Great Britain does not rule the waves of global finance as it once did. Long gone are the days of the informal club of trading nations bound together by the gold standard and informally headquartered in the City of London. Nonetheless, it remains one of the world’s most developed societies and economies, so what happens there still does, to some extent, reverberate in other corners of the globe. We got a taste of that this week, as credit markets (and to some extent equity bourses) got whipsawed by a massive dose of volatility in benchmark UK interest rates and at one intraday point a record low – as in a 150 year-plus record low – for the British pound sterling against the US dollar.

With all the other problems weighing on markets these days, this was a kerfuffle nobody needed.

Truss Scores An Own Goal

The problem started late last week when the new government of Prime Minister Liz Truss and her Exchequer Chancellor (more or less equivalent to our US Treasury Secretary) Kwasi Kwarteng announced a plan to implement a sweeping tax cut program, worth about £45 billion, on top of a set of fiscal measures to help households with caps on energy bills. The near-uniform response from the world of economists and financial policymakers was: energy caps risky but probably necessary; tax cuts funded by new debt nothing short of insane.

Britain’s headline inflation rate sits around 10 percent, driven mostly by sky-high energy prices that are not due to subside any time soon. The Bank of England, like other central banks, is already faced with the need to raise interest rates to bring inflation back down to manageable levels. A surge of new debt to fund a tax cut, the logic of which seems to be rooted in long-outdated theories of supply side economics, appears to many to be one of the most counterproductive measures a government could take. Hence the near-uniform criticism, including a surprisingly acerbic public comment from the International Monetary Fund of a type normally directed towards recalcitrant emerging markets with underfunded reserves, not a country with the oldest functioning central bank in the world.

The Meltdown in Gilts

Things went from bad to worse this past Tuesday, as the Truss government refused to back down from their fiscal plans. That day the pound touched a record low level of $1.03. Gilt (UK sovereign) yields skyrocketed, and the market seized up to the point of nearly ceasing to function entirely, requiring an emergency intervention by the Bank of England to buy long-dated benchmark bonds.

Oddly enough, the intervention by the BoE created a rare burst of optimism in world equity markets as the AI algorithms powering short-term trading models misread the British move as a “pivot” to lower rates (it most definitely was not that, as the trader-bots figured out the next day). The underlying story was quite a bit worse, in particular for anyone whose preponderance of personal net worth is domiciled in the UK. The big sellers of gilts during that near-total meltdown were pension funds engaged in a hedging scheme of sorts called Liability-Driven Investment. The basic idea of LDI is to sell off assets when price declines hit a trigger point – the problem being that when enough participants are all doing this at the same time, the price keeps going down, thus necessitating even more selling.

If that sounds familiar to you it may be because you remember the cause behind the stock market crash of October 19, 1987. That was a similar flavor of hedging called “portfolio insurance” – effective if one person does it, calamitous if everyone does it at the same time. In this week’s UK case, though, the underlying money was the politically charged category of pensions – hence the BoE’s decision to intervene before incurring any more wrath from John Bull’s retired mums and dads.

Cross-Border Spillovers

As the seisms in the UK spilled over into world markets this week, central bankers and other financial policymakers are once again faced with the dilemma of trying to steer a clear and consistent policy of fighting inflation while at the same time maintaining financial stability. The brief reprieve in risk assets this week when traders misread the BoE’s intervention as a potential pivot was ill-founded: nothing at this point could be more detrimental to the health of the global economy than for central banks to have to shove aside their anti-inflation policy in order to keep the markets functioning.

There are signs that a modicum of common sense will come back to the Truss government—they are meeting with the Office for Budget Responsibility to reassure markets of their intentions to keep British debt under control. The OBR, an independent forecaster somewhat akin to the Congressional Budget Office, wields considerable influence in shaping markets’ assessment of the credibility, or lack thereof, in government budgets. That would at least be a good start. There are enough genuinely tough problems out there for policymakers and markets to deal with. Own goals are not helpful.

At the tail end of another week of market mayhem, we are going to pick up with the very last point we made in our commentary last week: this is a cycle, not a crisis. We do not have systemically critical financial institutions teetering on the edge of insolvency. We do not have self-described “safe haven” asset classes (like the auction rate notes of 2008) freezing up and leaving investors holding non-tradable paper. Those are the signs of a full-blown financial crisis, and they are not present today.

Closing the Gap

That’s the good news. The bad news is that the current economic cycle is a trickier beast than those of recent decades. The 2020 pandemic, and the massive amount of fiscal stimulus and monetary liquidity provided to combat it, had the effect of creating both red-hot demand and widespread supply chain malfunctions at the same time, setting the stage for the inflation that has persisted throughout 2022.

The Fed, along with other central banks, misread the stickiness of this inflationary cycle (in fairness, they had not factored in with sufficient lead time the war in Ukraine and China’s zero tolerance lockdowns, which made a bad situation worse). They found themselves behind the curve in their initial policy responses this year. But more recently, and particularly in the past several months, they have been closing the gap. As the chart below shows, the magnitude of increases in the Fed funds rate (the blue line in the chart) since June have outpaced the more incremental moves of the last several cycles, and at least a couple more outsize moves are expected before the end of the year.

