Home » Powell’s New, New Mandate: Break the Fed Put
Powell’s New, New Mandate: Break the Fed Put
”Changing the inflation target is not something we are thinking about. And it’s not something we are going to think about thinking about under any circumstances. Our inflation target is 2%. Full stop.”
Fed Chairman, Jerome Powell. December 2022.
The stock market (S&P 500 Index) declined -18.3%. At its low during the year, the S&P 500 Index had fallen a sharp -25%. Since World War II, 2022 has been the 4th worst year for the broad stock market. The worst year was back in 2008 during the Great Financial Crisis when the S&P 500 Index fell -37%. The next two worst were 1974 (-26% and 2002 -22%). The results for the typical investor in 2022 were likely worst still as many investors (including Wedgewood) had a meaningful weighting in technology stocks (the NASDAQ Composite was -32% in 2022) and an underweight in the leading (by far) energy sector.
Source: J.P. Morgan Asset Management
We expected a tough year for the stock market as we exited 2021. It really wasn’t a prescient call. Recall that at the end of 2021, market valuations were excessive, corporate margins had feasted on trillion in fiscal and monetary stimulus – and the Federal Reserve was determined to raise rates good and hard. This is how we ended of fourth quarter 2021 Client Letter:
We at Wedgewood expect a very volatile 2022, particularly on the downside – Quantitative Tightening (QT) will see to that. Quantitative Easing (QE) has been the oxygen for financial markets for so long that we suspect that far too many market participants can’t remember a time without such market-steroids.
The graphic below reminds us that when speculation reigns, markets can go far higher than what seems sober. Relatedly, when speculators lose their collective psychology to speculate, then markets will repeat their long history of falling faster and further than what seems sober.
Here is what the same graphic twelve quick months later (Source: Investech).
For far too many years we’ve opined in these Letter’s that the Federal Reserve’s new monetary policy of Quantitative Easing (QE) was an experiment with vast potential unexpected consequences. At the risk of torturing a harsh metaphor, the Federal Reserve’s QE experiment would have made Mary Shelly (she of Frankenstein frame) proud. As with QE, so too with MMT.
The intended benefits of spurring economic growth, as it turns out, were few and far between. The victims of zero-interest policy were middle-class savers, and retirees who “played by the rules” prudently investing their holdings in the highest quality fixed income securities, only to see their interest income evaporate under QE. The outsized benefactors of QE were frenzied financial markets of every stripe, plus hard assets such as real estate, art and a myriad of luxury collectibles (Rolex Daytona’s and Day-Date’s come to mind).
Recall that the Federal Reserve’s balance sheet was “just” $800 billion when Bear Stearns collapsed in 2008. The Fed’s balance would then soar to $4.5 trillion by 2015. During the Pandemic it would explode to $9 trillion.
On the fiscal stimulus front, the policy of Modern Monetary Theory (MMT), whereby governments with a fiat currency system can print trillions in digital dollars may be much more of a topic of discussion in 2023. U.S. debt has reached $30 trillion. 45% of our debt must be refinanced over the next three years. According to Strategas, the average coupon to be rolled over is just 1.67%. Interest rates may decline significantly from current levels if Powell & Co. can get inflation to be sticky at 2%. If not, almost $14 trillion in U.S. federal debt will need to be rolled over at rates double and triple the miniscule rate of 1.67%. The size of this headwind is unknown, we’ve never been here before. It may rival the liquidity shrinkage on QT.
2022 was the beginning of a very different economic environment whereby leverage will be taken out of every nook and cranny of the economy. Powell & Co. with their enormous blunt toolkit, is steadfast in their desire to bring inflation back down to 2% – come bear market and recession hell or unemployment high water.
2023 will answer the elephant-in-the-room question: Will the largest financial and hard asset bubbles in U.S. history, injected with steroid 0% interest rates, plus $120 billion per month of Q.E. not either soft-land or hand-land when the post-addicted withdrawal of 5% interest rates and -$90 billion per month of QT fully courses through the circulatory system of the U.S. economy?
