Stocks rebounded Friday, erasing much of Thursday’s loss after the Labor Department issued a very strong employment report for March. Bond yields rose.
At the start of the year, the prevailing narrative was that growth in 2024 would slow from the 3%+ rate of the second half of 2023 while inflation would continue to moderate. Odds favored a soft landing over any possible recession. Markets were pricing in 3 or more cuts in the Federal Funds rate over the course of the year with the first cut coming as soon as March.
We are now over three months into the year and that picture has changed dramatically. Growth has sustained at a high rate and may have even accelerated in the first quarter. Manufacturing has turned around and is now contributing to GDP once again. The areas of strength last year, namely leisure & hospitality, education and expanding government, continue to be strong. At the same time, inflation has been running a bit hotter than previously anticipated. Despite some slowdown in the pace of inflation within the all-important shelter sector, inflation for both January and February was a bit hotter than expected. Many, including Fed Chair Jerome Powell, believe the early 2024 data is just a minor aberration from the steady decline that set in during the second half of 2023. But don’t forget it was the Fed that labeled inflation transient when it started to escalate a bit more than two years ago. Long-term inflation forecasts which had been anchored close to 2%, are now closer to 2.5%. That doesn’t sound like a big difference but it is.
Simply said, if long-term inflation expectations are rising, at whatever pace, while the Fed is pursuing a tight money policy, what happens when it takes its foot off the brakes and starts to moderate? The biggest fear in the back of every economist’s mind is that pressure is released too soon and inflation skyrockets back to new cyclical highs. There is also an attendant worry that staying tight for too long raises the odds of recession. After all, the Fed has dual mandates to maintain both price stability and growth. But right now, growth doesn’t seem to be the problem. If anything, it is accelerating. Yes, high interest rates pinch in places like housing, but the downward pressure is offset by high employment, sustained consumer spending and massive Federal deficits.
To that end, it’s an election year. President Biden, as all incumbents seem to do, wants to use money to make voters happy. He wants to expand student loan forgiveness even as the Supreme Court took away some of his flexibility. He wants to expand employment tax credits even to those who aren’t currently employed. Don’t ask me to explain that one! At the same time, monies approved to expand infrastructure and build semiconductor capacity are being awarded. Nothing gains votes more than government handouts. That always is a set of arrows in the quiver that aids incumbents. But it also accelerates GDP growth. It’s impact on inflation is less clear. And that’s the political dilemma this year. In voters’ heads, what’s more important, job security or the ravages of high inflation? We won’t know that answer until November.
But with that thought in mind, the odds of even three rate cuts this year are diminishing. At least one regional Federal Reserve Bank President suggests no increases might happen this year while one Governor even raises the possibility that another rate hike could even be necessary if inflation shows any sign of reaccelerating. If there is any serious chance the FOMC may even debate the possibility of a further rate hike, Wall Street would likely react quite negatively.
That makes Wednesday’s CPI report more important than in the recent past. It’s easy to slough off January’s hot report as a one-off. February’s numbers were a bit hot but not as disturbing as January. Should March be hot again, it would be hard to label three countertrend reports in a row as a counter trend.
Energy prices will likely elevate March numbers, and April as well. While the core numbers economists focus on try to eliminate the impact of commodity price changes, they are input costs that either pinch margins or get passed on to consumers. With GDP flirting with 4% growth, there is enough pricing power to suggest much will be passed through.
Thus, the CPI report coming Wednesday morning before the market opens takes on outsized importance. Friday will be the unofficial start to earnings season as several big banks report. The pace will pick up next week and reach crescendo stage the following two weeks. Assuming GDP and other economic data don’t lie, earnings this quarter should be quite good. While it is still early in the year and managments don’t want to go too far out on a limb, it is logical that expectations for the rest of 2024 will increase. Look for S&P composite earnings estimates to move past $230 with some of the more optimistic forecasters suggesting that $240 is possible. Even if that should that occur, the P/E for the S&P would be over 21 for this year, well beyond normal range.
The rest of the equation centers on interest rates, most notably the 10-year Treasury yield. When the Fed pivoted at the end of October and raised the likelihood that lower inflation would allow as many as 7 rate cuts in 2024, the 10-year bond yield within just three months went from 5% to under 4%. This morning, that rate sits at 4.45%. So far this year, the S&P 500 is up 9% while the yield on 10-year Treasuries has risen from 3.9% to just under 4.5%, an increase of about 50 basis points. Normally, such an increase should cause a commensurate decline in the P/E of forward earnings. Even allowing for a modest improvement in earnings estimates, that hasn’t happened. Indeed, the opposite has occurred. P/Es are rising as interest rates rise. That dichotomy doesn’t have to correct today or tomorrow. In 1987, it continued for eight months before correcting.
But it is important to remember that P/Es can’t increase over time while long-term interest rates are rising. No wonder cash continues to flow into money market funds and Treasury bills. The fear that high rates might disappear within a few months is dissipating. Investors are happy to get 5%+ for at least a few more months and not worry that a flurry of interest rate cuts and disappearing inflation will rob them of the opportunity of extending duration a bit later.
Thus, the bottom line is that markets have been adjusting to a different world than appeared likely just three months ago. The higher interest rates have created some rotation. The S&P 500 is slightly outperforming the NASDAQ Composite. If there is a common thread to equity performance, it is that stock prices on individual stocks are chasing changes in outlook. Within almost every sector there are winners and losers. Several large banks have done very well while regionals tied to commercial real estate have not. In the big cap tech world, there has been a huge disparity between the performances of Apple# and Tesla on one hand, and Meta Platforms# and Nvidia# on the other, all for very company-specific reasons. The same dichotomies happen within consumer goods, health care, and the industrial sector. This has truly been a stock picker’s market year-to-date. That will remain the dominant theme, even as we digest future Fed actions and pending earnings reports.
Today, actress Robin Wright is 58.
One final personal note. Just about 60 years ago, I was in summer camp in Maine. It was a foggy morning, the day of an expected solar eclipse. So, a group of us climbed up one of Maine’s highest mountains to get above the fog and see the spectacle. All I can say is that any vivid memory one has of his or her early teens is a true lifetime experience. It does get dark, but the corona generates enough light roughly equivalent to a couple of full moons. So, it isn’t pitch black. The most amazing this I remember, beside the obvious view of the moon blocking the sun, was watching the animals scatter, a combination of confusion and fear. Our eclipse glasses were self-manufactured using exposed camera film. My only caution today, is to stay safe which means don’t be near a roadway when the eclipse happens if you near the path of totality. A distracted motorist can be a lethal weapon. Hopefully, the weather will cooperate. As for that mountain I climbed 60-years ago, it is once again within the path of totality and the weather there is supposed to be spectacular today. No fog. But if I were there again, I would make that climb once more. The views looking up and down were equally memorable.
James M. Meyer, CFA 610-260-2220