The Fed funds target rate is now in the range of 3.0 to 3.25 percent. Indications provided by the members of the Federal Open Market Committee (FOMC) at this week’s meeting suggests that the Fed funds rate will eventually settle somewhere just north or just south of five percent, which would bring it much more in line with the high points of previous cycles in the 1990s and early 2000s, and far away from the abnormally low environment of the 2010s. The magnitude of this increase, from the rock-bottom floor of zero to 0.25 percent where the Fed funds rate sat for all of last year and most of 2020, would be the largest since the Volcker Fed increases of the early 1980s. Necessarily, as Fed chair Powell made clear at Wednesday’s FOMC press conference, closing the gap sufficiently to tame this inflation cycle will involve pain, in the form of higher unemployment and meaningfully lower growth. A recession sometime in 2023 is a likely outcome of this policy.

More Pain Now For Less Pain Later

Should the Fed have done more sooner? One can certainly make a good argument that the 0.25 percent Fed funds increase in March this year, coming as it did after Russia had already invaded Ukraine, was inadequate to the task at hand. It has been an evolutionary process for Jay Powell. The good news is that the Fed chair has evolved and adapted to the reality of the circumstances, rather than remaining ideologically wedded to a set of prior convictions. At the Wednesday FOMC briefing he laid out this reality in very clear terms: if we do not get inflation down now, with the full arsenal of monetary tools the central bank possesses, then the economy will not be good for anyone for a very long time to come.

The short-term movements in the equity market since the FOMC briefing have been decisively to the downside. This is reflective of the market’s myopic, unquenchable desire for a “pivot” – for the reflexive liquidity moves to put a floor under stock prices that have been a hallmark of every central banker since Alan Greenspan. It was an amusing moment during the press conference on Wednesday when a reporter from CNBC kept pressing Powell to say something – anything – about a pause in the rate hike program. Just one puckish reporter repeating the word “pause” several times caused the AI-powered trading programs to unleash their buy-signal Krakens, immediately driving the S&P 500 up some 50 points (Jay Powell successfully brushed back the reporter, and prices went back down).

These short-term price movements are backwards-looking, and they blithely ignore the basic fact that the very worst thing the Fed could do at this point would be to blink and pivot to easy money to fend off a recession. That’s what Arthur Burns did in the mid-1970s and it was a conspicuous failure. If the Powell Fed can stay the course until there is sufficient, decisive evidence that inflation has been brought back under control, then there will likely not be the need for the draconian double digit moves Paul Volcker had to make to restore the credibility lost under Burns and his successor William Miller.

There are risks, to be sure. But to repeat what we said above, this is a cycle, not a crisis. As a down cycle plays itself out, the key for any long-term investor is to look forward, not backward.

Two earnings seasons have come and gone this year, and in both instances the takeaway was something along the lines of “could have been worse.” Concerns that rising inflation would have a negative impact on sales growth and profitability margins have not turned out to be as dire as some were expecting. In fact by one very important measure – operating profitability – S&P 500 companies on the whole are doing better than ever. The chart below shows earnings before interest and taxes (EBIT) as a percentage of sales over the past ten years (the green dotted line). As you can see, the current EBIT margin of 15.5 percent is close to its highest level of the past decade.

Income, Jobs and Prices

Much of the recent strength in profit margins has been driven by price realizations. Companies facing higher input costs – raw materials, logistics & transportation, labor – have been able to offset those increased expenses by raising the price of the goods they sell to their own customers. The main reason for this is that consumer demand has remained resilient. Some of that has to do with the lingering effects of pent-up spending urges following the pandemic, and some of it has to do with the lower availability of many types of goods still impacted by dysfunctional supply chains. If more people want to buy, say, a bicycle and there aren’t as many bikes in the store as there were in years past, then your local bike shop will have no problem raising the price by a hefty amount (and if you have been out bike shopping any time in the past twelve months you know that this indeed is what has happened).

All that works fine…until it doesn’t. Resilient consumer demand has benefitted from a labor market that continues to run hot, and sufficient levels of personal income. The unemployment rate has remained at or close to 50-year lows throughout this year, with unusually high levels of job vacancies being a much bigger story than layoffs or salary cuts. But that appears to be changing. Although the evidence has been largely anecdotal up to this point, we expect that the upcoming earnings season will feature more reports from management teams about downsizing plans as the macroeconomic outlook turns down. When that happens, spending patterns will change as well. Those easy price increases will be a thing of the past, which suggests that we are probably at the point of peak margins.

Ship, Deliver, Warn

FedEx is one of the companies analysts use as a bellwether for global economic conditions. The shipping and packaging giant has its pulse on the highways and byways of global commerce, so when it comes out and says that things are looking pretty bad, Wall Street pays attention. The company came out after the closing bell on Thursday afternoon with a preliminary report on the three months ended August 31, which threw a wet blanket on investor sentiment in a week when sentiment really did not need yet another downer. The company missed analyst earnings expectations, withdrew forward guidance for the rest of the year and noted in particular that the rate at which conditions are worsening picked up considerably in the last few weeks of its fiscal quarter. Store closures, parked airplanes and a general hiring freeze will go into effect immediately; layoffs are probably not far behind.

