Andrew Pyle
September 22, 2023
The Fed is out of the Equation.
Typically, we would have published a blog following the Federal Reserve FOMC meeting, which concluded this past Wednesday; but I held off. This wasn’t just because the decision to leave rates unchanged was the consensus of market participants, nor that the language in the accompanying statement pointed to the possibility of at least one more rate hike starting with its November meeting was also largely baked into market expectations. No, I felt it better to deal with the meeting and Fed policy direction, in general, in today’s commentary as it’s meetings for the remainder of this year are largely irrelevant.
That is a fairly loaded statement I admit, however, if you step back and look at what J. Powell and crew are doing or about to do, their actions pale compared to more recent developments. What the Fed has done since 2022 (raising rates 5.25% since March of that year) is already in the pipeline. It is either not having the anticipated effect of creating a slowdown or recession in 2023, or we just haven’t seen the worst emanating from that pipeline. Regardless, whether the Fed is done tightening or is going to throw us one or two more rate hikes, what is done is done. Ally and I still expect that the full impact on business and consumer demand from higher borrowing costs is going to show up as we move into 2024. What is more important today is the layering of incremental economic challenges that could magnify the pressures that the Fed has sent down the pipe.
Let’s start with labour. There is no disputing the fact that employment in North America has held up better than what would normally be expected under the brunt of significantly higher interest rates. Some of this can be tied to the imbalance in labour supply and demand as a result of the pandemic and the fact that employers have been reticent to let go of workers for fear of not being able to replace them later. Thursday’s jobless claims report was another jolt for those thinking that conditions were only going to weaken, as initial claims fell to just above 200,000 – the lowest since January. Claims have, in fact, been trending lower since June and this has been one of the indicators thrown up as evidence that the U.S. economy is not only going to avert a recession and achieve a soft-landing, but may simply avoid a landing altogether.
While it is clear that the labour market remains tight and this is going to keep the unemployment rate lower for longer, this same tightness is going to reinforce the other dynamic that we are witnessing this year and that is the resurgence of union pressures for equalization. After a week of strike action by the United Auto Workers (UAW) union against one plant for each of the Big-3 automakers, there was a lot of anticipation coming into today’s announcement by the UAW. What we know at the time of the writing is that the union is going to target all GM and Stellantis parts plants in the USA. Both companies also announced layoffs this week as a result of the strike action so far. For now, the strike has not been expanded against Ford, which suggests there has been progress in talks between it and the UAW. Whether that is enough to get us closer to a resolution is unclear.
Any secured wage increases and ancillary benefits arising from an agreement will not be lost on other union and non-union workers in the U.S., but the more immediate concern is that strike activity could create a domino effect across related industries. This week, Ford Canada reached a deal with Canada’s autoworker union, Unifor. This averted a potential strike, but if we end up with protracted labour disruptions south of the border, this could still impact activity here. The broader the impact, the less likely we will see tight labour conditions persist and, again, this doesn’t factor in lagged effects from the Fed’s tightening program. Higher unemployment would compound the pressures on household budgets from the increase in borrowing costs, resulting in more defensive spending plans into the holiday season.
There is another headwind to household spending and that is the bounce back in energy prices. West Texas Intermediate (WTI) crude futures came close to testing US$95/barrel this week, while Brent futures crossed this level. From the intraday lows of around $65 back in March, we are now up close to 40%. Many expected a recovery into the summer because of the increased demand for gasoline, and we saw prices move back into the $80-100 range, but the move in September has been pretty spectacular.
In my segment on BNN Bloomberg this past Monday , I commented that oil may have overtaken the Fed as the next major focus of the market and I still believe that, at least over the near-term. At the core of the soft or no landing scenario, to which so many more analysts’ boats have moored to, was ever-continuing disinflation force that would allow the Fed to pull rates back from these lofty levels. Consumers, seeing disinflation around them, would lower their expectations for future inflation, giving the central bank even more leeway to normalize rates. That scenario has become a little tougher in light of where energy prices have gone, but I would argue that this isn’t really an inflation issue.
Higher energy prices, like higher borrowing costs, will have the effect of constraining household spending on discretionary goods and services. We are picking up some of the initial influence from energy prices in consumer confidence. Among the various items that are analyzed in the University of Michigan Consumer Sentiment survey, one of them is the question of how people feel about things five years down the road. As the below chart shows, this sub-component of the survey fell sharply in the initial September report to the lowest since September 2021. This may also be picking up on central bank rhetoric that interest rates may have to stay higher for longer, but I think it is reflective of the fact that gasoline and diesel prices are once again climbing.
For now, I’m going to leave out other potential headwinds like a U.S. government shutdown and geopolitical tensions. If the edges of the recent soft-landing view become frayed by current developments, then businesses are likely to alter their own guidance for revenues and earnings – just at the time when the street was anticipating a profit rebound. A few weeks back, we discussed the September-October period and how it has often been associated with higher volatility and weakness in equities. This is why Ally and I have maintained a defensive posture.
This week, the S&P500 fell below its August low and came within a point of its intraday low on June 26th. I mused back in that commentary that the major indices might even reverse all of the good work done through the third quarter and end in the red. Well, that’s where we are today and if we don’t see a rebound, this would be the first quarterly decline in the S&P since, well, last September. Remember that in 2022, we had three straight quarterly declines in the market and that was the first time since 2008-09. Since then, retracements have lasted a quarter and that includes the beginning of the pandemic. The TSX only had a two-quarter pullback in 2022, but we did see a three-quarter decline in 2015.
Against the headwinds we are facing today, a one-quarter setback for either the Canadian or U.S. market would be a good result. While it is unlikely that we see a full retracement to the lows seen last fall (a view I held on to into the Spring of this year), it is quite probable that stock valuations will decline further. Once a more realistic economic scenario is priced in, then we can go looking for opportunities.
On behalf of the Pyle Group, have a wonderful weekend.
Andrew Pyle
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Andrew Pyle is an Investment Advisor with CIBC Wood Gundy in Peterborough. The views of Andrew Pyle do not necessarily reflect those of CIBC World Markets Inc.