Will the Fed 'Break Something?' Plus, Airline Outlook

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What are the Fed's chances of navigating this just perfectly?

Well, I think they're way under 50%. I'm not sure if it's 35, 38, 40, not zero. There are voices, as you know, that are saying, you know, it's game over at zero and there's no way in hell that the Fed is going to have a soft landing under these circumstances. I'm not there at all.

Hello and welcome to the Barron Streetwise Podcast. I'm Jack Howe, and the voice you just heard is former Federal Reserve Vice Chair Alan Blinder. He has a new book out on the history of U.S. monetary policy, and he says the Fed's job today of bringing down inflation without breaking the economy isn't nearly as impossible as many investors say. We'll hear that case in a moment and say a few words on fears surrounding UK pension losses and struggling Credit Suisse. We'll also turn our attention from macro to micro and third quarter earnings reports, why one analyst says the much maligned Airline industry might be better positioned than it appears. Listening in is our audio producer, Meta. Hi, Meta.

Hi, Jack.

What do you say we start with a listener question? Do we have anyone?

We do. We've got Tim Curtin. He's a senior at Endicott College.

Endicott College, lovely coastal Massachusetts. Go Gulls. That's not what gulls sound like. Meta, you know, Endicott College is right next door to Salem, Massachusetts, which says that its name is synonymous with Halloween, and I've got to tell you, that really candies my corn.

I'm not sure I know what that even means.

You see, Salem is known, of course, for the witch trials in the 17th century, but I live in the north of Westchester County, New York, not far from Sleepy Hollow, which is the setting for early American novelist Washington Irving's story about a headless horseman. Sleepy Hollow understandably views itself as a bit of a Halloween headquarters too, but it's always overshadowed by those snooty Salemers with their witch museums and trolley tours and half-million seasonal visitors. And maybe we don't have most or any of that stuff, And it's true that they're not transforming the old Philipsburg Manor this year into Horseman's Hollow, but there's still the great jack-o'-lantern blaze and the haunted hayride and circus performers reenacting the Headless Horseman story. That's right, Salem, we've got circus performers.

Yeah, that's candy in your corn.

It's really carving my pumpkin. But Tim at Endicott College didn't ask to step into this heated Halloween controversy. He probably just has a question about investing. Let's hear it, Tim. I keep hearing that the Fed is going to continue to raise rates until something breaks. What impact do you think this will have on the stock market for the rest of 2022? Great question, Tim. Like you, I've been seeing and hearing that phrase everywhere.

We know that every time that the Fed hikes, something breaks.

They're going to push it until something breaks.

The thing that everyone is aware of when you start quantitative tightening things break.

It's unclear what exactly these things are that the Fed is said to be breaking. If we're talking about the stock and bond markets, then sure, both have taken a beating from rising interest rates this year. But both are at fairly ordinary valuations based on long-term averages for things like price-to-earnings ratios and yields. The bottom has not fallen out, in other words. It's just that the starting point for prices was high. If by something breaking we mean some sort of financial collapse that infects broader markets, the two candidates that seem to be getting the most mention are Credit Suisse and UK pensions. These are long and not especially exciting stories, but let me see if I can turn them into short and not especially exciting ones. Credit Suisse has suffered a share price collapse and trading in derivatives markets that imply financial distress. And some investors are drawing comparisons with a period before Lehman Brothers collapsed. But analysts say Credit Suisse has a comfortable capital position for now. Its main problem seems to be a long history of not being a particularly profitable investment bank. It could sell its riskiest operations and stick with safer asset management and be much more popular with investors. And it might. But it also might have to raise capital to pull off that transformation. We'll see. And UK pensions are taking losses on leveraged derivatives amid a spike in government bond yield, which sounds complicated, but what it really boils down to is the age-old problem of pension managers not sticking enough cash in boring, safe investments to fund short-term pension liabilities and instead using financial engineering to pretend they have enough boring stuff while buying riskier stuff. And the engineering has broken down. So they'll probably have to take losses and put up cash and reform their investing practices. But UK bond yields at last glance don't quite suggest chaos or panic. So again, we'll see. And if I notice anything else breaking, I'll let you know. But isn't there anyone who thinks the Fed might not raise rates until something breaks? Here's someone.

They are getting criticism. For going so fast. I think this is more than ironic because they were previously getting tons of criticism, deserved by the way, for starting so slow.

