"In The FED We Trust"

For months I have been publishing article after article pointing to the problems underpinning the US economy. Whether it is declining full-time unemployment , weakening consumer demand, higher consumer debt , sticky inflation, or simply the outperformance of the Magnificent 7 (Mag 7)… it would appear the rooster is coming home to roost as this month the markets reversed direction. In my last email I said “when the market rallies it takes the escalator up but when it falls it takes the elevator down”. April, and even today, appeared to be the start of an elevator down.

But why now?

Was the market overzealous? Maybe the FOMO of 2023’s Mag 7 led investors in Q4 and Q1 to pile into things that were overvalued? Could it have been the perceived FED pivot to cutting rates last November?

Whatever the answer, the net result is fairly straightforward… the equity markets are overvalued. Plain and simple. With the market cap weighted S&P 500 hovering around 20x 2024 projected earnings and the equal cap weighted S&P 500 hovering around 18x 2024 projected earnings… valuations across multiple sectors are stretched. If a reversion to the 10 YR average were to take place then the market cap weighted multiple would need to fall to around 17.5 and the equal cap weight multiple would need to fall to around 15. If this were to happen we could see almost a 20% decline in stock prices from current levels.

But wait there’s more…

The aforementioned earnings projections are based on earnings nearly doubling in Q4 from where they are trending in Q1 . If earnings falter at all – or if inflation continues to run higher and consumer spending continues to struggle – the aforementioned multiples could be impacted even more.

This brings us to what I am calling “The Great Debate”. The debate centers on the dual mandate of the Federal Reserve: maintain maximum unemployment or push for an inflation target of 2%. In today’s environment they are diametrically opposed.

The Great Debate

For the last two years the Federal Reserve has been working to fight inflation in a meaningful way. Arguably it has succeeded as inflation has declined from a peak around 9% to where it resides today at 3.5% (April CPI). Unfortunately, as the FED has expressed multiple times, the longer inflation remains above the 2% target the more engrained (and acceptable) higher input prices become. This can be seen in a number of industries, but none more prevalent than in food, insurance, and gas prices. Higher input prices lead to higher output prices which in turn leads to less money to be spent on discretionary goods/services.

As inflation remains sticky, or even edges higher, the input costs to other areas of the economy dramatically affects the majority of the economy (as defined by those households making less than $100k per year). Effects are felt through average daily spending (i.e. spending $200 a week on groceries that three years ago cost $125 – $150 a week). In order for the FED to have any impact on these areas (which arguably is very difficult as they are not discretionary items) the FED needs to slow growth which in turn means the FED needs to slow spending. However, to slow spending the FED needs to reduce the amount of money people can spend.

There is only one way to slow growth… take money out of the hands of corporations and consumers. The way they do this is by raising borrowing and financing costs to a point that people cannot afford to divert their money toward discretionary items. When companies cannot afford to borrow for expansion, or consumers cannot afford to borrow for home and car purchases, then the economy slows. Essentially, the FED needs to remove discretionary cash flow from the economy. Unfortunately they cannot specifically target an item or sector which means mandatory expenses are also impacted by increased borrowing costs.

To accomplish a slow down in the economy interest rates need to remain high enough for long enough that businesses begin to prioritize capital expenditures differently. For example, if labor costs are typically the largest part of a business’s capital expense structure then electing to lay people off could result in enough of an economic slow down that inflation moves closer to the FED’s 2% target.

Hence the diametrically opposed mandates! To lower inflation the FED may need to force a recession as a means to slow the economy. As noted in a prior letter, preceding each of the prior recessions was a jump in unemployment!

This inherently becomes the sticking point. If the FED keeps rates higher for longer, or even raises them again, then businesses will be forced to layoff more people. With the current NFIB data forecasting small business hiring to be at a multi year low , AND cash flow being sucked out of profits with higher operating costs, it is only a matter of time before full-time employees are laid off in larger quantities.

Unfortunately, as more full (and part) time employees are laid off the higher the unemployment rate becomes. As noted in a prior letter, the 30 year average for unemployment (between 1990 and 2020) was a little more than 5% . This means the FED can let unemployment drift higher without causing systemic problems… or so we are led to believe.

Historically speaking, when the unemployment rate begins to rapidly climb the FED’s maximum employment mandate is no longer achievable. This kicks off a cycle of interest rate cutting as a measure to stimulate the economy thus helping small businesses reduce borrowing costs which in turn allows them to higher more people with their excess capital.

It is important to note, during this rollercoaster ride a recession usually ensues. The DotCom crash led to a mild recession while the Great Financial Crisis nearly avoided a depression. In both cases the US equity markets were down greater than 35% – cumulatively.

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