An added risk, in our view, is the unstated goal by Jerome Powell in particular, to kill the “Fed Put.” Market participants who expect the Fed to quickly pivot to resume QE after they slay inflation may be in for a rude awakening. Slaying inflation AND killing the “Fed Put” means tighter for longer.
Powell & Co. seem determined to quell any meaningful stock market rally. The last thing the Fed wants is a sharp increase in the wealth effect from the stock market to quash the Fed’s carved in stone playbook to achieve their “2%” inflation” target. The New, New narrative transfixing Wall Street is so-called “Quantitative Pivoting,” whereby the instant QT is over, the Fed will pivot back to QE. In an ironic twist, the long-held maxim, “Don’t Fight the Fed” has become, “The Fed Fights Wall Street.”
Both stock and bond markets are completely hooked on the Fed – particularly the stock market. Risk-on or Risk-off – we’ve seen it on our quote screens all year long – and it continues as we type this Letter. In fact, we believe it’s not whether Powell & Co. engineer, a soft or hard landing – it’s now all about an “soft or hard pivot.” Regarding the stock market, trying to predict the next “soft or hard” Fed Pivot has almost become an investment strategy in and of itself, and it’s a terrible trap, in our view.
Source: Doubleline
The pace of tightening has been among the sharpest in decades. Time will tell if the Fed can engineer a Goldilocks soft landing, but the Fed has slammed on the monetary breaks about as hard as they ever have – four consecutive hikes in the Fed Funds Rate of 75 basis points is unprecedented.
Source: Piper Sandler
Recall too that while our Federal Reserve has been aggressively tightening for seven months (with one or two smaller hikes to come), but global short rates have been going up precipitously for two years, thanks to the tightening efforts by the European Central Bank, Bank of Japan and Bank of England. While the Fed’s balance sheet was reduced by relatively tiny -$206 billion (2.4%) in 2022 – the first annual decline since Powell’s first QT in 2018. If QT continues at the current pace of -$95 billion/month, such a reduction will be a significant headwind decline of -$1.14 trillion (13.3%) in 2023.
Source : Doubleline
In addition, according to the San Francisco Fed, the impact of Powell & Co.’s QT of $90 billion per month, they calculate that they effective Fed Funds Rate isn’t 4.25%-4.50%, but over 6%. All of this tightening has slammed the yield curve into inversion. Historically a poor omen for near future recession risk, albeit with significant lag times measured in many months – and note, an even worse as a timing indicator for stocks.
Source: Investech
Such historic tightening has crushed money supply growth to levels, again, for future economic risk.
All of this tightening has started to bite in the manufacturing sector. We’ve chronicled the weakness of various leading economic indicators (Conference Board and various manufacturing PMIs). Even the most recent ISM Services Sector PMI has now fallen into deep contractionary levels last seen during the height of the Pandemic in 2020 – its third largest drop ever.
The upshot of the ever-growing list of leading economic indicators flashing red recessionary risks has been slow in accumulating, but, in Wall Street parlance, is not “new news.” Contrarily, finding an economist that that hasn’t already forecast the “2023 Recession” is a tall order.
We continue to be concerned – what we worry about most – in 2023 is a soft or hard landing in corporate earnings. The U.S. consumer has thus far been resilient in their spending. Even though post-Pandemic spending has slowed, it remains positive. Given that the U.S. consumer has long represented about 70% of GDP, even if the manufacturing sector falls into a mild recession, as it did in 2015-2016 and 2019, the U.S. may keep the greater U.S. economy out of one. That said, any type of recessionary risk means significant risk for corporate profits. That is our continued worry.
We have considerable reason to be worried. Earning in 2022 were weak enough on much weaker peak-2021 margins, but higher cost of capital still needs to filter through the economy in 2023. Indeed, consensus estimates for 2023 haven’t been cut much at all. That’s not too surprising. Wall Street analyst are typically of the optimistic sort, yet according to FactSet, earnings estimates have been cut -6.5% in the fourth quarter – a considerable decline from the +31% growth in the same quarter last year. Lastly, as we have chronicled in past Letters, corporate margins boomed in 2021, declined some last year. We suspect that margin pressure will continue to come under pressure for most of 2023.
