The One Thing
In the hit 1991 movie City Slickers the city-dwelling main character, Mitch, played by Billy Crystal, is on a cattle drive with two friends trying to find deeper meanings in their lives while out on the range. A gritty cowboy, Curly, played by Jack Palance, tells Mitch the secret to life is simply “one thing.” It is up to Mitch to figure out the one thing most important in his life since it is different for everyone. Focusing on one thing may be good advice for most individuals, however for larger institutions, such as the Federal Reserve, it is decidedly more complicated.
The primary goal of a central bank is to provide price stability for their country’s currency by controlling inflation. Integral components of this are to manage the money supply and foster steady economic growth. The central bank of the United States, the Federal Reserve, has a dual mandate: price stability and maximize employment. But in the current environment these seem to be at odds with each other. Low unemployment is causing wages to increase at a quick pace, creating upward pressure to the prices of goods and services. The Fed has been on a path of increasing short-term interest rates throughout 2022 in an effort to bring inflation down to a level more conducive to promoting economic growth. If they continue to raise rates, conventional thought is it will cause a slowdown in economic growth and perhaps lead us into recession, likely having an adverse impact on employment. The Fed has explicitly stated they are willing to do this if it means they can get a handle on inflation. But based upon the latest employment report, the Fed’s efforts are not working when it comes to the labor market.
The larger than expected payroll and unemployment reports last Friday show that the labor market remains very resilient and the Fed’s interest rate hikes have had limited, if any, impact on employment. Wages also increased year-over-year by a larger than expected amount, showing wage pressures are not yet moderating. This gives the Fed ammunition to continue their current path of rate hikes with at least a half point rate hike likely in September, with increasing odds of another three-quarter point hike. This is why the stock market reacted negatively to the employment reports and bond yields spiked. A week ago we were talking about the probability of the Fed reversing course in 2023 and beginning to lower interest rates. That scenario remains a possibility but if economic reports show inflation continuing at elevated levels over coming months it will force the Fed to continue raising interest rates.
Keep them dogies movin’
It seems a foregone conclusion the Fed will raise interest rates at their next meeting in September, but there are still economic reports, namely inflation and employment, in the interim so there will very likely be changes in expectations for the magnitude of the interest rate hike. However, monetary policy can also work without central bankers doing anything. After the jobs reports, short-term and long-term bond yields surged with expectations of future interest rate increases. These higher rates will filter through to rates on mortgages, auto loans, and other forms of credit, having an immediate effect on demand.
We continue to closely monitor the bond markets, where we have seen a great deal of volatility recently. The spread, or difference in yields, between the 2-year and 10-year U.S. Treasury remains “inverted” with the 2-year yielding about 40 basis points, or 0.40%, more than the 10-year bond. Historically this has been a forewarning of a recession, especially when the inversion is this deep and prolonged. But it is difficult to see a recession occurring anytime soon with such strong job growth and a low unemployment rate.
Earnings reports continued in earnest last week with somewhat mixed results but overall could be considered resilient in the face of recent economic data. Companies continue to report revenue and earnings above previously lowered expectations. The market sold off last Tuesday, just to reverse course on Wednesday with the S&P 500 ending the week nearly flat, while the Dow Jones Industrial Average had a small loss and the Nasdaq enjoyed about a 2% gain. We continue to see strength in technology, which had been the most beaten-up sector this year. Oil prices continued to pullback on fears of slowing demand. Prices at the pump have been declining since mid-June with demand falling to levels not seen since the early days of the pandemic. This is what is known as demand destruction, which occurs when high prices cause consumers to change behavior and purchase less of a good, leading to lower demand and lower prices. It is unlikely that demand will continue to fall markedly past current levels, especially on a sustained basis, we doubt oil and gas prices will drop significantly from here unless ongoing supply constraints are eased. Lower energy prices could be reflected in upcoming inflation reports, possibly giving some reprieve to the Fed, but not appreciably enough to give them pause.
Over the past couple of decades when we experienced relatively benign inflation, arguably the most watched monthly economic report each month was the Nonfarm Payrolls report since job growth is generally accepted as a strong indicator of the health of the overall economy. Now with inflation running at 40-year highs, the inflation reports are also taking center stage. Consumer Price Index (CPI) and Producer Price Index (PPI) numbers will be released this week with the CPI and PPI expected to show year-over-year price increases of 8.7% and 10.4%, respectively. If they came in at these levels it would be lower than the previous month and could lend credence to the notion we have reached “peak inflation” with price increases slowing. This would be welcomed news from the Fed, but inflation remains at very elevated levels and the Fed would have further work to do.
While the spotlight remains on the Fed and inflation, stock markets are driven over the long term by corporate earnings. Profits are affected by higher prices since input costs tend to be higher and demand is generally weakened. A reduction in the pace of inflation would likely lead to some tailwinds for the stock market. From an investing perspective, quality of earnings is once again in vogue and we will continue to watch earnings reports over the next couple of weeks. When it comes to retirement, your focus should be on one thing – feeling secure. If you would like to discuss your retirement financial plans in detail, please do not hesitate to contact us.
Have a wonderful week!
Nathan Zeller, CFA, CFP®
Chief Investment Strategist
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