Is the Fed Now in its Final Act?
Probably, but long-term inflation isn't licked yet.
Last week brought the best news on inflation we’ve seen in quite a while.
The Labor Department reported the June Consumer Price Index increased at its slowest year-over-year pace since 2021, less than one-third the rate of a year ago. Inflation pressure tapered off even more on the wholesale level with the June Producer Price Index. And on Friday, government numbers actually showed a -0.2 percent decrease in the overall price of imports.
Depending on what benchmark you use, year-over-year inflation is now running around 3 percent. That’s still well above the Federal Reserve’s target of 2 percent. And inflation in some places remains quite elevated, for example yearly apartment rent increases are still running close to 6 percent.
But from a big picture perspective, the most radical tightening since the 1980s is working. What once appeared to be out of control inflation is now at seemingly manageable levels. And investor hopes are soaring that the Fed is nearly finished raising interest rates this time around.
Based on statements from policymakers and Fed Funds futures prices, the consensus expectation is we’ll still see at least one more increase this year, and probably two. The next now appears likely to happen at the Open Market Committee’s July 25-26 meeting, with a quarter-point boost to a new range of 5.25 and 5.5 percent.
But barring some unforeseen development—and significant geopolitical events can never be ruled out—it looks like Fed Funds is going to peak at less than 6 percent this cycle. That doesn’t mean interest rates are going lower this year. But it does set the stage for cuts next year, which the central bank has often done in advance of presidential elections.
All else equal, a lower cost of debt capital—i.e. lower interest rates—is positive for economic growth. And by extension, it’s bullish for corporate earnings and stock prices.
In this case, however, it’s important to keep a couple of caveats in mind.
First, the big stock averages have already been running this year. Fueled primarily by gains in the largest technology stocks, the S&P 500 is ahead 18.3 percent year to date including dividends paid. The Nasdaq 100, which this handful of stocks dominates even more thoroughly, is up 42.8 percent. And both major indexes and related ETFs can set new all-time highs with further gains of less than 8 percent.
That’s extraordinary, considering the shellacking both indexes took in 2022. But it also means the stock market’s most popular performance gauge—and the model on which many strategies benchmark—the S&P 500 is historically top heavy. In fact, just four sectors--Software, Internet, Computers and Semiconductors—are 36.9 percent of the Index. And a single stock Apple Inc (NSDQ: AAPL) is roughly 7.5 percent.
Moreover, a share of Apple will now cost you 32.4 times trailing 12 months’ earnings. The last time it was this expensive was at the beginning of 2022, just before it lost more than a quarter of its value.
Elliott Gue notes in his “The Free Market Speculator” posts—also on Substack—that market technicals are still generally positive for Big Tech stocks. And as the Fed winds down its current policy, some investors will be tempted to take it as an “all clear” to buy, which would likely extend upside momentum further still.
Nonetheless, these stocks and by extension S&P 500 ETFs are as expensive as they were before their most recent big decline. That’s a sure sign the pending end of Fed rate increases is priced in. Moreover, anything other than a soft landing for the economy is a serious risk at this point to knock a major hole into their prices.
Best in class non-tech companies aren’t nearly as exposed to big declines, mainly because they haven’t really participated in this year’s rally. But when the leaders take big hits, very few stocks and sectors have historically escaped wholly unscathed. And that means investors need to exercise caution even with best in class income stocks, while keeping a healthy amount of cash on hand.
Second, current Fed policy has done nothing to quell the longer-term forces that ignited recent inflation. In fact, by raising the cost of debt capital, they’ve intentionally put the brakes on investment, and by doing so have arguably worsened the gaps between supply and demand in key sectors where price increases were most acute last year.
That certainly includes energy, whether you’re talking about investment in oil and gas production or in the metals needed for renewable energy to replace fossil fuels. It also includes housing, though repurposing collapsing commercial real estate could ease space pressures over time.
Fed tightening also did nothing to combat the long-term inflation embedded by political decisions to redirect supply chains away from China to higher cost countries. In fact, higher interest rates have undeniably made it more expensive to build new facilities needed to do so.
The Fed will have its moment of victory over inflation. But these and other underlying pressures mean it’s only a matter of time before it will have to act again.
For some historical perspective, Fed Funds was effectively zero in the late 1950s just as it was in 2021. Then came the long-term secular inflation of the 1960s and 70s, which was fueled by forces beyond the central bank’s control. Those included the rising cost of America’s deepening involvement in the Vietnam War.
Successive Fed tightening in the early 1960s, late 60s, early 70s and the Volcker era brought down immediate headline inflation. But price increases always returned stronger than ever until investment revived to right the underlying supply/demand imbalances fueling them—with the US leading the way under the investment friendly policies of the Reagan Administration.
Sufficient investment is how real underlying inflation will be brought under control this time. But until it does, income investors especially will need to stick with strategies that preserve and grow principal. That includes owning a few beneficiaries like energy and natural resource producers.