This is what Fed chair Jay Powell meant a few weeks ago in his Jackson Hole speech when he warned that the Fed’s efforts to tame inflation will likely create economic pain. Pain will come in the form of higher unemployment, weaker consumer demand and – yes – lower profit margins. For investors, is this a sign that it’s time to run for the hills and build up the cash defenses? For portfolios with time horizons beyond  the next couple years, we believe the answer is no.

What is happening now is actually closer, in our opinion, to a textbook economic cycle than anything we have seen in the last couple of market convulsions (i.e., it is not a meltdown of the financial system circa 2008, nor is it an acute global health crisis a la 2020). The thing about economic cycles is this: they pass, and the downturn reverts back to growth. What the economy will actually look like on the other side of this cycle is still unclear – but that is a discussion for another day.

Within the last twenty-four hours the attention of much of the world has turned to the United Kingdom and the end of the remarkable seventy-year reign of Queen Elizabeth II. The UK gained a new sovereign head of state, King Charles III, just days after gaining a new prime minister, Liz Truss the first, who will face a mountain of problems as she settles into Number 10 Downing Street.

On the other side of the English Channel, European Commission president Ursula van der Leyen is trying to win the votes of EU member countries for a cap on gas prices targeted at Russia, which proposal is meeting with stiff resistance from some of those countries, notably Italy, which reasonably fear the consequences of Vladimir Putin turning off the gas taps entirely as the cold weather season approaches.

All in all, it seems like a good time to revisit one of our ongoing themes of this year, which that however tough the economic situation might be here at home, it is better here than there. We continue to believe that large cap US equities should be the outsize bedrock asset on the growth side of long-term portfolios.

The Truss Dilemma

Let’s start with the UK. In the coming weeks we will all have a chance to see the British at their best, with the pomp and circumstance that will accompany the period of mourning for the late, and much beloved, Queen Elizabeth. But the visual grandeur will not do anything to lessen the squeeze on living standards hitting all British households as soaring energy prices and a now-double digit inflation rate far outpace wage growth. Household energy bills are currently set to rise 80 percent between now and the end of the year, with further increases expected in the early months of 2023. Wholesale natural gas prices are fifteen times recent historical averages, leading most economists to predict general inflation levels of 14 or 15 percent by January next year.

The urgency of spiraling energy costs has made this Issue Number One for the incoming prime minister. She has given the broad outline of a plan (to be revealed in more detail next week) to freeze household energy bills for the next two years while providing additional relief on energy prices to businesses. Truss asserts that in addition to soothing household fears over upcoming energy bills, this plan will have the effect of reducing inflation.

That view is shared by, charitably speaking, very few mainstream economists including those at the Bank of England, who calculate that the Truss plan, whatever the details reveal next week, will cost about £150 billion over the next two years, which will ultimately be highly inflationary and require the bank to raise interest rates by even more than otherwise planned. The BoE is basing its entire institutional credibility on fighting inflation. That will be an even tougher climb if it has to countenance a massive amount of fiscal expansion from the incoming government.

The EU Dilemma: How Much Leverage?

It’s no secret that Europe has been working for months on reducing its dependence on Russian gas and thus improving its leverage in imposing sanctions to reduce a key source of revenue for Russia as it continues to wage its war against Ukraine. It has made some headway, with higher supplies from Norway, the North Sea and northern Africa, along with increased LNG imports, offsetting Russia’s dominance as the continent’s principal energy supplier. But it is not clear whether the EU currently has enough leverage to successfully implement a proposed price cap on gas that exclusively targets Russia. This is the proposal backed by EC head van der Leyen and supported by some, though by no means all, EU member states.

A cap on prices specifically targeting Russia would require the assent of all 27 member nations as it would be deemed a sanction applied as a bloc. A more general price cap that does not single out Russia but that would apply to all gas suppliers, which has been proposed as a counter-solution by Italy and Greece among others, would only require a simple majority to go ahead.

In the meantime, Russia appears to have turned off the spigot indefinitely for the NordStream1 pipeline that supplies much of northern Europe’s gas from Russia. Putin has threatened a complete shutdown, which would involve the other two main pipelines through Ukraine and the Black Sea that for the moment remain open. Despite better than expected replenishing of gas storage facilities, northern Europe especially still faces significant potential shortfalls in energy supplies as winter approaches.

The energy crisis, of course, is not the only issue affecting Europe’s economy which, like others around the world, is wrestling with the negative effects of persistent global supply chain problems, China’s faltering economy and a growing number of extreme climate-related events. But the energy dilemma that is front and center for both the UK and the EU is of several magnitudes more severe than the impact higher gas prices have been having on us here in the US. It is one of the defining factors in our ongoing view that things are better here than there, a view which will continue to influence our portfolio allocation decisions.

