Fed not declaring victory over inflation just yet

Although inflation is cooling, the Fed has yet to reach its 2 percent inflation target. Will the Fed stick to its original interest rate cycle or change its mind? Charles Schwab Senior Investment Strategist Kevin Gordon analyzes how the Fed’s rate hikes have been “guiding the market, meeting by meeting” and the interplay between inflation prints and job growth. Fed officials have been “emphasizing there is no preset path that once they get to the rate they just do a 180 and turnaround right away,” Gordon summated on the possibility of interest rate cuts.

Video Transcript

DIANE KING HALL: Inflation showed further signs of cooling in June, rising at its slowest annual rate since March of 2021. And while investors may be declaring victory, the Fed might not be so quick to join them. Kevin Gordon, Charles Schwab senior investment strategist is with us to deep dive into this. So you have some– there’s a general kind of market expectation for what the Fed will do with where inflation is. Obviously, we know what’s expected kind of next week, the majority expecting another hike. Is the market reading expectations right? Like, many are just pricing July, and that’s it. If you’re reading–

KEVIN GORDON: I think it makes sense. And for all of the criticism and the flak that the Fed gets, I think that the one thing that they’re doing pretty well is guiding the market meeting by meeting, helping sort of all investors understand that this is probably what they’re going to do. And I think actually, pretty effective, because you go a couple of months ago, everybody was on edge about a June pause. And then it was kind of inconceivable that they could hike again. But now, they’ve kind of guided us in that direction. You look at market pricing and probabilities, and we’re pretty much there.

I think the question after that is going to be very much the same case. What’s the language like? How do they come out and say whether inflation is not yet back where they need it to be in terms of trajectory? And that probably sets you up for another hike if they want to go in that direction. But as we’ve been outlining and really emphasizing, even if they stop after July, after the July hike, supposing we get one, as long as inflation continues to roll over, you still have real rates that creep higher. So in their mind, I think that’s kind of accomplishing the goal or getting closer to the goal where you’re getting more into restrictive territory.

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And that of course, if inflation doesn’t roll over as fast and then it kind of stabilizes, maybe they have to readjust and recalibrate from there. But we have a ton of data until the meeting after that, between now and then, even between the July meeting and then, from a labor perspective and from an inflation perspective too.

JULIE HYMAN: So at the beginning of the year, the market was pricing in cuts before the end of the year even though the Fed was signaling that probably wasn’t going to happen. What is the market now getting wrong about what the Fed is going to do?

KEVIN GORDON: Well, I think there’s still– the market has just pushed back the expectation for cuts now into 24. So I think the Fed has been successful in sort of quashing the idea that there was going to be a cut this year. But I think it’s going to be more of the same story where Powell, in particular, has been emphasizing there is no preset path where once they get to the terminal rate and the peak rate, then they just do a 180 and turn around right away. They would need to see a lot more developments, not just from the inflation and the labor side, but now from the growth side. Because you’ve got estimates for growth, at least for the second quarter, now moving higher and the expectation that there’s going to be a little bit of a re-acceleration.

We have a lot more data to get through to see if that’s actually going to hold. But I think that’s probably going to be more of the struggle because those three components of the puzzle for them are not fitting in perfectly right now. And I think that’s probably what he’s going to emphasize a lot more moving forward.

DIANE KING HALL: Speaking of components of the puzzle, you talked about the labor market. And we had that new data on jobless claims yesterday, which was– I mean, they dropped by 9,000 to 228,000. That wasn’t the expectation going into that. What do you think that does in terms of the Fed’s moves, not for July, but going forward?

KEVIN GORDON: If you stay in that kind of tighter labor environment, our view has been that they’re probably going to start focusing more on that. Because the trajectory for inflation has largely improved, even for some of the metrics that they’re looking at. You’re not back to target for something like Core Services Ex-Housing, but you’re getting there and you’re starting to see more of an easing. Plus on the labor side, I think we have to keep in mind, because job growth is still relatively strong, wage growth is still relatively strong. With inflation coming down, inflation-adjusted income growth is going back up.

And that’s happening now at a time when you’re still in a bit of a tighter labor supply environment. And I think for the Fed, it poses a little bit of an issue even if they don’t think that wage growth is the primary driver of inflation. The fact that they think inflation and wage growth tend to follow each other or at least move alongside each other, I think that’s probably going to be more of a focus.

JULIE HYMAN: We’ve been talking to you and Liz Ann for a while now. And you have been emphasizing that given all of this that we’ve been discussing as the backdrop, quality is where people should be going in their portfolios. What would cause you to change that? What– you know, what kind of backdrop dynamics would mean that you could get sort of more bullish on a different set of factors?

KEVIN GORDON: I think you’d have to– well, the one thing I’ll say is that quality takes different shapes over time. So right now, in particular, and probably since December, we’ve been thinking that quality, in the form of looking at pricing power, has been something to focus on. Because right now, the difference in 2023 versus 2022 is that you have real revenue growth and real earnings growth starting to contract in a broad sense for the overall economy. So if that’s–

JULIE HYMAN: Is pricing power still is important to you right now?

KEVIN GORDON: Oh, absolutely. Because if that’s the environment where overall pricing power is just falling, by nature of inflation rolling over, you have to look for companies that have been able to withstand that and that can actually grow in unit sales or in volume terms. Those that benefited from inflation, like they did last year, if they have no other strategy to kind of boost sales, then you’re probably caught in a tougher place. So quality can take different shapes over time, different– and it can have many different faces. But in terms of moving down the quality spectrum into stuff that maybe is more high beta or tends to rally when the economy re-accelerates–

JULIE HYMAN: Or to take on more risk, in other words.

KEVIN GORDON: Absolutely. I think it’s a little early in the sense that if we do get a re-acceleration in growth, we’re not yet sure how hostile the Fed is going to be to that scenario, especially when you don’t have inflation back to target. So it’s part of this kind of broader story of taking a little bit of a breather and a step back. And not that we’re saying don’t be invested in the market or go to cash, that’s never really the view that we have. It’s been– you could find parts of the market that do relatively well and that kind of skew defensive.

DIANE KING HALL: What parts do you like right now? Is it defensive plays? What are the boring plays that you like?

KEVIN GORDON: Well, sometimes quality looks boring in a way. But as a factor, I think the nice part about it is that you can pretty much find that in any sector. So in our view, it keeps you out of this game of feeling you have to jump in and out of different sectors on a month-to-month or a quarter-to-quarter–

DIANE KING HALL: It’s not double Dutch.

KEVIN GORDON: Exactly. Or a quarter-to-quarter basis. First of all, that’s impossible. Nobody knows how to time that perfectly. Second of all, if you have that quality filter and that lens, you can kind of keep yourself in gear that way. And by the way, some of the largest names in the indexes, whether it’s the NASDAQ or the S&P, exhibit a lot of those factors where it’s strong cash, strong margins on a trailing, and a forward basis. So you can get pretty strong performance wrapped up in a quality factor.