Welcome to The Enduring Investor. A newsletter letter focused on investing, finance and economics. I discuss capital markets and share lessons from investing, advising and operating private companies.
If a friend or colleague forwarded this to you, you can easily subscribe by clicking below.
“Financial markets are like, ‘It’s cool, but it’s not cold.’ And the Fed’s like, ‘It’s not even tepid yet.’ They’re speaking different languages, even though they’re both talking about inflation.” - Diane Swonk, chief economist at KPMG US
Conventional wisdom says “don’t fight the Fed.” Yet investor sentiment is different. There’s a growing disconnect between monetary policy and financial markets.
The Fed Funds rate is 4.25-4.5% as of their last meeting in December. This is the highest level since 2007. The Fed is meeting Jan 31 and Feb 1st to decide on further rate hikes. Market has priced in 25 bps hike, but there’s a small chance for a 50 bps rate hike.
The misalignment between Wall Street and Fed is concerning.
Latest labor print shows 3.5% unemployment rate in the U.S., practically max employment. In many regions of the country, it’s in the 2.2-2.9% range (rare sight). With inflation starting to cool - albeit still above Fed’s 2% mandate - Fed’s focus is on labor markets and credit markets.
Low unemployment is good. So, why are we concerned?
Low unemployment creates tighter labor market conditions. This will force the Fed to believe that their efforts aren’t enough… leading to more rate hikes. The Fed will do everything in it’s power to control inflation and is willing to risk a recession for it.
Additionally, this may lead to further price instability. Remember, the Fed has two focus areas:
Price stability (control inflation)
Max employment
It’s a delicate balance. A soft landing is unlikely if labor markets remain this strong.
Core inflation for December ‘22 was 5.71% clearly indicating that real interest rates are still negative.
The tech layoff news we’re all hearing about has minimal impact on broader market. It’s a small sub-sect of a very large ecosystem.
Light at the end of the tunnel?
Yes, but it might take 18-24 months. Here’s what I think will happen first:
Real interest rates need to be positive and remain positive for a steady period of time
Labor market can’t remain this tight as rates rise and wage inflation will cool
Core inflation needs to show a steady pace towards sub-3% range by end of ‘23
Financial markets need alignment with Fed expectations. Otherwise, hard landing will create a surprise drop in asset prices vs something that’s manageable.
Weekend Reading
Earnings insight as of Jan 27, 2023 (long read)
Higher rates will lead to next gen startups (6 min read)