In the good old days of the 2010s there was a simple mantra called “risk-on / risk-off.”  For most of the time between 2010 and 2020 the switch was set to “on” and money was to be made by placing one’s chips in equities and a handful of other risk assets of various shapes and sizes. Every now and then something happened – Eurozone crisis, China currency devaluation or what have you, and the switch flipped to “off.” For most of us, the off switch was never long enough to merit a deep-seated change to portfolio strategy. This was the heyday, after all, of the “Fed put” – the provision of liquidity (or sometimes nothing more than nice words and assurances) to backstop market risk. If you held a conservative growth-type of portfolio with a decent allocation to quality fixed income securities, that was sufficient to ride out the periodic freak-outs in equity markets.

All That Glitters Is Not Gold, Nor Japanese Yen

For those who wanted to be more creative with their hedging, though, there were a few tried-and-true defensive strategies to be had. Two assets that have long earned regular financial media coverage during risk asset downturns are gold and the Japanese yen, both of which have traditionally been thought of as relatively safe places to be during times of economic turmoil. In the 1970s, for example, an investor with nothing but gold and yen in her portfolio would have outperformed the socks off someone with a traditional 60/40 equity and bond allocation.

Not so much today. The chart below shows the performance of gold, the yen and the S&P 500 for the current year to date. It does not look very hedge-like.

True – gold did shoot up back in February and March when the stock market went through its first downward cycle of the year. But since then it has fallen more than 15 percent from the early-March high, which is not what one wants a hedge asset to do. If anything, gold more or less tracked the stock market as the latter lost ground on its way to the mid-June bear market.

The yen has its own story. The chronically low inflationary – and occasionally deflationary – Japanese economy would in theory seem to be an attractive port in a storm while inflation surges elsewhere in the world. But the yen is down more than 21 percent against the US dollar and is trading around a quarter-century low versus the greenback.

The explanation is reasonably straightforward. While the Fed, along with the central banks of most other developed economies, is pursuing a hawkish monetary tightening policy to combat inflation, the Bank of Japan continues to inject massive stimulus into the system through purchases of bonds and equities. Japan faces a number of fairly unique (for now, anyway) economic factors that are formidable obstacles against robust growth and price inflation. As interest rates rise elsewhere in the world, Japanese sovereign debt is still anchored around zero percent (the 10-year JGB yields a quarter percent today, compared to 3.25 percent for US Treasuries and even 1.5 percent for the German Bund, which a year ago carried a negative yield).

Times Change

It’s not just about rates, though. After all, US interest rates rose sharply in the 1970s as well, yet that did not seem to diminish the charms of gold and the yen. But there were other circumstances at play then that are not comparable to conditions today. In fact, the strength of both assets back then can probably be traced directly back to that August day in 1971 when the US went off the gold standard, bringing down the entire edifice of the macroeconomic regime in place since the end of the Second World War.

When the dollar was able to float freely against other currencies, notably the yen and the German mark, pressures that had been building up for years were released, and these currencies soared while the dollar devalued. As for gold itself, its luster grew as a predictable store of value in a volatile climate. Last week in this commentary we talked about the stop-and-go monetary policy of Fed chair Arthur Burns during the first half of the decade. Interest rates bobbed up and down as Fed policy lurched from fighting inflation to fighting recession, but gold was steady. Even late in the decade, when the more decisive monetary policy of the Volcker Fed pushed interest rates into and beyond the high teens, the price of gold kept going up as investors sought a haven from a world they seemed to understand less and less.

That was then. We have plenty of economic, social and geopolitical challenges today, but they are different in many important ways from the ones of fifty years ago. Times have changed. What worked yesterday does not necessarily work well today, or tomorrow.

As we write this commentary on Friday morning, Fed chair Jay Powell is still about 30 minutes away from giving his much-anticipated speech at the Jackson Hole, Wyoming meeting of central bankers that will wrap up today. So we don’t know exactly what Powell will say, but we imagine the following supposition won’t be far off from the truth: Powell will say that fighting inflation is the Fed’s top priority, that monetary policy will stay tight for as long as it takes to bring inflation back down to the central bank’s two percent target level, and that he and his fellow policymakers will take a strict data-driven approach to determining what specific actions make sense at each Open Market Committee meeting in the coming months.

We also know that the market will be looking closely for any comments that could support the “peak Fed” narrative supplying much of the fuel for the recent rally in equities: signs that inflation is at least starting to level off (today’s Personal Consumption Expenditures index is the latest sign that such leveling off may actually be taking place), and a prudential approach to not getting any more restrictive with rates than is necessary to get the job done.

What the market won’t be doing (because Mr. Market has an attention span roughly commensurate with that of a fruit fly) is dwelling too deeply on the lessons of monetary policy from the 1970s. But Powell, who is steeped in the history of his institution, will be very much guided by the lessons of the past: in particular, the stories of three Fed chairs from that era and their battles with inflation.

