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“The biggest rate hike since 1994.” That is how the vast majority of financial news outlets described the Fed’s 75 basis point (0.75 percentage point or three-quarter point) rate hike this week. 1994, 1994, 1994. Yet none of the coverage we encountered took the time to explain what was going on then—the simple fact that the Fed last undertook a 75 bp hike then was apparently enough for context. That is rather a shame, in my view, considering late 1994 was an interesting stretch with some parallels to today. There were also plenty of differences, so I won’t argue anything here is a blueprint or predictive, but a trip down memory lane can help dispel the notion that the Fed did something inherently and automatically destructive this week.
Like 2022, 1994 was a midterm election year under a first-term Democratic president whose polling numbers were on the slide amid a raft of political infighting—a phenomenon that, as Fisher Investments founder and Executive Chair Ken Fisher wrote in Forbes at the time, “weakens faith in our institutions” and spurs volatility.[i] The S&P 500 didn’t fall nearly as much in 1994 as this year, but it came close to a correction, and stocks seesawed hard all year before finishing mildly negative. Yet economic growth was robust and unemployment was low—by all rights, things that should have inspired cheer.
However, they mostly fueled angst. You see, inflation was low, but the Fed—with Paul Volcker’s battle against inflation still relatively fresh in the Board of Governors’ memory—worried it wouldn’t stay that way. They worried not about monetary excess, but supply and labor shortages. They saw a strong risk that the US economy simply lacked the capacity to produce as many goods as the populace demanded. They obsessed over a metric called capacity utilization, which essentially measures the amount of slack in heavy industry, worrying it was too high—that companies couldn’t raise output without incurring significant costs in new equipment and facilities, which supposedly risked driving consumer prices higher. So, to prevent supply shortages from driving prices higher, they started hiking rates in February.
The University of Michigan’s widely watched consumer sentiment index fell to 50.2 this month—the index’s record low, if the final reading confirms the preliminary estimate on June 24. This confidence measure matches other recent dour polls: See Bank of America’s June fund manager survey (73% of respondents anticipate a weaker economy over the next 12 months) or a Financial Times/University of Chicago Booth School of Business poll (nearly 70% of economists expect a US recession next year).[i] In our view, the U-Michigan index’s record figure is an opportunity to revisit an important lesson. Sentiment gauges are, at best, coincident—moods don’t foretell economic activity, and it is often wiser to view them as a sign of what markets pre-priced already than what is to come.
All components of the U-Michigan index fell in June, from the outlook on business conditions over the next year (-24% m/m) to consumers’ assessment of their personal financial situations (-20% m/m). Among consumers, 46% attributed their negative views to inflation—the second-highest share since 1981. Half of respondents “spontaneously” mentioned rising gas prices in survey interviews, up from 30% in May and just 13% in June 2021, with consumers projecting gas prices to rise by a median of 25 cents over the next 12 months. From a historical perspective, the U-Michigan’s sentiment measure undercut its prior record low of 51.7 in May 1980, amid that year’s recession.
Exhibit 1: Feelings at a New Low?
Will it be 50, 75 or 100? In the run-up to Wednesday’s Federal Open Market Committee rate decision and presser, that was the debate. Not whether they would hike, but by how much—50 basis points (bps, or 0.50 percentage point), as Fed Chair Jerome Powell intimated in May? Or would they be more aggressive, aiming to tighten policy in an effort to cool inflation? In the end, they opted to go bigger, hiking rates by 75 bps—the biggest single hike since 1994. With the S&P 500 entering a bear market earlier this week (breaching -20% from January 3’s high), many now fear the Fed erroneously and aggressively tightening against this backdrop means a recession is coming. While we understand that logic, it seems like a hasty conclusion, in our view. Let us explain.
First, while this downturn is now officially a bear market, it still looks mostly sentiment-driven to us. An unusually wide array of worries has taken turns dragging markets lower this year. Inflation. Putin’s vile Ukraine invasion and fears of wider war. Oil, commodity and other goods shortages. Chinese lockdowns. Eurozone economic weakness. Political worries. All have, at times, dominated discussion—unlike typical downturns, which generally feature one or two fears.
