What I Care About This Week | 2022 Aug 29

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Photo by Jayant Kulkarni on Pexels.com

by Franklin J. Parker, CFA

The Summary

  • The Federal Reserve’s annual retreat at Jackson Hole, WY was last week. Historically, this has been a time when Fed speeches are used to provide a defense of policy as well as some nuance and outlook for that policy. This meeting was no different. Chairman Powell reiterated the FOMC’s commitment to bringing down inflation even if that meant enduring “some economic pain.” This was one of the few times that the chairman acknowledged the Fed’s willingness to push the economy into a recession if it meant bringing down inflation.

  • This week we get unemployment data (3.5% expected), factory orders for August (0.2% increase), consumer confidence (slight rise), and job openings (slight decline). Investors are watching all of this through the lens of Federal Reserve activity, and also with an eye to a potential slowdown in the drivers of this economy. Those two are the main forces pulling prices around.

  • As I have often discussed here, investors are struggling to balance the influence of the Fed with the influence of corporate profit growth. Earnings season was generally ok, and outlooks are positive — most analysts expect ongoing profit growth through the end of the year. Yet the Fed’s ongoing guidance that rates are likely to trend higher has spooked many investors. This tug-of-war between generally ok economic data and the Federal Reserve is likely to continue for the near future. However, it is the economic data that will drive the general direction of market prices, at least in my view. As long as consumer demand is strong and corporate profit growth continues, I expect prices to drift higher.

The Details

When operating in a high-inflation environment, companies typically go through three stages.

Stage 1. Usually corporate executives see higher costs coming. To get ahead of those higher costs, they will raise prices as quickly as possible. This shows up as expanded profit margins and higher-than-normal earnings growth. Of course, that also means higher stock prices.

Stage 2. Thankfully, companies cannot raise prices forever so they are eventually forced to begin eating these higher costs. This shows up as lower margins and decreasing profits. As we would expect, this also means lower stock prices.

Stage 3. For as long as high inflation remains, this tug-of-war exists. Companies will raise prices when/if they can, and inflation will work to eat away their profits. Generally speaking, when viewed over a long period of time, companies tend to keep up with inflation, but it is certainly not a straight line. Inflation injects lots of volatility into profits and, by extension, market prices.

Fathom Consulting put out a chart this morning that shows we are firmly in Stage 2. After increasing profit margins over the past year, US companies are now unable to continue passing those increased costs on to consumers. This bodes well for future inflation figures, but creates a challenge for future profits.

Chart of the Week

This week’s chart is my favorite recession indicator: the 3-month US Treasury yield minus the 10-year US Treasury yield. When this figure turns negative, a recession is typically not too far behind. While financial news focuses on other yield curve indicators, I find that none of the others are as reliable as this one. While the indicator has moved very quickly toward zero over the past few months, it has not yet turned negative. Once it does, my “recession clock” begins in earnest — we typically get anywhere from 6 to 18 months before the recession hits. Interestingly, the indicator tends to become positive again just before the recession actually hits.

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