Arthur Burns and the Perils of Stop-Go

Arthur Burns was chairman of the Fed in October 1973, when US support for Israel in the Arab-Israeli War resulted in the OPEC cartel’s decision, led by Saudi Arabia, to place an embargo on oil exports to the US and other Israel-allied countries. As the above chart shows, the consequences of this action were dramatic. Oil prices, which had already been rising, quadrupled. Inflation (the crimson line in the above chart) shot up and the US fell into a protracted recession (the green columns in the chart represent quarter-to-quarter GDP growth).

The Burns Fed raised the Fed funds rate to 13 percent (blue line in the chart), but then dramatically cut the rate all the way back down to 5.1 percent to try and ease the harsh effects of the recession. The Fed, remember, has a dual mandate of prices stability and maximum employment, making decisions tortuously difficult when both inflation and unemployment are running high. Inflation eventually came down from over 12 percent to under six percent thanks to the recession.

But six percent does not qualify as low inflation. As the above chart shows, a series of stop-go rate decisions characterized the middle years of the decade, as the Burns Fed alternated between rate hikes to bring down inflation and rate cuts to spur employment and boost GDP growth. Inflation kept rising, however, and was back over seven percent by 1977.

 Bill Miller’s Failed Incrementalism

In early 1978 the reins of Fed chair passed to G. William Miller, who began a series of very measured, incremental rate hikes. As you can see in the above chart, though, consumer prices kept going up right along with the rate hikes throughout the year. Meanwhile the overall economy, which grew at a relatively brisk clip during 1978, ran out of steam. Real GDP growth grew at an anemic pace in early 1979, while inflation surged back into double-digits. This was the real beginning of “stagflation,” the unsavory combination of low growth and high inflation. The Miller Fed’s continuation of tepid, incremental rate hikes did nothing to restrain soaring consumer prices.

Paul Volcker Starves the Beast

In mid-1979 President Carter appointed Miller as Treasury Secretary, and Paul Volcker took over the chairmanship of the Fed. Volcker understood that something different was required to break the cycle of high inflation. He believed that one of the key drivers behind the endemic inflation of the previous years was growth in the money supply, which needed to be restrained. The practical effects of this view soon became known, as the Volcker Fed in one fell swoop raised the Fed funds rate in October 1979 from 13 to 15.5 percent.

That was just the beginning: the Fed funds rate would go as high as 20 percent on two separate occasions before the central bank was finally satisfied that its work was done. The collateral damage was clear: the US economy suffered two deep recessions during 1980 and 1981, with high unemployment and sky-high interest rates choking off consumer activity across the economy. But inflation came down, and a new era of prolonged economic growth got under way.

More Now, Less Later

Jay Powell is an ardent admirer of the Volcker Fed, but he also does not want to be the central banker who has to choke off an economy in order to tame inflation. So while the current Fed chair gives his speech this morning, somewhere in the back of his mind are the lessons learned from the Burns Fed and the Miller Fed. A stop-go approach – which the stock market seems to be hoping for every time the word “pivot” comes up – where policy toggles between inflation and unemployment/recession, will diminish the bank’s credibility and ultimately fail to bring down inflation. An overly cautious incremental approach like the Miller Fed will not work if inflationary expectations are already baked into business and household spending decisions. Investors may not want to hear that a bit more toughness today is necessary so that things don’t have to be at Paul Volcker levels of toughness tomorrow. But that is the message we believe has been driving the Fed’s very consistent message on this topic over the past few weeks, and what we imagine will be the ongoing intention as Powell comes back from Wyoming and gets down to the business of preparing for the next policy meeting in September.

All things considered, it was a fairly quiet week this week for anyone not trying to trade shares of Bed, Bath & Beyond. Meme stock mania is by no means a thing of the past! But apart from faltering companies with outdated business models rising by more than 100 percent and then falling more than 60 percent just a few days later (including the 40 percent-plus plunge during premarket trading this morning) – well, as we noted in our piece last week, the dog days are here. It may be a good time to sit back and think about things…for example, where did all that recession talk of a few weeks back suddenly go?

Curve Says Yes, Spreads Say No

It was just a bit more than three weeks ago when the Bureau of Economic Analysis released its report showing that real GDP growth declined in the second quarter, the second consecutive quarter of negative growth. That result necessitated furrowed-brow musings about the R-word on those Brady Bunch-like pundit panels on CNBC, since two quarters of negative growth is commonly (though erroneously) seen as a proxy for recession. But those conversations seem to have drifted into the ether in the weeks since the BEA report.

We typically look to the bond market for clues about economic expectations, but here as well we’re not getting much more than static. The yield curve is inverted from the 6-month T-bill to the 10-year Treasury note, which would suggest that the bond market’s message is “recession ahead, batten down the hatches.” But we get a different signal entirely from risk credit spreads. Risk spreads between benchmark Treasuries and lower-rated investment grade bonds (Moody’s Baa) are right about at their 3-year averages. Meanwhile the junk bond market has rallied furiously on the back of the recent strength in US equity markets. The ICE BofA High Yield Index, which was flirting with nine percent back in June, is back down around 7.2 percent. Yes, junk bond investors are still paying below-inflation rates for holding these higher-risk securities. Relatively tight risk spreads suggest that nobody is thinking too seriously about the potential for corporate defaults, which of course tend to be higher during a recession.

