Wall Street jargon has now embraced aeronautics. Pundits have been busy talking
up how The Federal Reserve will “glide the economy to a soft landing”. In this analogy,
the earlier stimulus spending by the government is the propulsion. The Fed’s applying
interest rates is the brake. The economy’s inflation rate is the gauge that dictates the
proximity to the ground, which the Fed defines as an inflation rate of two percent per year.
Reality has a way of sending analogies like this off course. A financial failure on
the scale of Silicon Valley Bank nearly caused this to happen earlier this year. So long as
the analogy persists and is accepted, the more it will be incorporated into investment
thinking and decisions until it is contradicted and discredited.
Such rosy scenarios as “soft landings” seldom come to pass the way they are
predicted. They sound good when they are being promoted, but do not have a lot of
substance behind them and usually many unintended consequences. For example, the
most recent quarterly earnings are down sharply on both the prior quarter and the year
earlier. Yet Wall Street celebrates the earnings coming in “better than expected”. Say
what?
To understand this, visualize a track and field event, where the officials constantly
lower the bar to the high jump until the athlete steps over it. Wall Street roars. An entire
cottage industry consists of buying stocks that speculators feel will outperform their
quarterly estimates the day before their earnings come out and sell the next day. Great for
the brokers, less so for the customers who pay short-term capital gains on the trade
assuming they made money. If not, there is always another company with earnings coming
out to try to outguess.
The issue is not just whether the Fed can engineer a soft economic landing, but
what such a landing will do to financial markets over time. It will probably mean higher
interest rates for longer, which will put pressure on some corporations’ over-leveraged
balance sheets, to say nothing of start-ups needing financing and commercial real estate
lending. There is an estimated $1.5 Trillion in corporate debt maturing in the next 12
months. Each one percent increase in the interest rate on the debt, should it be rolled over
and reissued, would ding corporate profits by $15 Billion per year. This does not even
account for the interest on government debt, the principal amount of which is growing at
the rate of $5 Billion a day.
The latter trend would seem to suggest higher taxes or lower government spending,
or both. Neither of these options make for a robust economy. It is probably too much to
expect the politicians to address this issue before the 2024 elections. After that it will be
topic A of conversation or should be. Meanwhile, resumption of student debt repayments
will siphon off $70 billion of consumer buying power a year going forward. This is not a
large number in a $25 trillion economy, but it is still a drag. It will accelerate the division
between demographic, social and economic groups in ways that many can foresee but few
want to acknowledge.
There are still parts of the market that have not been sucked up by the euphoria over
projecting the Fed Chairman as some sort of kin to the Wright Brothers, piloting the
economy to a soft landing. Because so many people use packaged financial products like
ETFs to invest, they pass on many firms that have better prospects but are not selected to
be in an index, often because of their size. As for the momentum crowd, live by the sword
and die by the same. One of the biggest mischaracterizations of investing is that it can
make everyone wealthy. In the end it usually makes more people gullible than rich. Most
investors do not have the requisite combination of knowledge and patience to ride out an
entire market cycle which can last at times for years. People in rising markets think they
are smart. Never confuse brains with a bull market.
As Garrison Keillor wrote of the mythical Lake Woebegone where, “all the women
are strong, all the men are good-looking, and all the children are above average,” there
are some things that statistics will not support about investing. Shedding excessive costs,
giving a strategy a long enough time frame to jell, and either knowing what is going on or
trusting in someone to know for you is vital to one’s eventual success.
The Economy
Economic activity continues positive if slowing. Most of the storm clouds over the
economy currently exists abroad, especially in China. This affects us as we buy,
sometimes reluctantly, their commodities and products, and they buy, with equal
reluctance, our country’s debt. In doing so they keep our interest rates lower than they
otherwise would be in the process. This exchange may be ending.
The domestic economy has been see-sawing between goods and services since
Covid, when services were restricted, and goods were purchased with abandon. Now
services are in greater demand. Hopefully, things will be back to more normal trends in
2024.
Inflation
Inflation continues to abate. The issue is whether it will decline to the arbitrary level
of two percent per year which will let the Fed declare victory and lower interest rates.
The factors encouraging inflation seem to suggest the Fed will not attain its goal.
Energy prices are once again rising. Labor markets continue tight, making wage gains
increasingly expected. The war in Ukraine escalates the cost of food for the world. A
falling dollar will make imports more expensive. Resources used to make EV batteries
are in some of the most hostile places on earth.
All this suggests that the inflation rate will go up before it goes down. Whether the
Fed will raise interest rates again and by how much will be a parlor game that will be
played the end of this year and into 2024. At a minimum, it means that current rates will
remain for longer than most people are expecting,
Interest Rates
With inflation driving interest rates, there is little hope of any decline. Indeed, with
the stress higher rates are putting on the financial system, it seems safe to say a meaningful
decline in rates will require some sort of financial crisis to engineer.
The good news is that interest rates are finally getting to the point of rewarding
savers. The bad news is that the level of interest rates is making people and businesses
reluctant to commit to paying the same high rates in the long term.
Exhibit A for this is the housing industry. With so many sitting on mortgages of 2-
3 percent, there is an understandable reluctance to move even when events like
downsizing would suggest it. On the other hand, the higher rates are pricing out many
who are entering the housing market. There is a dearth of entry level affordable housing
supply for most first-time buyers.
The solution is smaller lots which require local zoning approval. This pits existing
homeowners who feel cheaper houses will depreciate their own home values against
developers who want to build to satisfy demand. his will not be an easy issue to resolve.
The federal government has almost no leverage in the argument.
The Stock Market
A pickup in volatility would suggest we may be looking at some sort of correction
in the foreseeable future. Technology stocks like Apple are encountering slowing sales.
Given their size, the other issues should not be far behind.
When the so called “Magnificent Seven” stocks (Apple, Microsoft, Alphabet (nee
Google), Meta (nee Facebook), Netflix, Tesla, and Amazon) take on water, become
worried. These companies make up a big chunk of the index funds used to offset or reduce
the risk of portfolio decline. This strategy assumes there is liquidity, or someone on the
other side of the trade to buy at the current price. If there is not, look out below.
Warren M. Barnett, CFA
August 10, 2023
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