Powell Curveball Sparks Market Sell-Off: May. 4, 2023

Articles From: IBKR Macroeconomics
Website: IBKR Macroeconomics

By:

Interactive Brokers’ Senior Economist

Federal Reserve Chairman Jerome Powell sought to dash investors’ hopes for fed funds rate cuts in the coming months yesterday, but his emphasis on persistent inflation fell on deaf ears with markets continuing to anticipate lower interest rates later this year. The growing gap between Powell and investors could set the stage for a volatile couple of weeks if this coming Friday’s employment data and next Wednesday’s Consumer Price Index (CPI) are hotter than expected and cause investors to rethink their rate cut expectations and slash equity valuations accordingly. In another sign of the Fed’s commitment to achieving price stability, Powell focused on fighting inflation rather than tweaking monetary policy to help minimize the growing regional bank debacle. Inflation fears, furthermore, aren’t limited to the U.S., with the European Central Bank having just expressed concerns about persistent price increases and hiking its key interest rate 25 basis points (bps).

Powell Maintains His Discipline On Inflation

After the Fed announced an expected 25-bp hike yesterday that brings the fed funds target rate to a range of 5%-5.25%, Powell said the central banks’ Federal Open Market Committee may be open to pausing future increases if inflation cooperates, but committee members believe inflation won’t come down quickly and has potential to surge upward if monetary policy is loosened prematurely. Powell noted that when the Fed’s messaging has tilted to a less hawkish stance during the past 12 months or so, financial conditions loosened, helping to reignite price increases. In such an environment, cutting rates isn’t appropriate. Additionally, the committee expressed strong support for the rate increase with all members voting in favor of the change.

During a corporate earnings season in which many companies are reporting strong consumer spending on dining out, traveling and other forms of entertainment, Powell said persistent inflation in the non-housing services sector and a tight labor market were concerning and emphasized that the Fed will continue to observe additional data to assess if the current level of restrictive monetary policy is appropriate. Powell also said it’s too soon to fully understand the impact of banking failures on credit availability.

Markets are responding negatively on the fourth day of May, looking to lose value for the fourth consecutive day. All major indexes are down with the cyclically tilted Dow Industrial and Russell 2000 Indexes down roughly 1% and 2% respectively. Bond yields are cratering led by the short-end, as investors bet that the Fed’s tight monetary policy will cause a recession. The dollar is roughly unchanged as fears of a global slowdown are propelling the greenback. WTI crude oil is roughly unchanged after making a new year-to-date low overnight, touching $63.64 per barrel.

The River of Denial Runs Deep

Despite Powell’s warnings of persistent inflation, the Fed futures market is pricing in a 4.2% fed funds rate by late December, illustrating the sizeable gap in expectations among investors and the central bank. At a time when banking instability appears to be increasing, corporate earnings growth is weakening and recession fears are mounting, investors’ strong denial of the Fed’s inflation concerns could face additional, and potentially painful, reality checks with the U.S. jobs report scheduled to be released tomorrow and the Consumer Price Index release schedule for this coming Wednesday. If the data is hotter than expected, investors may finally align monetary policy expectations with the Fed. Moreover, corporate earnings reports, including Paramount’s first-quarter results, validate Powell’s concerns regarding strong demand for non-housing services, while also illustrating that businesses are cutting back on advertising and other expenses.

Powell’s hawkish stance comes as share prices for Western Alliance, Metropolitan Bank and PacWest have experienced sizeable declines as bank runs could cause the financial institutions to sell held to maturity securities at a loss. These banks have reported that deposit outflows have stabilized, but they are navigating a hazardous landscape, including having exposure to commercial mortgage debt while businesses are cutting back on expenses and work from home arrangements are curtailing demand of office space. Commercial building owners are also facing higher premiums for purchasing rate caps that mortgage issuers often required when providing floating-rate financing. The concerns follow Silicon Valley Bank, Signature Bank and First Republic Bank collapsing after getting hit by heavy redemptions.

