by Franklin J. Parker, CFA
The Summary
- This is an important data week. We get inflation figures for March, which are very important (about 8.5% year-over-year is the expected increase). Retail sales and industrial production figures also post. These are all key insights to watch to help gauge the health of the US economy.
- Hard to believe, but quarterly earnings are starting this week with big-name financials reporting: JPMorgan, BlackRock, MorganStanley, Wells Fargo, and Citigroup all report this week. Overall, earnings are expected to be considerably thinner than last quarter, with the estimate hovering around 10% growth over last year for the S&P 500 as a whole. However, financials and real estate are expected to see earnings contractions (-11% and -18%, respectively), with consumer staples seeing no growth, and energy expected to see explosive earnings growth (+72%). As I discussed before, more than anything, inflation creates volatility in earnings as companies struggle to maintain pricing power in the face of ever-rising costs.
- As I have talked about, and others have pointed out, the risks of a recession are growing. Many indicators are flashing warning signs, although it does not appear that a recession is imminent. That doesn’t necessarily mean we should be on the sidelines, but it does generate some caution. Inflation—both current and projected—is a serious concern, and the Fed appears poised to tighten much more quickly than markets seem to anticipate. In my view, risks to the downside are growing, though there is still a case to see a run-up into the end of the year. Caution is warranted.
The Details
Last week, the Fed announced that they plan to reduce their bond holdings by $95 billion per month, with almost all of that coming from maturities in the portfolio.
This is an often-overlooked aspect of the Fed’s balance sheet policy: with almost $9 trillion worth of bonds, there are bonds maturing constantly. To maintain the target size, the Fed must continually buy bonds in the open market—a process that continues to push cash into the financial system, even if they are not printing that money directly. It should not technically be inflationary since the actual number of dollars is not changing, but it is if you look at the basics of the inflation equation.
Inflation is the amount of money times the velocity of that money (velocity is how often money changes hands). You can increase inflation by increasing the amount of money, or by increasing the velocity of that money (or both). When a bond matures from the Fed’s balance sheet, the company sends cash to the Fed and the Fed takes that cash and buys bonds in the open market, creating transactions. In short, that cash moves faster than it otherwise would because of the Fed’s influence. Even though no more dollars exist, velocity is slightly higher.
The Fed is now trying to wind that down. By allowing $95 billion worth of bonds to simply mature, when the company sends the cash to the Fed, that cash is effectively taken out of existence, reducing both the number of dollars as well as the velocity of those dollars.
In my view, the Fed is behind the curve in dealing with inflation, and their tools also appear severely limited to deal with inflation that may end up in the double-digits. Their only real hope is to pull cash from the financial system as quickly as possible, but that comes at the cost of a possible recession.
Markets, then, may be surprised at how aggressive the Fed will be—at least in the beginning—and then again surprised at how little they can do after that initial aggression. In the end, as I have said many times before, investors must remain flexible and adaptable!
Chart of the Week
This week’s chart is a breakdown of earnings growth expectations by sector. In theory, price changes and earnings growth expectations should be in lock-step, but they often are not. In general, we have seen valuations contract (which is a healthy thing, longer-term), but there are still some sectors were those valuations remain stretched—especially in the face of lowered earnings growth. In any event, investors will be watching this earnings season very closely.
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