Investors Are Anticipating Goldilocks’ Arrival

The markets are ignoring one of the prime investment rules: Don’t fight the Fed.

Federal Reserve officials say they will have to maintain tight monetary policy considerably longer to bring inflation to the 2% target, even after the historically aggressive rate increases of 2022. Markets seem to disagree, while anticipating what some call a soft landing or a Goldilocks scenario.

Futures markets expect the Fed will stop raising rates soon, and then quickly reduce interest rates and increase liquidity in the second half of 2023.

Supporting the Goldilocks case is that since peaking last June, the 12-month inflation rate declined from almost 9% to less than 6.5%. The markets expect the rapid decline to continue.

Stock prices also reflect optimism that inflation will decline without a recession or meaningful dips in economic growth or corporate earnings. That’s why the markets are fighting the Fed.

I think we’re near a turning point but not the one that investors expect. Inflation will decline but is unlikely to reach the Fed’s target without a hit to earnings and growth.

The labor market remains very tight, and has been supporting retail sales, growth and inflation. While compensation is increasing at a slower rate than a year ago, the increases are too high for inflation to fall to 2%.

But the tight labor market is one of the few remaining supports of growth. The fiscal and monetary stimulus are gone. Many households have spent the savings they accumulated during the pandemic. They also slashed savings rates. At some point, they’re likely to increase savings rates.

Corporate earnings already fell more than is reflected in stock prices. When energy and commodity companies are excluded, corporate earnings declined in 2022. Profit margins also shrank because of higher input prices and reduced revenue.

The falloff in the number of speculative startups is more important than many realize.

When the Fed pumped liquidity into the economy, venture capital investors in turn pumped money into startups without much regard to prospects for profits or even revenue.

The startups signed up for cloud services, online advertising and other services from big, global technology companies. Startup funding has been reduced, producing a follow-on negative effect on the tech giants.

During the pandemic, consumers shifted spending from services to goods. That benefitted a lot of retailers and goods manufacturers.

Since mid-2021, consumer spending has been shifting back to services. That shift is good news for service companies, but bad news for companies that benefited from the previous shift and increased capacity to meet that demand.

In the financial crisis of 2008-2009 and the pandemic recession, most of the economy shrank quickly at about the same time. Neither of those downturns was due to Fed tightening.

We’re in a more traditional cycle in which sectors of the economy respond to Fed tightening at different times. Interest-sensitive sectors such as housing fall first along with speculative and leveraged sectors.

Most recently big layoffs were announced by the major tech companies, and in their earnings reports they made pessimistic statements about the future.

But the services businesses and especially smaller, privately-held businesses still are doing well. That’s where the most jobs have been added over the last six months or so, with big gains in leisure and hospitality.

Investors overlook the typical lags in the effects of monetary policy. Usually, it takes 12 to 18 months after a change in policy for the full economy to show the effects. The Fed became serious about tightening only in May 2022, less than a year ago.

The Fed will keep monetary policy tight until it is confident the inflation genie is back in the bottle. As long as the labor market is strong and other factors support higher prices, the Fed won’t shift to an easy monetary policy.