six months, some of the most prominent bulls have given many reasons for markets to regain their bullish tenor and chief among them are robust profits. All of the aforementioned political, environmental, economic issues are simply to be ignored; profits will drive prices higher. FactSet offers a really good earnings review for the S&P 500 that they update weekly, and that report suggests that things are going pretty well. The second quarter saw 6% growth in earnings, which is quite low, but still 73% of companies had an EPS surprise.
The key here is that many companies are simply raising prices to keep profitability in line. That may work in the short term, but the Fed has made it pretty clear that if prices keep rising, interest rates will keep rising. If interest rates keep rising then consumers and businesses will have nothing left to spend.
The market rout of 2008-2009 was caused, in part by too much debt, but in hindsight, it might be better to look at that episode as an inability to cover expenses. Back in 2007, 13% of household disposable income was going to debt service. At that time, a mortgage was about 6.3% and the Federal funds rate was around 5%. Today, those numbers are 5.2% (mortgage) and 2.34% (Federal funds). Today, due to the massive decline in rates during the ‘Great Recession’ and the COVID pandemic, debt service is only using 9.5% of personal income after bottoming out around 8.5% last year.
That reversal is likely to continue in the coming quarters as rates rise. The lower rates during the last decade came with a moral hazard too. Household debt levels have risen from under $14 trillion in 2014 to $18 trillion now. Higher interest rates will dramatically impact most consumers and their ability to spend.
Raising prices can only work for so long, particularly for discretionary items. Companies such as Wal-Mart have highlighted in their recent earnings releases that consumption has been affected by inflation. The NY Fed has highlighted that credit card debt is rising rapidly as people try to pay for their lifestyle.
As usual, it is probably a bit early to worry. The market is taking all of this in stride, but the outcome is pretty well understood. When consumption falls companies get stuck with inventory, need to spend more to create demand. When that is timed with inflation, employment costs rise, production and distribution costs rise and all of these events cause profits to fall.
Under a normal business cycle it would probably be wise to stay invested until these problems are the focus of headlines. By contrast, the unusually large number of strains affecting society currently, while asset prices remain overvalued leaves the door open to a significant and unexpected sell off. Hold on to the assets with long term value, but if you are considering selling assets, particularly illiquid assets, current market conditions may provide a great opportunity to do that.