That's Alan Blinder. He's an economist, Princeton professor, and writer who served as vice chairman of the Federal Reserve during the mid-1990s. And he calls the current pace of rate hikes appropriate.

It seems to me if you agree with the criticism that you got started too late and you're behind the curve in inflation, inflation is way too high, you want to get up to a higher interest rate quickly, much more quickly than the Fed normally does. That does raise the question of how far, and can you take it too far? And you can, but I'm not worried about that yet.

As you heard at the beginning of this episode, Alan puts the odds of a so-called soft landing for the Fed at well below 50%, but also well above zero. Maybe a percentage in the 30s, give or take.

It will take a lot of skill and some good luck. For example, a piece of good luck that they'll need is that this latest OPEC agreement not really cut back oil production that much and not drive up oil prices that much.

So we'll need a bit of luck. But what makes Alan more hopeful than those "something's about to break" people? One thing is a careful study of history. Alan has a new book out called A Monetary and Fiscal History of the United States, 1961 to 2021. And one of the episodes he recounts in the book is, of course, former Fed Chair Paul Volcker's fight against high inflation starting in the late 1970s. I was 7 years old at the time, and as I described it in a recent Barron's column, he raised rates so aggressively that I almost Benjamin Buttoned back to 6. Bond prices plunged. The jump in UK government bond yields I mentioned a few minutes ago involved 30-year issues hitting 5% yields. But starting in the late 1970s, the 30-year US Treasury yield went from 10% to 15% in under 2 years. Housing and car demand got hit hard. Unemployment rates for builders and auto factory workers went on to top 20%. But inflation was brought under control, and after 3 years of on-and-off recession, the US enjoyed 8 years of uninterrupted growth. 2 things are very different now. First, the job that current Fed Chair Jerome Powell is facing isn't as difficult as the one that faced Paul Volcker. Here's Alan.

A misreading of history is that Paul Volcker brought inflation down from 13% to 3% or something like that. A proper reading of history, and this is recounted in some detail in my book, is that he brought core inflation, that's without food and energy, because after all, the Fed can't do much about those, down from about 10% to about 4%. That's still a big achievement. It's 6 percentage points. Jay Powell doesn't have to bring the inflation rate down by 6 percentage points. He has to bring it down by about 2 percentage points, and the end of the food and oil shocks and the dissipation of the supply bottlenecks will do the rest. That's a job, but nothing like what Paul Volcker had.

Alan points out that many investors track inflation using the Consumer Price Index. A fresh reading there this past week puts prices up 8.2% over the year through September, which is obviously a lot. But the Fed tracks a different measure called the Core Personal Consumption Expenditures Price Index, which ignores food and energy prices because those are volatile and not necessarily under the Fed's control. You might agree or disagree with the Fed's reasoning on that, but the latest core PCE reading is much lower than CPI, 4.9% during the year through August. That's why Alan says The Fed only has to bring inflation down by a couple of points and that market forces will do the rest, with some luck in the form of OPEC not cutting oil production as much as feared. The other reason that today doesn't entirely resemble the Volcker era is that starting economic conditions are better. Here's Alan.

When people talk about that, they often forget that this episode started with an unemployment rate of about 3.5%, about 500,000 jobs per month being created. You can come down from those numbers quite a bit. Well, up on the unemployment, down on the job creation without causing a tremendous amount of economic hardship. There's always some, and Powell has said there's going to be some pain. But, you know, to put a spuriously accurate number on that, If we never get above 4.5% unemployment in this episode, I'm not saying that'll happen, but if that happens, I think we'll look back on it and say it was a pretty soft landing.

Thanks, Alan. And for Tim from Endicott University, I have tried to answer a question about whether something big might break, but that wasn't quite your question. Your question was, what effect will the possibility of something breaking have on the stock market for the rest of 2022? And that one is much easier, at least for me. I don't know. I've never seen a reliable way to accurately predict the short-term direction or magnitude of stock market movements, and I'm pretty sure there isn't one. That's one reason that stocks do so well over long time periods. You get rewarded for the risk you take over short time periods. If you want me to guess, even though I can't possibly guess accurately, I'll guess that stocks are going up, but just know that I always guess that because stocks rise more often than they fall. If you plan to spend your money by the end of this year, you shouldn't put it in stocks. Keep it in cash. If you're asking because you want to know whether it's a good time to buy and you plan to hold for decades, then yes, I think it's a good time to buy, and on that one I'm more confident. And if you plan to keep buying over your career, then, I recommend that you buy now and quietly hope that everything falls and stays low so that you can keep buying cheaply. Just don't celebrate out loud because us older savers are likely to be cranky about the declines. But so long as we're reasonably diversified and in stocks for the long run and not doing any liability masquerading like those pension advisors, we should do fine too. And now I am Macro'd out. Let's talk micro company earnings and airlines. That's next after this quick break.