But after last week’s US consumer price index acceleration surprised many pundits, worries of hot inflation triggering an even more aggressive Fed returned to the fore. Some, as today’s Q&A with Powell suggested, even think the Fed is trying to induce a recession to slow rising prices. (A notion the Fed Chair repeatedly rejected.) These fears stoked big swings last Friday. And, on Monday, market-based expectations shifted swiftly toward a 75 bps hike and stocks tumbled below the -20% threshold that technically marks a bear market.[i] Now, to be clear, there isn’t anything about rising rates—whether short or long—that automatically dooms stocks. The relationship is vastly overrated. But it does seem to have roiled sentiment, especially as some alleged the upturn in expectations was based on leaked information emerging during the Fed’s media blackout period. Regardless, Treasury yields jumped, pricing in the rumored action, with 3-month yields rising from 1.26% last Tuesday to 1.83% yesterday, on the cusp of today’s announcement.[ii] 10-year yields similarly rose from 2.98% to 3.49%.[iii]
When global stock and bond markets entered this year’s rough patch, it was probably only a matter of time before investors returned to a long-running source of worry: Italian debt. Any time eurozone bond yields rise, people worry Italy’s debt woes will return, with soaring borrowing costs rendering the country unable to finance its debt—and resurrecting the eurozone debt crisis. So it went this week as Italy’s 10-year yields jumped past 4.0%, leading to an emergency ECB meeting Wednesday to address the issue. In typical eurocrat fashion, the bank announced a plan to have a plan but offered scant detail, leaving observers guessing. Time will tell what exactly they roll out, but we don’t see much evidence Italy needs the help.
Pundits were a bit surprised last week when the ECB didn’t address Italian debt at its regularly scheduled meeting. Italian 10-year yields exceeded 3.0% at the time, and debt fears were already percolating. The bank’s silence, coupled with its jawboning about raising its policy rate later this summer, seemingly sent sentiment sharply lower, triggering that jump over 4.0% for the first time since 2013, as the eurozone crisis wound down. (Exhibit 1) Hence, today’s emergency meeting.
Exhibit 1: Italian Yields in Context
Normally, central bank actions to move short-term interest rates to 0% wouldn’t constitute “tightening.” Yet that is what many seem to believe since last Thursday, when the ECB announced its intention to hike policy rates by 25 basis points (0.25 percentage point) at its July meeting and beyond. With its deposit facility rate currently at -0.5%, markets are expecting that to hit 0% by September. Many blamed the ECB’s announcement for European stocks’ sharp selloff late in the week. In this case, while 0% is higher than -0.5%, that doesn’t mean monetary policy is becoming more restrictive. Rather, we see it as a move back to normal after years of negative rates, which could very well bring some benefits.
The ECB has three benchmark rates it uses to conduct monetary policy: its main refinancing operations (MRO), marginal lending facility and deposit facility. The MRO rate is what banks pay to borrow from the ECB for a week. This borrowing is collateralized, meaning banks must provide the ECB with eligible assets to guarantee the loan. The MRO rate is currently set at 0%. The marginal lending facility rate is banks’ overnight borrowing cost, which is also collateralized, but typically costs more, now 0.25%.
The deposit facility rate determines what banks receive for keeping funds at the ECB overnight. Notably, this rate has been negative since June 2014—which means banks have had to pay the ECB to store their money. Imagine paying your bank a 0.5% annual rate to hold your deposits—a bit unusual and perverse. The ECB has set this rate progressively further below zero—starting at -0.1% eight years ago and bottoming at -0.5% from September 2019 onward—in an attempt to spur lending. This may sound promising: Penalize banks for storing cash at the central bank as a prod for them to lend instead. But the experiment hasn’t worked out that way. It has backfired, weighing on lending—not prompting it—which is why we think the ECB’s aim to remove negative rates is a blessing in disguise, putting an end to a long-misguided “extraordinary” policy.
