Working On a Soft Landing

Markets continue to stumble as we roll towards the end of April. The S&P 500 has now posted three straight weeks of losses and the Dow four. Equities are finding progress difficult against a backdrop of sharply rising interest rates. Inflation is not letting up, and the Fed is ramping up its fight on multiple fronts. Bonds are simply playing catch up to this reality. For equities to make a stand, we need progress on a soft landing. It is a tall order for the Fed to rein in inflation without driving the economy into recession but still possible. 

Consumer prices increased 8.5% year-over-year in the month of March. Gains were broad-based but continued to be driven by a surge in food and energy prices. With war raging on, it is difficult to see these pressures easing anytime soon. Also of concern was a 4.4% increase in rents. Rising housing costs have the propensity to drive a wage/price spiral if left unchecked. Inflation continues to build in the pipeline as well. Producer prices increased 11.2% in the month of March and shows few signs of abating. 

In response, the Fed has dramatically stepped up their rhetoric against inflation. Committee members appear to be on board with at least 50 bps hikes at their next two meetings and several more increases thereafter. Ultimately, the Federal Funds rate could land above 3%, a level not seen in over a decade. Getting there too fast presents a major challenge for the trajectory of the economy, however. Consumers do their borrowing largely on the front end of the curve and could soon be hit with much higher interest rates on their auto, credit card, and personal loans. This comes just as pandemic savings are starting to run dry. Credit utilization is approaching pre-pandemic levels, and notable banks are starting to raise their loan-loss reserves.

To spread the burden of fighting inflation, the Fed is also starting to unwind the massive balance sheet it has built up post-covid. The Fed plans to trim 60 billion in treasuries and 35 billion in mortgage-backed securities from the balance sheet a month going forward. With some of this product longer in maturity, the Fed can ideally massage the yield curve enough to avoid inversion.

Still, for all the inflationary pressure and the plight of the Fed, company fundamentals seem to be holding up remarkably well. We are just a week into the Q1 earnings season, but results have been decent so far. Sales for those that have reported in the S&P 500 have surprised to the upside by 1.1%, and earnings have surprised to the upside by 7.2%. What stands out is the ability for many companies to pass through price increases without consumers balking. Procter and Gamble specifically noted that volumes had declined much less than anticipated in response to higher prices. P&G is not alone. Railroads, consumer products companies, and several others are successfully pushing through price increases to offset inflationary pressures. There is obviously a limit to this in terms of sustainability, but for now, consumers appear to have a cushion. 

The question remains whether the Fed can get a handle on inflation before consumers are broken. Consumers are showing resilience in the face of pressure, but they can only do so much. Supply chains are still out of whack because of war and covid. The West is moving on from covid, but China is not. A key piece of the supply chain remains broken and must be fixed for a soft landing to come together. War also continues to distort commodity prices, and resolution on that front would help with a soft landing as well. These are difficult items for the wish list. As such, we remain cautious and weighted towards equities that are domestic, essential, energy immune, and that have pricing power. 

Thanks, 
Preston May, CBE®
Research Analyst