by Franklin J. Parker, CFA
The Summary
- The Bottom Line. With the Fed maintaining its aggressive posture, investors are forced to continue bidding down company valuations. This is likely to put the P/E ratio for public (and private) companies under continued pressure. This, all while inflation takes its bite from corporate profits. Despite all of this, demand remains strong and the labor market remains tight. Until the fundamentals of the economy start to erode in a meaningful way, investors may do well to simply sit tight and let this transition develop.
- Earnings reports were largely sidelined in the news last week, overshadowed by the Fed and other big economic data. As it stands, 85% of S&P 500 companies have reported results, and it appears that earnings will be about 2.2% higher than they were at this time last year. Overall, this shows that earnings are beginning to wane in a meaningful way, and analysts now expect negative earnings growth in Q4 of this year (-1%). There is probably no more illustrative point about the damaging power of inflation on corporate profits than seeing revenues up by 10% and profits down 1%.
- Last week saw considerable data, but none more important than the Fed’s interest rate hike and press conference. The Fed firmly declined to pivot, and seemed to warn investors that rates will keep going up, and may stay at higher levels for some time. Of course, markets sold away the hope of that dovish change in expectation of an aggressive Fed.
- This week, we see the all-important inflation figure (8%, year-over-year is expected), and we also get consumer sentiment data. Of course, the US midterm elections are also this week (though market reaction is expected to be muted). Consumer credit posted today with a slight decline (down $5 billion, which was a pleasant surprise). Overall, this week is much quieter on the data front than last.
The Details
One thing that really struck me at the Fed’s press conference last week were several questions from reporters on how the Fed knows when rates are just right. In other words: what does the Fed believe causes or halts inflation? Understanding the Fed’s model helps investors understand how to interpret the data through the Fed’s lens.
And this is a topic that has been rather hot lately, especially in the political sphere (there is an election tomorrow, after all). And it is an important question: what causes inflation?
Sen. Elizabeth Warren has suggested that inflation is the result of higher energy costs from the war in Ukraine, and even corporate greed. Sen. Mitch McConnell has blamed excessive spending. Others have blamed bottlenecked supply chains.
Discerning the cause(s) of inflation is important because different causes call for different solutions and different tools.
Economists, generally, have three formal models of inflation of which I am aware:
- Inflation is always and everywhere a monetary phenomenon. This was Nobel-laureate Milton Friedman’s view. He believed that central banks are the sole responsible parties for inflation. Creating currency from nothing debases your currency. Therefore, inflation is a monetary policy issue.
- Inflation is the result of deficit spending on things that do not create economic growth. This is a much more recent view, one espoused by what is generally called Modern Monetary Theory. In short, creating currency from nothing is not necessarily bad, so long as it is spent on productive projects. It is inflationary when those projects are not productive.
- Inflation is the result of the interplay between monetary policy, government spending, taxes, and economic growth. This is known as the Fiscal Theory of Price Level. Inflation is the result people losing faith in a government’s ability to repay its debts.
Each, of course, carries its own recommended solutions (and models). What became clear to me last week, however, is that the Fed does not subscribe to any particular view or model. In short, the Fed seems to believe that inflation exists, they have tools, so they’ll use them until they work.
And so we wait for them to work.
Chart of the Week
This week’s chart is a look at household savings rates in the US, UK, and Eurozone. The Covid stimulus across these areas is clearly seen as the spike on the chart. However, individuals in each economic zone have not responded the same over the past couple of years. The Eurozone and UK have both maintained higher savings rates than before the pandemic (and saw less of a spike). The US, by contrast, has seen savings rates plummet to 20-year lows, only lower in 2005.
In short, while people are still saving, it is clear that current spending in the US is coming from money that would have been saved in the previous economic cycle. While this is keeping consumer demand up, there is a limit. At some point consumers are forced to slow down and again resort to saving.
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