Among the lesser-seen worries in the cornucopia garnering investors’ ire lately hides S&P 500 Financials earnings’ -19.9% y/y plunge in Q1 2022—a highly unusual development during a stretch where most economic indicators are on an upswing and the vast majority of sectors are enjoying earnings growth.[i] The culprit, as The Wall Street Journal examined last weekend, is both simple and complex: A relatively new accounting rule is distorting earnings math bigtime. Interestingly, unlike the last time an accounting rule change distorted bank earnings, US Financials are actually holding up better than the S&P 500 overall. That is a change from 2007 – 2009, when another accounting rule destroyed bank balance sheets, triggering the global financial crisis. Understanding the rules’ differences can help investors get a better grasp of both past and present, in our view.
The rule in question is known as Current Expected Credit Loss, or CECL. As the name implies, it requires banks to account for all reasonably expected losses in their loan portfolio based on current economic conditions. Before CECL came on the scene, banks had to recognize—and provision for—loan losses only when they were imminent. While this system worked well for decades, following the 2007 – 2009 financial crisis, some industry critics argued banks were late to acknowledge trouble in their loan portfolios. In our view, they were misinterpreting the havoc wreaked by another accounting rule—FAS 157, the mark-to-market accounting rule, and its illogical application to illiquid and hard-to-value assets that banks never intended to sell. But cooler heads rarely prevail in these matters, so regulators decided the best way to shore up banks’ defenses would be to require them to provision for all expected credit losses over a loan’s entire lifetime.
What this means, in practice, is that banks must constantly adjust a given loan’s probability of default, usually based on current economic and financial conditions—and on the presumption that these conditions will last indefinitely. This has led to some outsized swings in banks’ earnings—swings that don’t totally reflect actual economic reality. In early 2020, at the height of lockdowns, this led to banks ratcheting up default projections and beefing up loan loss reserves accordingly. That was a big contributor to falling bank earnings early that year, as these provisions are basically paper losses. But a year later, with economies more open and an alphabet soup of fiscal and monetary assistance programs in place, expected defaults plunged, enabling banks to reduce their loan loss provisions—a paper gain. Now, high inflation and rising interest rates are again raising default projections, contributing to S&P 500 bank earnings falling -30.7% in Q1 2022.[ii] At some point in the future this will flip again, delivering a paper fillip to earnings.
As global markets suffered another bad day Monday, investors had more dreary news to chew over. One bit came from the UK, where the Office for National Statistics (ONS) reported monthly GDP fell -0.3% m/m in April, the second-straight drop—setting off another round of UK recession chatter.[i] In our view, the jury is still out on the UK economy and whether this year’s painful cost-of-living increases will be enough to tip consumer spending—and overall output—negative for a sustained period. But under the hood, the seemingly weak GDP report actually featured some reasons for optimism.
As most of the coverage rightly pointed out, all three of the major monthly GDP components—services, heavy industry and construction—fell. Industrial output fell -0.6% m/m, with manufacturing (-1.0%) leading the way down, while construction activity fell -0.4%.[ii] Services—about 80% of total UK output—fell -0.3%, but this comes with a big asterisk: the end of COVID testing and tracing and the vaccination drive.[iii] COVID-related activity has skewed GDP wildly at times over the past two years, as it shows up as big jumps and dives in the human health and social work activities component of services industry output—an economic accounting quirk that is largely unique to the UK. This category fell -5.6% m/m in April, shaving half a percentage point off the service sector’s growth rate.[iv] Exclude it, and services would have grown 0.2% m/m, which would be enough of a move to make headline GDP growth flattish or slightly positive. Now, flattish growth isn’t great, but it also isn’t a deepening contraction, and the latter is what everyone fears now.
Elsewhere in the services sector, there were some bright spots—especially in consumer-facing areas that, in theory, should be benefiting from the easing of COVID restrictions and return of travel and leisure activities. Overall, the ONS estimates consumer-facing services rose 2.6% m/m.[v] Wholesale and retail trade jumped 2.7% m/m—and that figure is adjusted for inflation—while activity at restaurants and hotels rose 1.0%.[vi] The nebulously named “other service activities,” which includes the beauty industry, soared 5.5% m/m.[vii] Interestingly, retail’s rapid rise came despite the tax hikes and energy price cap increase that took effect in April, suggesting that—at least at the outset—consumers were far more resilient to these added pressures than economists anticipated. Also positive: Auto sales contributed strongly to the retail total as supply recovered, confirming our hunch that March’s slide wasn’t a product of weak demand.