All Eyes Turn to Wyoming…Again

The very sparsely populated state of Wyoming does not tend to be in the news spotlight very often. This week was a star turn for the state in the political arena as Republican congresswoman Liz Cheney lost her seat in a high-profile and controversial primary contest. Media attention will remain fixated on the Cowboy State next week as the world’s leading central bankers convene for their annual get-together in Jackson Hole. In particular, observers will be closely parsing anything Jay Powell has to say about…well, anything, but especially how his views on growth, recession and inflation translate into what action the Fed might take at its September FOMC meeting.

Right now the market is about evenly split between expectations for another interest rate hike of 0.75 percent, following from the decision at the July FOMC meeting, and 0.50 percent. Equity bulls who want to keep the recent bounce party going for a bit longer will be hoping for that latter outcome, which would also suggest that the central bank, while far from done in its efforts to bring inflation down, is mindful of the chances for a recession and the need to not overstep too far into restrictive interest rate territory.

Jobs and Earnings

But in walking that tight line between too much and too little, the Fed also needs to take note of the signals we are getting from the jobs market and from corporate earnings, neither of which seem to suggest that a recession is looming. Analyst estimates for 2022 earnings growth have come down only slightly. The current consensus is for about 8.11 percent earnings per share growth for the full year, compared to the March 31 estimate of 8.9 percent. Even more notable is the resilience of expectations for record-high profit margins. This, even as household spending patterns continue to shift away from more discretionary consumer items towards lower-margin staples. As far as jobs go, nothing in the BLS report at the beginning of this month suggested that high unemployment is going to be a problem any time soon.

What we can say for the moment is that, those consecutive negative GDP reports notwithstanding, our economy is neither currently in nor close to being in the kind of conditions normally associated with a recession. We do not see a compelling reason why, if the Fed wants to push all of its inflation-fighting buttons sooner rathe than later, it should do anything other than another 0.75 percent hike in September. That plus a couple more CPI reports moving in the same direction as last Wednesday’s July report, would suggest to us a path forward to a resumption of moderate growth with moderate inflation. That may not sound all that exciting, but it is preferable to the alternative of stagflation – or a deep recession.

Once upon a time, the entire month of August was set aside as that special stretch of the calendar when folks could check out for a little while. These were the “dog days of summer,” a time for trashy novels at the beach, or fly fishing in a Montana stream, or anything other than paying attention to the news and the usual daily grind.

This year, the first couple weeks of the year’s eighth month have been anything but relaxing. Important economic data – persistent inflation, the strangest jobs market in recent memory, declines in productivity – demanded our constant attention alongside troubling geopolitical developments from China’s military exercises around Taiwan to Europe’s frenetic attempts to find non-Russian solutions to its energy crisis. And there has been no lack of domestic political drama here in the US as well, with the critical midterm elections just around the corner. The dog days have been on hold.

Wake Me Up When the Jobs Numbers Hit

Of course, anything could happen between now and Labor Day. But in terms of scheduled news releases with the potential to shape a durable market narrative, there really isn’t much on tap until three weeks from today, when the Bureau of Labor Statistics releases its monthly jobs report on September 2. It would be a good idea to rest up between now and then, because once the jobs reports hits, it’s going to be several straight weeks of market-moving potential: the ECB monetary policy meeting on September 8, followed by the August CPI report on September 13 and then the Fed’s next interest rate move on September 21.

We will be particularly interested in that jobs report, because the US labor market as it stands today is really hard to comprehend. Last week, of course, we had a blowout report with 528,000 nonfarm payroll gains and an unemployment rate of 3.5 percent, matching the pre-pandemic low in February 2020, which is also the lowest jobless rate since 1969. The majority of mainstream economists do not think it is possible to bring inflation down from the upper single digits to the Fed’s target rate of two percent while maintaining historically low unemployment.

Vacancies Here, Layoffs There

Those same economists are hard pressed, though, to say how much they expect unemployment to rise while the Fed tries to bring down inflation. We are seeing two things happening at the same time right now. First, there are still tons of job vacancies out there – 1.9 for every unemployed American, according to the BLS’s latest numbers. Second, layoffs are gaining steam in many industry sectors, including technology and diverse consumer services.

Sometimes the layoffs and the vacancies happen in the same company. A recent article in the Financial Times described the situation at Gannett, the publishing house with more than 250 titles including USA Today. There are vacancies galore on Gannett’s news routes, where it can’t find enough people to deliver the morning papers. Around 12 percent of the company’s news routes are unstaffed, according to the FT article. At the same time, cost pressures on its printing business are forcing painful layoffs in that part of the company. Similar concerns about rising input costs at other prominent companies have been in the news recently. Yet the high vacancy rate continues to signal a robust labor market and is perhaps the most potent argument against the idea that the US is in or close to being in a recession.

Meanwhile, Ignore the Noise

Will that string of September reports about jobs, inflation and central bank decisions help us make better sense of what is actually going on in the economy? Hopefully so. In the meantime, though, the absence of hard news is unlikely to deter markets from moving in strange ways. We expect that volume will be light during these final weeks of August, which creates the potential for more exaggerated lurches one way or another.