Data is everywhere. When orchestrated properly, it sings. At Morningstar, we analyze and enrich data, making it actionable and powerful for you. Morningstar, where data speaks.

Welcome back. Enough about inflation now and central banks and currency swings. I want to hear about how Nerf blasters are selling and Big Macs and house paint and pickup trucks and gas turbines and credit card accounts, even cigarettes and missiles, and especially those big fancy machines that etch the silicon wafers that make the chips that power the computers that From what I hear, not many of us are buying right now. And I'll learn about all of that and more over the next 3 weeks when the bulk of big US companies report quarterly earnings, which will be influenced by, okay, inflation and central banks and currency swings, fine. Just give me a few weeks to focus on actual commerce. Who's selling what to whom, marked up by how much? And at a glance, based on estimates, I'd say the state of commerce has been better. It's by no means a disaster. Revenues for the third quarter reporting season are expected to rise by close to 10% versus a year ago, so we're still spending, but much of that increase is just inflation being passed along to customers. Earnings are expected to grow by less than 3%. That compares with growth of nearly 8% the quarter before and 10% the quarter before that. 2 things that almost always happen around reporting time is that analysts take down estimates for months beforehand, and then companies triumphantly announce that they've beaten those lowered estimates. This time around, the estimate decline heading into reporting season has been about twice as large as usual. So will companies still report upside surprises? Of course they will. The single worst quarter for surprises in more than a quarter century of data came during the global financial crisis when companies missed estimates by 0.1%. So Wall Street has gotten quite good at not guessing too high. In fact, it's reasonable to assume that earnings will come in a couple of points above expectations, if you can still call them expectations, when everyone expects them to be exceeded. So a 5% overall growth rate is by no means out of the question. Energy companies will report much better growth than that, and banks on the whole are likely to report declines led by their investment activities. One of the weakest performers, believe it or not, could be big tech. We've all come to expect rapturous growth from Apple, Microsoft, Alphabet, and others in good times and bad, but those three are expected to report minimal earnings growth, and Amazon and Facebook, now called Meta, could report big declines. There are a variety of reasons, but a big one is that we splurged on tech a year ago, which makes comparisons difficult. And some companies like Facebook are also spending a lot to try to find new ways to grow. Now let's take a look at one group that'll report soon, and it might be the opposite of big tech in terms of popularity.

Sometimes I feel like there are more sell-side analysts covering airlines than there are investors in airlines.

That's Helane Baker. She's an airline analyst at Cowen and Company. Company. I spoke with her recently about travel trends and the group's deep unpopularity with investors. One index of airline stocks is down 43% over the past year versus a 17% decline for a broad U.S. stock index covering all industries. Valuations for airline stocks look exceptionally low. If we look at estimates for next year, most big airlines trade under 10 times earnings. If we look further out to forecasts for 2024, when conditions will be closer to whatever normal is, many of the shares go for 5x earnings or less. Maybe those estimates will prove too high, but valuations like that also give a lot of room for error. I am anything but an airline bull. I'm well aware of the group's long-standing reputation for swinging from modest profits during good times deep losses during bad times, including some high-profile bankruptcies and bailouts in decades past during times of financial stress. Also, airlines use complicated machines and labor, both of which are hard to get right now, and loads of fuel, which is expensive. And for consumers, the experience often stinks. At the end of summer, I took my family on a big theme park trip to Orlando. Prices were way up, but I went all out because we hadn't taken a long-distance trip since the pandemic. On the way down, the flight was canceled last minute, so we missed a day at the parks. After a long wait on hold, a phone rep told me that it was due to weather, so the airline didn't owe me anything. But the gate rep at the airport said it was actually due to a broken clasp on an overhead baggage compartment and that the airline didn't have the part it needed on hand. I won't say which airline, but let's just say it's big in New York. Days later, I got an email apology with a credit for $50 for all 4 of us, good toward a future flight. Even when things go smoothly, I find air travel, including shuffling through airports and security lines, unpleasant these days. I recently wrote in a column that airline travel has come to resemble a porta-potty visit—sometimes necessary but never good. Maybe I took a little poetic license there, but bottom line, I'm vacationing closer to home for a while. I mean, technically I have flights booked to South Florida next week and Europe down the road, but that's for business. Usually reporting or talking to rich people about what other rich people are saying about getting richer. My employer pays for that.

