Central Banks Ponder, Markets Act

Last Week’s Major Stories

Who is Right, Small Businesses or Equity Investors?

Stocks are up thanks to a solid economy benefiting from massive fiscal spending projects. There has been $2 trillion in government funding allocated to the Infrastructure Investment and Jobs Act for roads and bridges, the Inflation Reduction Act for domestic energy production and manufacturing, and the CHIPS and Science Act to build domestic supply chains and onshore semiconductor research and manufacturing. Meanwhile, the National Federation of Independent Businesses (NFIB) March survey reflected that small businesses have a less optimistic outlook than during the pandemic, hitting a 12-year low. Hiring plans are the lowest since the pandemic despite a general view among investors and economists that the labor market is solid. Small businesses borrowed money last month at 9.8%, the highest level since 2007, as the equity markets peaked right before the 2008 recession.

These dire results contradict equity indices at record highs. This is especially confusing as small businesses’ earnings outlook and capital expenditure plans are not improving. Is it possible that small businesses are not seeing that benefit? Or is it possible that when speculation is rife, investors ignore warning signs such as those from the NFIB, rising inflation, and the potential of another war breaking out in the Middle East? From our perspective, negatives are ignored during such periods…until they aren’t.

BoJ and ECB Fiddling About

Central bankers around the world are waiting; markets are not. The big three central banks in Europe, Japan, and the U.S. want more inflation data before acting, while investors globally are moving fast and bidding up commodity prices, especially in the major crude and gold markets. Meanwhile, the Japanese Yen is at a 44-year low, driven lower by a significant interest rate gap between the U.S. and Japan, as resilient U.S. economic growth attracts international capital flows. Japan’s central bank, the Bank of Japan (BoJ), created the weak Yen problem by waiting too long to raise rates out of fear of reversing a fragile economic recovery. When they did raise rates last month, they hesitated to say whether they would raise rates again, and the Yen weakened again. Rapid yen weakness can be destabilizing, and it pushed BoJ Governor Ueda last week to suggest a follow-up rate hike could come as early as July or October due to increasing wage inflation. The market is frustrated that the BoJ is not being more aggressive and could raise rates when they publish new quarterly growth and inflation forecasts at their next meeting on April 26.

The BoJ is in a bind because the government just downgraded its assessment of the economy for the first time since Feb 2019 based on back-to-back declines in its Coincident Index. This downgrade makes the Policy Board (Japan’s FOMC) hesitant to hike for fear of creating a recession. The European Central Bank (ECB) is also worried about a recession, with economic growth forecast at only 0.6% for 2024, and that may force a rate cut without evidence of lower inflation. Both Japan and Europe are facing the possibility of a lose-lose situation. If they both act, investors may remember the last time the BoJ raised rates a second (and final) time in 2007, marking the top in the Nikkei stock index, and if Europe cuts, a weaker Euro could discourage near-term investment on the Continent. If they don’t act, the Yen is at risk of falling fast against the backdrop of an impending European recession. The small reversals we are seeing in the equity markets recently could be that stock investors are beginning to consider these dilemmas.

CPI with a Cape

This year, three months of higher-than-expected Consumer Price Index (CPI) core inflation changed investors’ views about how often the Federal Reserve will cut rates. Their current concern is based on the central bank’s favored inflation measure called “supercore” inflation. The Fed typically looks at core inflation, excluding volatile food and energy prices, because demand for those items is not affected by the Fed's changing interest rates. ? While manufacturers’ ability to ?produce again without supply chain constraints has driven goods inflation below the Fed’s 2% inflation target, overall inflation measures remain above target due to services inflation. American consumers are comfortably employed and continue to pay up for the rising costs of services. That has led the Fed to focus on core services inflation and additionally exclude housing because they believe shelter and rent inflation is temporarily elevated. Federal Open Market Committee (FOMC) voters believe supercore inflation is the most accurate representation of inflation.

The problem is that supercore inflation is, true to its name, up in the sky. That measure rose 4.8% in March, and calculating inflation’s momentum by taking the last three months of data and annualizing it, yields an 8% inflation level. Investors began the year expecting six rate cuts, but after this data, they anticipate fewer than two, moving below the Fed’s 2024 forecast of three rate cuts for the first time this year. The March Personal Consumption Expenditure (PCE) inflation data is scheduled for release on Friday, April 26, and may not be as high as CPI because some items that boosted CPI in March are not weighted as high in the PCE calculation. The Fed looks at both CPI and PCE but favors PCE due to its lower housing inflation weighting of 20% versus 40% in CPI. The PCE data could create a big market move since it is published two trading days before the May 1 FOMC statement and press conference. There is no expectation for a rate cut at the May meeting, but if PCE inflation also runs above expectations, investors will continue to reduce their view on Fed rate hikes, which will weigh on stock prices.

This Week’s Developing Storylines

1. Powell Alert: On April 16, at 1:15 pm E.S.T, Bank of Canada (BoC) Governor Tiff Macklem, head of the Governing Council (Canada’s FOMC) was scheduled to speak alone about ?“Economic Trends in North America.” Powell ended up inserting himself into the program. This is important because April 16 is the last day before the two-week blackout period starts, where FOMC voters cannot speak to the press. Given that the latest CPI data came in hotter than expected, he either wants to repeat his conviction that inflation is on a downward path or soften that stance as a preview to the April 30-May 1 FOMC meeting. It will be a market moving event.
2. April 17 marks the release of the Beige Book, the business survey that is compiled by each of the regional Federal Reserve Banks. The FOMC will consider the economic data during its April 30-May 1 meeting. This will be of particular interest because a few weeks ago, the ?Atlanta Fed President Raphael Bostic wrote that one group of Atlanta business leaders said they “were ready to pounce” at the first hint of a rate cut. We will see if that was the general assessment in this report. If so, the chances of a rate cut will be pushed out even further, disappointing equity investors.
3. On April 18, two major homebuilders, DR Horton and KB Home, report earnings. Netflix comes out the same day, but we are more interested in these two companies for what they have to say about the strength of first-time home purchasers and the general environment for housing with such poor affordability conditions.