Having powered its way through the many data points of the past three weeks, the stock market will test its ability to make up more of the ground lost during the bear market of the year’s first half. The rally has been strong, but some of the driving factors seem to be clinging onto the way things were in 2021. Meme stocks, cryptocurrencies and some of the junkier parts of the growth stock universe have all had their moments, and it will not surprise us much if those moments don’t last much longer. The bond market appears skeptical of the rally in stocks, with the yield curve firmly inverted from 6-month Treasury bills to the 10-year T-note.

Whatever winds up happening for the remainder of the month, we are inclined to think that much of it will be noise. The financial media these days are full of technical talk – pain trades, short covering, positioning dynamics and other expressions that long-term investors can afford to ignore. Tune out the noise, rest the body and mind, and get ready for an action-packed September.

The second quarter earnings season is winding down, with 435 companies on the S&P 500 having delivered their results as of this morning. If all the moving pieces of corporate financial performance could be boiled down to one simple phrase describing the market’s reaction it would have to be this: Could have been worse. With the twin fears of prolonged inflation and economic downturn as a backdrop, investors and analysts were assuming the worst as company management teams teed up their quarterly earnings calls to share their views on what the coming months are likely to bring.

Sure enough, the general tenor in many of these calls was more downbeat than in recent prior quarters, but not dramatically so. The normal way these things go is that analysts have a consensus expectation for what they think a company’s key numbers will come in at, and companies routinely beat the consensus (called an “upside surprise” or “earnings beat” in Street-speak). Typically, more than 70 percent of companies record earnings beats (which lends itself to some cynicism about how the game is played between companies and the analysts who cover them). This time the beat rate is in about the mid-sixties. While that is below the norm, it still means that more companies reported higher than expected earnings versus those who underperformed. Thus the mantra behind the market’s recent upbeat mood: Could have been worse.

But there is much more to the story than the superficial takeaway headlines that tend to feed into stock market momentum trends. We have a few observations of our own about the good, the bad and the questionable as we sift through the Q2 numbers.

The Top Line

Here’s a bit of good news: sales for S&P 500 companies grew by a brisk 13.6 percent from the second quarter of 2021 to the second quarter of 2022. Double-digit sales growth is generally something investors like to see – it means that whatever Company XYZ is selling, it sold substantially more this year than last year. But there is an important qualification to that bit of good news this year: the sales number, which is normally the top line of a company’s income statement, incorporates inflation.

If Company XYZ makes, say, umbrellas, then its sales consist of the number of umbrellas sold (the volume) times the price of each umbrella. If it sells exactly the same number of umbrellas this year as it sold last year, but is able to raise the price of each umbrella by 10 percent, then its sales have grown by 10 percent in that year. That is exactly what we heard from many management teams on calls this quarter: volumes were slightly higher, flat or down, but price realizations were much higher as they passed inflationary costs onto their customers.

The Middle Lines

As you travel down the income statement you come to the various measures of profitability. EBIT – Earnings Before Interest and Taxes – is a good measure of a company’s operating profitability. This number was also pretty decent for the second quarter: S&P 500 have companies reported EBIT growth of 13.2 percent thus far. Again – double digit growth is normally something to cheer. But let’s think about this for a moment. If sales grew by 13.6 percent and operating profits grew by 13.2 percent, then profits grew less than sales. Not by much, perhaps, but in the language of financial performance it means that operating profit margins (i.e. profits divided by sales) fell. That could mean different things to different companies, but the most likely go-to takeaway is that companies were not able to pass all of their own cost increases (e.g. raw materials, logistics, labor) onto their customers. This will be an extremely important trend to continue following in the months ahead leading to the third quarter reporting season.

The Bottom Line

Finally we come to what many like to call simply The Number: net earnings (usually expressed as earnings per share). Now, as a pure measure of financial performance net earnings is actually a pretty flawed number. All sorts of things that may have little to do with ongoing operations – one-off restructuring costs, legal settlements arising from litigation, adjustments reflecting technical accounting changes – these can all make the “bottom line” look very different from quarter to quarter.

Nevertheless, the buck stops here as they say. For the second quarter, the net earnings growth rate was 6.8 percent for the S&P 500. Again – nothing to sneeze at, but that reflects less than half the growth rate of top line sales. How much of this is related to some of those non-operating expenses and how much represents genuine margin deterioration is unclear at the aggregate level, but again is something that will demand closer attention as the second half of the year proceeds.

The Takeaway: Mixed

What we take away from our observations is that by the standard of corporate financial performance, we have no reason to believe we are in a recession today or likely to be in one soon (if anything, this view is reinforced by the jobs numbers which came out this morning, showing the strongest conditions in the labor market since the months right before the pandemic). Sales are up, companies are making money and staying ahead of what Wall Street analysts expect them to be earning.

In regard to the early evidence this quarter of profit margin deterioration, we should also remember that margins in recent quarters have been at historical highs. In an environment of inflation and slowing growth we shouldn’t be too surprised that they are slipping. As long as the slippage is reasonably contained then we shouldn’t have too much cause to worry, at least for the moment.