Source: J.P. Morgan asset Management
Source: FactSet Research
As we enter 2023, Powell & Co. and his inflation warriors are getting what they want: The financial markets have been crushed, financial speculation has all but vanished (crypto, SPACs, IPOs), a bevy of leading economic indicators are pointing to a weaker economy, most inflation measure long peaked back in 2020 (some, not all), yet the Fed still faces quite the conundrum.
Source: Investech
The U.S. labor market porridge remains too hot. To get such porridge “just right” the Fed may keep rates higher for longer – and an added benefit to killing the “Fed Put” once and for all.
2002 was all about the “P” in P/E multiples. Sharply higher interest rates crushed valuations. We suspect that 2023 will be about the “E.” Similar to our message during the bear market last year, we will continue to be patient and let the market serve up bargains.
January 2023
David A. Rolfe, CFA Chief Investment Officer
Michael X. Quigley, CFA Senior Portfolio Manager
Christopher T. Jersan, CFA Portfolio Manager
The information and statistical data contained herein have been obtained from sources, which we believe to be reliable, but in no way are warranted by us to accuracy or completeness. We do not undertake to advise you as to any change in figures or our views. This is not a solicitation of any order to buy or sell. We, our affiliates and any officer, director or stockholder or any member of their families, may have a position in and may from time to time purchase or sell any of the above mentioned or related securities. Past results are no guarantee of future results.
This report includes candid statements and observations regarding investment strategies, individual securities, and economic and market conditions; however, there is no guarantee that these statements, opinions or forecasts will prove to be correct. These comments may also include the expression of opinions that are speculative in nature and should not be relied on as statements of fact.
Wedgewood Partners is committed to communicating with our investment partners as candidly as possible because we believe our investors benefit from understanding our investment philosophy, investment process, stock selection methodology and investor temperament. Our views and opinions include “forward-looking statements” which may or may not be accurate over the long term. Forward-looking statements can be identified by words like “believe,” “think,” “expect,” “anticipate,” or similar expressions. You should not place undue reliance on forward-looking statements, which are current as of the date of this report. We disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events or otherwise. While we believe we have a reasonable basis for our appraisals and we have confidence in our opinions, actual results may differ materially from those we anticipate.
The information provided in this material should not be considered a recommendation to buy, sell or hold any particular security.
Powell’s New, New Mandate: Break the Fed Put
The stock market (S&P 500 Index) declined -18.3%. At its low during the year, the S&P 500 Index had fallen a sharp -25%. Since World War II, 2022 has been the 4th worst year for the broad stock market. The worst year was back in 2008 during the Great Financial Crisis when the S&P 500 Index fell -37%. The next two worst were 1974 (-26% and 2002 -22%). The results for the typical investor in 2022 were likely worst still as many investors (including Wedgewood) had a meaningful weighting in technology stocks (the NASDAQ Composite was -32% in 2022) and an underweight in the leading (by far) energy sector.
We expected a tough year for the stock market as we exited 2021. It really wasn’t a prescient call. Recall that at the end of 2021, market valuations were excessive, corporate margins had feasted on trillion in fiscal and monetary stimulus – and the Federal Reserve was determined to raise rates good and hard. This is how we ended of fourth quarter 2021 Client Letter:
Here is what the same graphic twelve quick months later (Source: Investech).
For far too many years we’ve opined in these Letter’s that the Federal Reserve’s new monetary policy of Quantitative Easing (QE) was an experiment with vast potential unexpected consequences. At the risk of torturing a harsh metaphor, the Federal Reserve’s QE experiment would have made Mary Shelly (she of Frankenstein frame) proud. As with QE, so too with MMT.