Investors Cling to Earnings Growth Expectations

As businesses scale back on growth initiatives such as advertising and Fed comments make rate cuts this year appear unlikely, investors appear to be dismissing the potential for higher financing costs and slowing economic growth to hurt corporate earnings. Meanwhile, the forward 12-month P/E ratio for the S&P 500 is 18.1, which is substantial considering the high level of interest rates across the yield curve alongside recession risk. As investors continue to anticipate rate cuts and fail to downgrade earnings expectations despite a potential recession, a tight labor market and hotter-than-expected employment and CPI data could have a multiprong impact on equity valuations. On one hand, acceptance of the potential for higher fed funds rates for longer-than-anticipated increases the likelihood for recession, which could cause investors to downgrade their earnings outlook. Secondly, the higher financing costs associated with a longer-than-anticipated period of higher fed funds rates could further crimp corporate profits and stymie growth initiatives.

The Labor Crunch

There are currently 1.6 open jobs for every unemployed working-age individual in the U.S.  Powell said labor wage pressures aren’t a major driver of inflation, but examples illustrate that a labor shortage is crimping supply, which in turn is allowing strong demand to support price gains.  In Minnesota, Daikin Applied Americas Inc. is struggling to keep up with demand for its climate control equipment, largely because it can’t find workers. It’s resorted to novel recruitment efforts, including visiting women’s shelters, reaching out to immigrant support groups and accepting applicants without high school degrees or manufacturing experience.

Earnings Results Validate Services Sector Inflation Concerns

First-quarter earnings continue to show that consumers are splurging on entertainment, travel and dining out while in some instances, businesses are cutting back on advertising and other expenses. This strong consumer demand is likely to support ongoing inflation in the non-housing services sector and has been illustrated by the following examples.

  • Paramount, which provides streaming TV, traditional linear TV and theater movies posted adjusted diluted earnings per share (EPS) of $0.09 compared to $0.60 in the year ago quarter and below the consensus expectation of $0.14. Its revenues also declined from $7.33 billion in the year-ago quarter to $7.27 billion and missed the consensus expectation of $7.43 billion. Consumers can’t be blamed for the weak showing. Indeed, revenues for the company’s direct-to-consumer channel, which includes streaming services, grew 39% year-over-year (y/y), driven primarily by subscription growth, with advertising revenue increasing only 15% as part of a secular trend of companies increasingly using digital marketing. It’s television advertising, however, declined 11% y/y, driven by weakness in global advertising and few NFL games on Paramount’s CBS channel. Theater revenues declined 6% y/y, largely due to some of the company’s major releases occurring on the last day of the quarter. The company’s earnings suffered from spending on growth initiatives, including its direct-to-consumer channel.
  • Cedar Fair Entertainment, which operates entertainment parks in California, posted an EPS loss of $2.61, missing the expectation for positive EPS of $1.90. Its revenues of $84.55 million missed expectations of $104.77 million. Cedar Fair attributes the weak showing to rainy weather deterring park visits during the quarter, but it reports favorable spending among its visitors, with per capita spending increasing to $64.47, up 10% from the year-ago quarter, driven, in part, by the company increasing its prices. The company anticipates strong consumer spending during the remainder of this year.

Apple’s earnings are critical this afternoon, as its large share of customers and mega-cap market size have an out-sized influence on the market. Tomorrow’s jobs report is likely to come in hot following ADP’s blow-out number, pushing investors to align their expectations closer to the Fed’s. Finally, the weekend will be influential as well, with the potential of the FDIC taking a few other regional banks into receivership, further denting investor sentiment and propelling volatility.

As look we look to the end of the week, the calendar is not short of fireworks. Apple’s earnings are critical this afternoon, as its large share of customers and mega-cap market size have an out-sized influence on the market. Tomorrow’s jobs report is likely to come in hot following ADP’s blow-out number, pushing investors to align their expectations closer to the Fed’s. Finally, the weekend will be influential as well, with the potential of the FDIC taking a few other regional banks into receivership, further denting investor sentiment and propelling volatility.

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