Fed Raises Key Rate by 75 bps as Expected While Earnings Track the Economy

FOMC Raises Fed Funds Rate by 75 bps 

As was broadly expected, the Federal Reserve’s Open Market Committee announced Wednesday that they voted unanimously to raise the Fed Funds Rate by 75 bps to curb inflation. The Fed’s press release noted that elevated inflation is reflecting supply/demand imbalances, broader price pressures, and higher food and energy prices. They also noted softening economic activity, but unemployment remains low with robust job gains. The Fed Funds Target Rate is now 2.25-2.50%. Fed Chair Powell indicated they are close to the neutral rate currently with a goal to get the Fed Funds Rate to 3.25%-3.5%. 

In their subsequent press conference, Fed Chair Powell noted that ongoing rate hikes will be appropriate. The pace and magnitude of those increases will depend on the incoming data – particularly economic growth and the labor market. The Fed has moved expeditiously to get to a neutral rate and will watch closely the impacts of its actions “before deciding when to slow down.” Consumer spending, the housing sector and likely business investments all declined in the second quarter. Yet, the labor market remains robust with over 11 million job openings, a 3.6% unemployment rate and historically low initial claims. Inflation remains well above the Fed’s 2% goal and the Fed will continue moving expeditiously until inflation comes down. Markets rallied on the “data dependent” news and the fact that we may have experienced the peak size of rate hikes. Expectations are for a 50-bps increase in September, but again, all eyes will be on the incoming economic data over the next 8 weeks, until the next Fed meeting. 

Consumer Demand Preferences Apparent in Earnings 

As of this writing, roughly 25% of the S&P 500 has reported Q2 earnings. Revenues are on track for 9.8% y/y growth, while earnings are on track to expand 9.3% y/y. While certain companies have reported strong consumer spending – particularly in travel and leisure services – many companies have reported a slowdown in consumer demand for discretionary goods, shifting toward services and essentials. Price actions have allowed many companies to expand margins, passing along higher costs, but we’re seeing signs of that price action hurting consumers and destroying pockets of demand. 

Economic indicators are confirming this demand destruction. Services PMI came in at 47%, dipping below 50% for the first time since the pandemic began, signaling a contraction in market conditions. Rising mortgage rates continue to weigh on housing demand as new home sales fell -8.1% m/m in June. In tandem with a decline in housing, Restoration Hardware (RH) recently lowered its guidance for 2022 revenue to -2% to -5% and lowered operating margin guidance to between 21% and 22%. 

A slowdown in economic activity can be tied to a slowdown in earnings growth, but aggregate S&P 500 earnings have been revised downward just -2% since peak expectations in June. Real GDP is still projected to rise 0.8% q/q in Q2, according to FactSet, while EPS is projected to rise 7.3% sequentially – both better than Q1. We receive the preliminary Q2 GDP report this Thursday, July 28^th. 

Chart 1: Real GDP Growth and Earnings Growth, Including Q2 Estimates¹ 

Commercial, Secular Trends Drive Growth as Consumers Budget Their Spending 

As inflation continues to impact company bottom lines – from labor to freight to materials – consumers are less willing to absorb these costs in end-product pricing. AT&T (T) cited a delay in payment collections from their consumer base and McDonald’s (MCD) cited customers trading down, substituting combo meals for value menu items. Walmart (WMT) shared in their press release that they are “now anticipating more pressure on general merchandise in the back half.” This also follows Walmart reporting a 33% increase in inventories back in May as retailers struggled to anticipate the shifts in consumer behavior. Further, UPS (UPS) reported residential volumes down -8.2%, but 65% of their largest business clients increased volumes. 3M (MMM) reported revenue growth in every segment besides its consumer products. Similarly, Texas Instruments (TXN) saw strength in auto and industrial markets, but weaker demand for its consumer products. And Microsoft (MSFT) reported a slowdown in videogames, but provided a strong outlook based on strong IT and commercial demand. 