Did I say porta-potty?

I meant I'm happy to help. Anyhow, I asked Helena Cowan, is the airline business as weak as stock valuations suggest? It doesn't seem so. Some parts of the market have roared back since Labor Day.

After Labor Day, there seemed to be a sea change in coastal markets, especially in New York and Boston and San Francisco and LA, where we saw a return to office and we saw a big increase in international that started really in mid-June and continues to this day, and which is surprising. Normally you would see a big drop-off in international September, October, and we haven't seen that.

Helane says the travel demand is shifting from domestic leisure toward business and international flights, which can be lucrative for airlines.

And the shift in mix has interesting implications for what the airlines are gonna think about going into 2023. So I think the things you're gonna see them talk about on the revenue side of the equation is the shift where some business travel is coming back. International is definitely roaring back. It's mostly transatlantic, Caribbean, Mexico, Central and South America.

Travel between the US and China is particularly weak and could stay weak on trade tensions. But Helane points to the experience of United Airlines, which used to view China as a growth driver and lately has added flights to popular destinations like Malaga, Spain. Meta, Malaga, right?

What do you say? Malaga? I found a pronouncer. Ma-la-ga.

I'm supposed to say it slow like that? Popular destinations like Malaga. For now, for domestic travel, Helene is concerned about the impact of high prices. She gave an example of a family of 4 trying to visit Orlando on $4,000.

And then they go online and they see it's $500 a person to travel there. So that's half the budget. Then when they get there, they have to stay in a hotel or an Airbnb or something. Maybe they can do it for $700, $800, and then they have to rent a car, and rental cars are really expensive. So maybe it's another $700, $800. And now we've used $3,500, $3,600 of our $4,000 vacation budget, and we haven't even set foot into the Magic Kingdom yet. And so people just go, that's it, I'm opting out, and we're driving, and we can take the dog, and we don't have to pay for seat assignments to get us all together, and we don't have to, you know, whatever.

Some of those details sound familiar, except we spent a lot more on lodging because we stayed at the theme park place, and you should see what they get for rooms now, including at the hotel we like where you can see giraffes and zebras from your balcony. Also, we'd never make that drive because one of the dogs is way too hairy and sheds a lot, and both of the kids seem to have turned a bit feral during the pandemic from too much screen time, so now they argue a lot. But the point is that inflation everywhere, not just for flights, could cut into leisure demand. I thought you said that the kids turned out a bit furry during the pandemic. Not so far. Not yet. Now, we don't have time to cover pilot shortages and production delays at aircraft manufacturers, but just know that Helane says that supply for airlines remains constrained.. And that might be good for investors.

So theoretically, the airlines are— the market's already completely discounting recession and bad news for the airlines. They historically disappoint because they buy aircraft at the top of the market and take delivery in a recession or at the bottom of the market. And this time they can't do that because they can't get the planes and they don't have the people.

I asked Helane whether investors should buy airlines here, and she said yes. At the time of our conversation, she had positive recommendations on United Airlines ticker UAL, Sun Country Airlines SNCY, Southwest Airlines LUV, and Alaska Air Group ALK. And then this past week, Delta reported quarterly results including record revenue, believe it or not, on a continued shift toward business and international. Shares rose 4%. Helane upgraded them to outperform. Her price target implies more than 75% upside from here. Other airlines report in the days and weeks ahead. Let's see whether they show similar strength and whether investors come around to the shares. Thank you, Helane, and thanks again to Alan and Tim. Thank you all for listening. If you want to ask a question on the podcast like our friend Tim, just tape one on your phone using the voice memo app and email it to jack.how@barons.com. Meta Lutzoff is our producer. Jackson's getting married right now. Meta, what do you think Jackson's doing right at this moment?

He's handing the ring.

I was gonna say dancing to Kool and the Gang, but it could be either one. See you next week.

Data is everywhere. When orchestrated properly, it sings. At Morningstar, we analyze and enrich data, making it actionable and powerful for you. Morningstar.

Where data speaks.