Daniel Malinovski
August 3, 2023
Macro Monday

The Fed's Dilemma and an Inflationary Market Outlook

The Federal Reserve has continuously found itself in a challenging position as it faces the task of managing high inflation while also dealing with the consequences of aggressive interest rate hikes. In this update, we will examine the recent developments in the Fed's policies, the impact on banks, the looming debt ceiling issue, and the potential market implications.

Undeniably, the Federal Reserve has displayed exceptional proficiency in managing the ongoing economic crisis, effectively averting any catastrophic domino effects or systemic collapses. While we must acknowledge that the possibility of future economic tailwinds and a deflationary spiral, along with potential banking crises, cannot be entirely dismissed, it is important to recognize and commend the Fed for its adept handling of the current economic landscape. The Federal Reserve's skilful manoeuvring in navigating the complexities of the present economic situation warrants our appreciation and recognition.

The Fed's primary goal is to maintain inflation around 2%, but the past year has seen inflation soaring well above this target, reaching a peak of 9.1% in the US. Consequently, the Fed responded with unprecedented interest rate hikes, reducing inflation to 4.9%. However, this level remains significantly higher than the desired target, putting the Fed in a difficult position.

Over the past 15 years, banks and financial institutions have become accustomed to low-interest rates and easy access to cheap money. The rapid rate hikes have created problems for banks as they hold a significant amount of low-yielding loans, mortgages, and bonds on their balance sheets. With higher rates, the value of these assets has decreased substantially, leading to estimated paper losses of at least $1.7 trillion. Consequently, many banks have experienced major liquidity issues, causing customer concerns and withdrawals. Some banks, such as Silvergate Bank, Silicon Valley Bank, Signature Bank, Credit Suisse, and First Republic Bank, have already collapsed, necessitating intervention from the FDIC.

In contrast, recent banking sector news includes that the bank earnings season that has passed in the last two weeks has shown positive results, with Bank of America reporting a 19% year-over-year profit increase. Net interest income growth has been a key driver of profits for banks, contributing to the positive momentum. However, attention is being paid to how banks are preparing for a potential economic downturn, as evidenced by Bank of America's increased net charge-offs and reserves for soured loans.

While the market has experienced a shift in sentiment, with smaller companies and meme stocks rallying, concerns remain about market breadth. The economy's performance and inflation trends will play a crucial role in determining whether investors continue to focus on mega-cap tech stocks or diversify into other sectors.

The Federal Reserve faces a challenging dilemma as it seeks to balance high inflation and the consequences of aggressive interest rate hikes. The impact on banks may further complicate the situation, although so far it has added only positive fuel to the burning fire of increasing stock prices. Investors should continue to closely monitor the Fed's decisions and market developments, as these factors will shape the future trajectory of the economy and investment opportunities.

On Inflation

Inflation, once a fierce adversary, is now experiencing a notable decline. The consumer price index has seen a modest rise of just 3% in June compared to the previous year, marking its smallest increase since March 2021. Over the past 12 months, inflation has receded by a significant 6.1 percentage points, which represents the largest decline since the deflationary times of 2009. This substantial drop in the rate of CPI, from over 9% to 6.1 percentage points, has yet to be witnessed since May 1952 when the index plummeted by 7.4 points to 1.9%.

Let us reflect on the magnitude of this accomplishment. While it is true that overall inflation figures remain unacceptably high, it is essential to focus on the direction rather than the level. With inflation trending downward, the stock market is poised for an upward trajectory. It's a straightforward principle that investors should heed, and it is a significant factor behind the remarkable surge in the market throughout 2023.

The upward momentum of the stock market may persist. Notably, the finished goods component of the producer price index, which dates back to the late 1940s, experienced a substantial decline of 3.1%, creating a record-breaking 6.1 percentage point gap with the CPI in June. This divergence suggests that profit margins are holding up or that consumer inflation will pose less of a concern.

Consequently, a record disparity of this nature has historically been an opportune time to invest in stocks. Past occurrences of such a gap have resulted in the S&P 500 averaging a 3.6% gain over the subsequent three months and a remarkable 19% rise over the following year. These instances often coincide with the tail end of a recession or the early stages of an expansion, and they have been accompanied by above-average equity returns.

As investors, it remains crucial to carefully observe the direction of inflation, which will provide valuable insights into the future prospects of the stock market. Admittedly we must acknowledge the decline in inflation rates and position ourselves to seize the opportunities that lie ahead. It is in these moments that astute investors recognize the potential for long-term growth.



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