"Because the soul of this nation is strong, because the backbone of this nation is strong, because the people of this nation are strong, the state of the union is strong." - President Biden
All eyes were on Capitol Hill yesterday, the first Tuesday in February, as Joe Biden delivered his third State of the Union address to the Nation. Earlier in the day, however, all eyes were also on Washington, DC, where Fed Chair Jerome Powell and Carlyle Group Founder David Rubenstein discussed the state of the American economic and monetary landscape. Rates and FX traders watched the two talk live, eagerly awaiting any possible guidance on the future of monetary policy. The two-year Treasury yield momentarily dipped from 4.45% to 4.40% during the meeting, only to rebound back to 4.45% by the day’s end. The equities market similarly whipsawed, with the Nasdaq rising, falling, and ultimately rising yet again to close the day at session highs. I found this troubling, as I thought that Chair Powell and Minneapolis Fed President Neel Kashkari were both clear yesterday in their remarks: restrictive monetary policy is not going anywhere anytime soon. There are likely at least two more 25bps hikes ahead, claims Kashkari, who sees Fed Funds going to 5.4% later this year and remaining there through the remainder of the year. Though the Fed’s famous dot plot forecast is often inaccurate, I think the market would do well to heed the warnings of Powell and Kashkari.
Anyone who doubts the Fed’s continued hawkishness should remember that the Fed has learned from the mistakes it made in 1975, when it prematurely cut rates, leading to another debilitating bout of stagflation that sent asset prices and the economy spiraling. Though commodity prices have fallen significantly from their highs last year, core inflation remains entrenched. You do not need a PhD in economics to recognize this. Just take a trip to the market or try renting an apartment and you will instantly recognize that inflation has not moderated to the extent needed for the Fed to cut rates. The January jobs report was, as CNBC reported, “stunningly good,” with nonfarm payrolls increasing an insane 517k in a single month, lowering the unemployment rate to 3.4%. For context, that is the lowest unemployment rate since 1969, the year of Woodstock and RFK’s assassination. President Biden yesterday declared the state of our Union as "strong." Today I declare the state of our labor market, somewhat surprisingly, "strong."
Though the odds of a so-called “soft-landing” may be substantially higher than previously anticipated, I remain hesitant of investing in the equities market and see a continuation of many of last year’s trends this year, the most notable of which being negative returns in both the debt and equities markets. As I wrote on GrasshopperFinancial.com in July, I see the equities markets trapped between an inflationary rock and a recessionary hard place. I maintain entrenched in the camp that believes further economic growth, a robust economy, and earnings beats will be accompanied by still higher rates and persistent inflation. I think it will prove wildly difficult to eradicate core inflation without something, namely the financial markets or the real economy, breaking.
As always, I may be wrong. The ideal soft landing may manifest, with earnings and GDP up but inflation down. That is possible, especially if commodity prices remain low and the war in Ukraine settles down. For now, though, Putin keeps rattling his nuclear sabers, Dunkins near me are offering $19 an hour, and rents keep rising. Chair Powell stressed in his meeting with Rubenstein that the Fed’s long-run 2% PCE inflation target remains non-negotiable; that is, the central bank will not tolerate a 3% long-run inflation rate. Powell also said that he expects 2023 to be a year of significant disinflation, a bullish and perhaps overly optimistic base case, as I see it.
Putting the pieces together reveals that the bond yields imply even lower inflation rates than the Fed calls for in its optimistic outlook. A more cautious bond market would lead to lower valuations for stocks and a further tightening of conditions. With the Fed put gone, one thing remains inarguably true: this is a stockpicker’s market. Those who buy good inflation-proof businesses at fair valuations will outperform those who buy unprofitable and high-flying tech companies. I remain, for the time being and alongside my advisors, bearish on both the stock and bond market. At 4.9%, the one-year Treasury looks a lot more attractive than Apple at 26x earnings.
For more on rates, stocks, and politics:
2023 SOTU Transcript ,per the NYT
Michael Burry, per Markets Insider
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