The intended benefits of spurring economic growth, as it turns out, were few and far between. The victims of zero-interest policy were middle-class savers, and retirees who “played by the rules” prudently investing their holdings in the highest quality fixed income securities, only to see their interest income evaporate under QE. The outsized benefactors of QE were frenzied financial markets of every stripe, plus hard assets such as real estate, art and a myriad of luxury collectibles (Rolex Daytona’s and Day-Date’s come to mind).
Recall that the Federal Reserve’s balance sheet was “just” $800 billion when Bear Stearns collapsed in 2008. The Fed’s balance would then soar to $4.5 trillion by 2015. During the Pandemic it would explode to $9 trillion.
On the fiscal stimulus front, the policy of Modern Monetary Theory (MMT), whereby governments with a fiat currency system can print trillions in digital dollars may be much more of a topic of discussion in 2023. U.S. debt has reached $30 trillion. 45% of our debt must be refinanced over the next three years. According to Strategas, the average coupon to be rolled over is just 1.67%. Interest rates may decline significantly from current levels if Powell & Co. can get inflation to be sticky at 2%. If not, almost $14 trillion in U.S. federal debt will need to be rolled over at rates double and triple the miniscule rate of 1.67%. The size of this headwind is unknown, we’ve never been here before. It may rival the liquidity shrinkage on QT.
2022 was the beginning of a very different economic environment whereby leverage will be taken out of every nook and cranny of the economy. Powell & Co. with their enormous blunt toolkit, is steadfast in their desire to bring inflation back down to 2% – come bear market and recession hell or unemployment high water.
2023 will answer the elephant-in-the-room question: Will the largest financial and hard asset bubbles in U.S. history, injected with steroid 0% interest rates, plus $120 billion per month of Q.E. not either soft-land or hand-land when the post-addicted withdrawal of 5% interest rates and -$90 billion per month of QT fully courses through the circulatory system of the U.S. economy?
An added risk, in our view, is the unstated goal by Jerome Powell in particular, to kill the “Fed Put.” Market participants who expect the Fed to quickly pivot to resume QE after they slay inflation may be in for a rude awakening. Slaying inflation AND killing the “Fed Put” means tighter for longer.
Powell & Co. seem determined to quell any meaningful stock market rally. The last thing the Fed wants is a sharp increase in the wealth effect from the stock market to quash the Fed’s carved in stone playbook to achieve their “2%” inflation” target. The New, New narrative transfixing Wall Street is so-called “Quantitative Pivoting,” whereby the instant QT is over, the Fed will pivot back to QE. In an ironic twist, the long-held maxim, “Don’t Fight the Fed” has become, “The Fed Fights Wall Street.”
Both stock and bond markets are completely hooked on the Fed – particularly the stock market. Risk-on or Risk-off – we’ve seen it on our quote screens all year long – and it continues as we type this Letter. In fact, we believe it’s not whether Powell & Co. engineer, a soft or hard landing – it’s now all about an “soft or hard pivot.” Regarding the stock market, trying to predict the next “soft or hard” Fed Pivot has almost become an investment strategy in and of itself, and it’s a terrible trap, in our view.
The pace of tightening has been among the sharpest in decades. Time will tell if the Fed can engineer a Goldilocks soft landing, but the Fed has slammed on the monetary breaks about as hard as they ever have – four consecutive hikes in the Fed Funds Rate of 75 basis points is unprecedented.
Recall too that while our Federal Reserve has been aggressively tightening for seven months (with one or two smaller hikes to come), but global short rates have been going up precipitously for two years, thanks to the tightening efforts by the European Central Bank, Bank of Japan and Bank of England. While the Fed’s balance sheet was reduced by relatively tiny -$206 billion (2.4%) in 2022 – the first annual decline since Powell’s first QT in 2018. If QT continues at the current pace of -$95 billion/month, such a reduction will be a significant headwind decline of -$1.14 trillion (13.3%) in 2023.
In addition, according to the San Francisco Fed, the impact of Powell & Co.’s QT of $90 billion per month, they calculate that they effective Fed Funds Rate isn’t 4.25%-4.50%, but over 6%. All of this tightening has slammed the yield curve into inversion. Historically a poor omen for near future recession risk, albeit with significant lag times measured in many months – and note, an even worse as a timing indicator for stocks.