But consumer behavior is changing. Higher food and gas prices are forcing households to curb spending in other, more discretionary areas. There is clearly a limit as to how much additional capacity companies have to pass on their own inflationary costs downstream. What that limit is depends on a number of factors – not least of all, of course, on how much more inflation we have in store and how effective the Fed proves to be in bringing it down. Some indicators of long-term inflation have come down recently, notably break-even rates in five and ten year fixed income yields. But the Fed itself has been very clear this week that it still has a long way to go in getting to where it feels comfortable with inflation. More rate hikes are in the works. Meanwhile, we will be paying very close attention to those margin trends.

We have seen this show before, and not too long ago. In early March the state of the world looked pretty bad. Russia had just invaded Ukraine, inflation was showing itself to be anything but transitory, and the Fed was getting ready to raise rates for the first time since 2018 – not by the usual incremental bump of 0.25 percent but by a whopping 0.5 percent. Investors, seemingly, were desperate for anything that could be remotely construed as “good for stocks.” And so, upon the Fed’s rate hike announcement on March 16, a market that had been sputtering along sideways since hitting a year-to-date low on March 8 kicked into high gear. This rally finally petered out on March 29, but not until the S&P 500 had racked up an impressive trough-to-peak gain of 11.1 percent from that March 8 low.

There Must Be a Pony Out Back

No doubt that old FOMO feeling kicked in for many punters during the latter days of that March rally and they put their chips on the table. Unfortunately for them, the subsequent reversal was a brutal fall of 20.1 percent from that March 29 high to the low point for the year so far on June 16. But never fear – if at first you fail miserably, try and try again. Since hitting that low on June 16 stocks have rallied impressively once again, generating a price gain of 11.7 percent to the market close on July 28. The chart below shows the S&P 500 price trend year to date with the March and June-July rallies highlighted.

The vibes this time seem entirely familiar. When investors are burned out from losses they will take anything – any little green shoot real or imaginary – as good news. Good news is good news, unclear news is good news, bad news is good news. If there’s manure under the Christmas tree there must be a pony out back. The Fed met again this week and, as widely expected, raised interest rates by 0.75 percent. Going into the Fed meeting there had been a great deal of chatter in the market about a supposed “Fed pivot.” This is the idea that inflation will come more or less under control sometime between now and the end of the year, thus the Fed will start to slow down the pace of its rate hikes. Then, with growing signs of the economy slowing, the Fed will stop raising rates entirely next year and pivot back to a dovish sequence of rate cuts to encourage growth. The stock market lives and breathes for low interest rates, so this imagined pivot was enough to sustain the post-6/16 rally heading into the meeting this week.

Tune Out the Negative

During the press conference that followed the conclusion of the Fed’s policy meeting on Wednesday, Chair Jay Powell said absolutely nothing about a pivot. In fact he was very clear that the best way to view Fed policy in 2023 would be to stick with the most recent set of Summary Economic Projections that came out a month earlier, after the June meeting. Those projections point to a continuation of rate hikes into 2023 on the assumption that the central bank will still be in the process of bringing down inflation. Powell was also crystal clear about the bank’s not wavering from this singular focus on inflation, regardless of the potential impact on growth. He noted – consistent with the opinion of pretty much every mainstream economist everywhere – that the current unemployment rate of 3.6 percent is highly likely to rise as the economy slows down. But things will be far worse, for far longer, if we can’t get prices under control.

Investors tuned out all of those points. What they focused on, practically to the exclusion of everything else, was Powell saying that at some point, as policy tightens, it would be appropriate to “slow the pace of increases” while they assess how the policy is affecting inflation and the economy. That single comment by itself, and irrespective of everything else Powell said, was enough to power the Nasdaq Composite to a four percent intraday gain.

Less than 24 hours later the report for second quarter GDP came out, and it showed a second straight month of negative real GDP growth (bear in mind that this is only a preliminary estimate and will be revised two more times). That inevitably sparked much chatter about inflation, since two consecutive negative quarters is often used as a thumbnail explanation for a recession (it is not an accurate explanation, however, and neither Powell himself nor most economists nor ourselves think we are actually in one right now). The GDP report, if anything, seemed to add fuel to the bulls. There must be a Fed pivot in there somewhere!

Beware the Greed Trap

Look, we are as pleased as anyone that equities have done as well as they have this month, after such a dismal start to the year. What you heard many times from us during that first half of the year was to beware the “fear trap” – don’t panic and dive for cover, because getting the timing right is diabolically hard and the risk of missing out on growth is significant. Now comes the other side of that warning – don’t fall into the “greed trap.” This is every bit as pernicious as the fear trap – as anyone who tried to play market timer during that eleven percent March rally learned. We believe there are likely to be many more bumps in the road ahead as we work through all the many risks and global uncertainties at play. We’ll take whatever gains we can get from the animal spirits currently at play, but we do not think this is the time to double down on hope and a prayer. Keep positioned for growth, but don’t lose sight of the further downside potential.