Ouch. Today’s CPI report showed US inflation reaccelerating to 8.6% y/y in May—notching a new 40-year high—and stocks didn’t like it.[i] The S&P 500 dropped -2.9% in price terms on the day, extending Europe’s earlier declines.[ii] Fast inflation and market volatility is a painful combination, especially for those trying to grow their assets over time to support living expenses. The fear of hardship is real, and we get it. So at times like this, we think it is best to breathe deep, think longer term and remember some first principles.
The precise reasons for sharp volatility are always impossible to pin down. On its face, the CPI acceleration was modest, and the 8.6% rate is but a whisker faster than March’s 8.5%. But it wouldn’t surprise us if the world’s expectations heading into today were a touch too optimistic. You see, for the past two months, the financial world’s general take on US inflation is that it is peaking. We saw it when the inflation rate hit its prior high in March—there was a lot of this is the top chatter. We saw it in April, when CPI decelerated to 8.3% y/y—then, it is finally easing was the general spirit. On both occasions, we counseled against that mentality and the follies of trying to predict such turning points in general.
Today’s market reaction is a prime example. Last month, as the world cheered April’s CPI slowdown, we cautioned:
Last Friday the Bureau of Labor Statistics released May’s jobs report, which revealed nonfarm payrolls rose 390,000, exceeding estimates of 322,000, while the 3.6% unemployment rate was a tick higher than expectations for 3.5%.[i] Oddly, some pundits fretted the data were too strong, arguing the Fed must act to cool the economy and hot labor market, which they posit could further fan already hot inflation. Ergo, with an eye toward next week’s Fed meeting, ongoing quick jobs growth may mean more rate hikes are coming—risking a sharper-than-desired economic slowdown. However, this argument overstates the link between jobs and monetary policy—and the Fed’s powers, in our view.
Since the Fed’s dual mandate targets maximum employment while ensuring price stability over time, one might think it stands to reason there is a link between unemployment and inflation—and that the Fed will use its tools to raise or lower unemployment as needed to maintain price stability. Fed officials’ public comments seem to imply as much. Fed Chair Jerome Powell said recently that an unemployment rate consistent with stable inflation “is probably well above 3.6%” these days while Fed Governor Christopher Waller spoke last week about curtailing excess job openings to help cool prices.[ii]
But changes in interest rates don’t directly affect hiring. For one, businesses generally don’t borrow to fund payroll. Borrowed capital typically goes to longer-term investments in facilities, capital equipment and intellectual property. That may mean some hiring further downstream, but the impact isn’t direct and it certainly isn’t quick.
A curious trend has emerged in European economic data in recent weeks—one we think is worth watching. While so-called soft data (e.g., survey-based indicators, chief among them purchasing managers’ indexes, or PMIs) have stayed strong across the board, some hard data (e.g., output measures like retail sales and industrial production) have struggled. French industrial production and German retail sales defied PMIs with contractions in recent days, missing consensus expectations in the process. German industrial production, released overnight, did grow 0.7% m/m in April, but that figure missed expectations—and follows a worse-than-expected -3.7% decline in March.[i] Now, we don’t think this is predictive for eurozone stocks, as markets are forward-looking. But we do think the data perhaps shed light on what eurozone stocks have priced in already, and they illustrate the follies of relying too much on any one indicator.
Exhibits 1 – 4 show the past few months’ worth of hard and soft data for the eurozone’s four largest economies (Germany, France, Spain and Italy). We limited our look to this short window for a simple reason: Pundits globally warn the war in Ukraine is a huge risk for Continental Europe’s economy, and that conflict started in late February. One looking only at PMIs would presume all four have sailed through with flying colors. But harder data show some struggles.
Exhibit 1: Germany