Such historic tightening has crushed money supply growth to levels, again, for future economic risk.
All of this tightening has started to bite in the manufacturing sector. We’ve chronicled the weakness of various leading economic indicators (Conference Board and various manufacturing PMIs). Even the most recent ISM Services Sector PMI has now fallen into deep contractionary levels last seen during the height of the Pandemic in 2020 – its third largest drop ever.
The upshot of the ever-growing list of leading economic indicators flashing red recessionary risks has been slow in accumulating, but, in Wall Street parlance, is not “new news.” Contrarily, finding an economist that that hasn’t already forecast the “2023 Recession” is a tall order.
We continue to be concerned – what we worry about most – in 2023 is a soft or hard landing in corporate earnings. The U.S. consumer has thus far been resilient in their spending. Even though post-Pandemic spending has slowed, it remains positive. Given that the U.S. consumer has long represented about 70% of GDP, even if the manufacturing sector falls into a mild recession, as it did in 2015-2016 and 2019, the U.S. may keep the greater U.S. economy out of one. That said, any type of recessionary risk means significant risk for corporate profits. That is our continued worry.
We have considerable reason to be worried. Earning in 2022 were weak enough on much weaker peak-2021 margins, but higher cost of capital still needs to filter through the economy in 2023. Indeed, consensus estimates for 2023 haven’t been cut much at all. That’s not too surprising. Wall Street analyst are typically of the optimistic sort, yet according to FactSet, earnings estimates have been cut -6.5% in the fourth quarter – a considerable decline from the +31% growth in the same quarter last year. Lastly, as we have chronicled in past Letters, corporate margins boomed in 2021, declined some last year. We suspect that margin pressure will continue to come under pressure for most of 2023.
As we enter 2023, Powell & Co. and his inflation warriors are getting what they want: The financial markets have been crushed, financial speculation has all but vanished (crypto, SPACs, IPOs), a bevy of leading economic indicators are pointing to a weaker economy, most inflation measure long peaked back in 2020 (some, not all), yet the Fed still faces quite the conundrum.
The U.S. labor market porridge remains too hot. To get such porridge “just right” the Fed may keep rates higher for longer – and an added benefit to killing the “Fed Put” once and for all.
2002 was all about the “P” in P/E multiples. Sharply higher interest rates crushed valuations. We suspect that 2023 will be about the “E.” Similar to our message during the bear market last year, we will continue to be patient and let the market serve up bargains.
January 2023
David A. Rolfe, CFA
Chief Investment Officer
Michael X. Quigley, CFA
Senior Portfolio Manager
Christopher T. Jersan, CFA
Portfolio Manager
The information and statistical data contained herein have been obtained from sources, which we believe to be reliable, but in no way are warranted by us to accuracy or completeness. We do not undertake to advise you as to any change in figures or our views. This is not a solicitation of any order to buy or sell. We, our affiliates and any officer, director or stockholder or any member of their families, may have a position in and may from time to time purchase or sell any of the above mentioned or related securities. Past results are no guarantee of future results.
This report includes candid statements and observations regarding investment strategies, individual securities, and economic and market conditions; however, there is no guarantee that these statements, opinions or forecasts will prove to be correct. These comments may also include the expression of opinions that are speculative in nature and should not be relied on as statements of fact.
Wedgewood Partners is committed to communicating with our investment partners as candidly as possible because we believe our investors benefit from understanding our investment philosophy, investment process, stock selection methodology and investor temperament. Our views and opinions include “forward-looking statements” which may or may not be accurate over the long term. Forward-looking statements can be identified by words like “believe,” “think,” “expect,” “anticipate,” or similar expressions. You should not place undue reliance on forward-looking statements, which are current as of the date of this report. We disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events or otherwise. While we believe we have a reasonable basis for our appraisals and we have confidence in our opinions, actual results may differ materially from those we anticipate.
The information provided in this material should not be considered a recommendation to buy, sell or hold any particular security.