Companies with diverse business operations, particularly those further from the consumer, may have more protection in a slowing consumer demand economy. We’re following secular themes like energy security, which is supporting investments in traditional oil and gas, but also alternative energy and energy efficiency solutions that can lower costs and contribute to net-zero carbon objectives. Onshoring has increased demand due to the supply bottlenecks and reliance on Asia for many input materials. A bipartisan bill to boost U.S. chip production has passed in the U.S. Senate, with a number of manufacturers committed to investing in U.S. production plants. Redwood Materials this week announced a $3.5 billion investment in a battery-materials plant in Nevada that will support U.S. electric vehicle production.² General Electric (GE) benefitted broadly from these trends to build greater capacity: Its aviation revenues increased +47% y/y, driven by volumes, while their power equipment revenues rose +18% y/y and renewable energy equipment orders increased +19% y/y. 

Many businesses are benefitting from the underlying, secular need for greater efficiency, capacity and upgrading technology. The consumer, which represents nearly 70% of the U.S. economy, drove growth for the past two years, but policy has shifted, and inflation costs have pinched consumers’ capacity for continued spending growth. Strong consumer demand remains for some of the last re-opening beneficiaries, like international travel as noted by Visa (V) and American Express (AXP), but overall demand is waning. 

Companies with technological differentiators and inelastic demand can be better protected from a consumer slowdown compared to more cyclical names. Health care and insurance providers are examples of businesses with more inelastic demand as elective procedures steadily increase, U.S. employment remains strong, and both pharmaceutical prices and insurance premiums rise. UnitedHealth Group (UNH) reported seeing preventative care and annual wellness visits among Medicare patients returning to pre-pandemic levels. 

As consumers and businesses, alike, tighten their belts and look to trim costs, the market has favored secular trends and defensive businesses. Consumer-cyclical companies that have sold-off, but maintain long-term secular growth opportunities, strong management and healthy balance sheets, may offer attractive buying opportunities for long-term investors. 

Risks That are Priced-in vs. Remaining Uncertainties 

The Fed has communicated that the pace of future rate hikes will depend on incoming data, though currently, “inflation is much too high” and “ongoing increases in the target range […] will be appropriate.” Multiples have compressed, but they can still compress further. We’re learning more and more from companies about the health of the consumer – healthy savings levels, but increasingly cutting expenditures. And the geopolitical environment remains contentious: Energy security is a major risk in Europe, China stimulus policy is trying to reignite a struggling economy with liquidity risks and uncertain lockdown measures, and the strong U.S. dollar and inflation are diminishing purchase power and access to essential goods across emerging markets – resulting in protests and distressed government debt. 

The combination of priced-in Fed action, a majority of companies reporting better-than-expected, and a still healthy consumer with $2 trillion excess savings, low unemployment and rising wages has led the S&P 500 higher +6% to start the second half of 2022. Risks and opportunities both exist in the market, and we’re staying focused on Fed policy – measuring its impact on inflation, consumer demand and employment. Earnings are continuing in full-force, and we learn more every day. 

Stephanie Link: CNBC TV Schedule 

Sources

1. FactSet (chart)
2. Wall Street Journal

Disclosures

Investment Solutions at Hightower Advisors is a team of investment professionals registered with Hightower Securities, LLC, member FINRA/SIPC, & Hightower Advisors, LLC a registered investment advisor with the SEC. All securities are offered through Hightower Securities, LLC and advisory services are offered through Hightower Advisors, LLC. This is not an offer to buy or sell securities. No investment process is free of risk and there is no guarantee that the investment process described herein will be profitable. Investors may lose all of their investments. Past performance is not indicative of current or future performance and is not a guarantee. In preparing these materials, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public and internal sources; as such, neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Hightower shall not in any way be liable for claims and make no expressed or implied representations or warranties as to their accuracy or completeness or for statements or errors contained in or omissions from them. This document was created for informational purposes only; the opinions expressed are solely those of the author, and do not represent those of Hightower Advisors, LLC or any of its affiliates.