The big event last week was the FOMC meeting. While the decision to lower the Fed Funds rate for the first time this year wasn’t very controversial, the pace of future rate cuts was. Based on post-meeting statements and the dot plots of future predictions, it appears the Fed is ready to bring interest rates down on the short-end of the curve to somewhere between 3.0% and 3.5% within the coming months. The pace of decline can be argued among analysts and economists but the direction is clear.
The Fed operates under two mandates to foster full employment and to keep inflation relatively stable. In recent years, relatively stable has come to mean as close to 2% as possible. Inflation is currently running closer to 3%. It is likely to stay a bit higher than target for at least the next several months while the impact of tariffs works its way through the economy. Inventories of pre-purchased foreign goods have largely been depleted and many of the tariffs only went into place in mid-summer. Companies have been cautious raising prices to offset the impact of tariffs fearing buyer resistance. Instead of a large one-time adjustment, the path forward seems to be small incremental increases. Just listen to Wal-Mart and Amazon.
The Fed rightfully sees the tariff impact as a short-term headwind. Unless President Trump wants to add another layer of tariff increases onto what already has been announced, the impact should largely be absorbed over the next few months. As for the state of the overall economy, the best way to put it for now is that it’s moving forward albeit at a slower pace than last year. More on that in a moment.
As noted, the Fed operates under two mandates. Given that inflation isn’t too hot and shows few signs of pending acceleration, the focus has swung to the second mandate, full employment. With all the adjustments, largely due to late incoming data, it appears that our economy today isn’t strong enough to add jobs in any meaningful way. The unemployment rate has risen to 4.3%, the highest in over a year. While the jump is small and the rate still comfortably low, what is clear is that both labor demand and supply are dropping roughly in tandem. We have spoken of this several times in recent letters. Digging deeper, the labor related problems are concerning enough to generate sharper Fed focus.
During the post-pandemic period of supply chain disruption and rapid increases in immigration, after-tax wages, particularly for lower income workers rose sharply, even ahead of the pace of inflation. But now, average wage increases for low-income workers is down to about 1%. They are not keeping pace with inflation. Job opportunities are fewer as well. While corporations are loath to fire skilled workers, they aren’t hiring either. Profit margins are increasing largely because more is getting done with fewer workers. While some point to the benefits of AI, it’s unlikely that is the primary cause yet. Few companies have incorporated AI to the extent that would be reflected in meaningful productivity changes yet.
It isn’t just low-income workers who are suffering. Unemployment rates among recent college graduates have been rising for more than two years. It is now well over 6%. Job openings are down over 40% in less than three years. While President Trump’s efforts to reshore manufacturing may gain momentum over the next several years, building new factories takes time, in most cases several years. Manufacturing employment this year is down. Immigration is also down while the ratio of deaths to births is trending upward due to our aging population. Housing starts are barely over 1.3 million annualized as the average age of first-time home buyers passes 38. Blame that on affordability issues. Then add on the decline in the Federal workforce. All those opting for early retirement will come off Federal payrolls at the end of September. That likely means over 100,000 workers will be added to the pool of Americans seeking jobs.
All these pressures accentuate the need for lower rates. GDP growth, stripping out inventory adjustments and the impact of the trade deficit, is running just a bit over 1%. Growth is all at the high end of the income spectrum. Higher income workers are expanding credit card spending by more than 2% annualized. Lower income workers aren’t expanding credit card spending at all. The goal of lowering interest rates is to ease the burden on those using credit cards or buy now, pay later programs.
While Fed efforts to lower rates will undoubtedly be stimulative, one can’t totally ignore the disruptive influences taking place around the world. While our media in the U.S. focuses on all things Trump, France just selected its 7th prime minister in just a short period of time. The current U.K. government is highly unpopular. Germany’s new government is still trying to get its bearings. Leadership in both Japan and South Korea is in flux. I have noted in the past that central bank policies around the world are much more important to economic growth trends than politics. But one can’t help note the elevated state of worldwide tumult and its possible impact on world economies.
Indeed, the surge in populism around the globe is rooted in the widening spread between the economic haves and have-nots. Earlier I noted some U.S. data describing the situation in the U.S. but the same divergence is happening almost everywhere. China is living through a real estate bust and slowing population growth. Remember the old commercial tag line, “You can’t fool Mother Nature”? In the economic world, you can’t fool the reality of demographic changes. In the U.S. a year ago, population was growing at a 0.9% annual rate. Today, that is below 0.6% and falling. Part is immigration, part is lower birth rates, and part is aging. The aging pattern is worldwide. Without change, that means population growth worldwide will be in decline later this century.
So why is the stock market so strong? Given an S&P 500 P/E of over 25, and over 20 even backing out the Mag 7, it’s hard to say stocks are cheap. But, at the same time, don’t forget the old saw that says don’t fight the Fed. Fiscal and monetary policies today are both stimulative. Over time, that means faster growth and higher profits. 10-year Treasury yields are still anchored in the 4.0-4.5% range. While earnings growth could slow in the second half of this year if tariff costs squeeze margins a bit, corporate cash flows accelerate stock buybacks which help to elevate growth in earnings per share, the primary driver of growth and, over time, stock prices.
One last factor is worth noting, the value of the dollar on world markets. Currency values fluctuate to balance out the relative economic advantages and disadvantages of various nations. Strength begets a strong currency. Slowing growth, and lower interest rates serve to weaken currency values. So far this year, the dollar is down 10% against a breadbasket of leading currencies. That means it is 10% more expensive for us to buy foreign goods. That’s over and above any tariff impact. Conversely, our goods and services are 10% cheaper to foreigners. The S&P 500 is up 13% year-to-date. But to a European living in a world of euros, it is flat. So what. We don’t live in a world of euros; we live in a world of dollars. It matters because money flows to strength. If the costs to invest in the U.S. go up by 10% and protectionist headwinds add further barriers, then one has to question when or if all those promises of future investment in the U.S. will come to pass. A weak currency will help to reduce our trade deficit, a key Trump goal. But the goal to make it here, not there, isn’t helped by currency weakness.
The persistence of inflation and the weakness of the dollar are evident in the surging prices of gold. Inflation devalues all currencies. Political unrest chases money to safe havens. Gold has been that safe haven for millennium. I have focused most of this note on labor and the divergence of economic fortunes between the rich and poor. But price stability can’t be ignored. It is highly possible that the pace of inflation will exceed the Fed Funds rate in coming months. If so, that will drive changes in asset allocation, perhaps in the direction of even higher stock prices. There is over $7 trillion parked in U.S. money market funds today. Some will seek a different haven if fiscal and monetary policy get too stimulative. New Fed Governor Stephen Miran last week advocated for a cut in the Fed Funds rate to 3% by the end of this year and more cuts next year. He also was the lone dissent to the Fed’s rate decision. President Trump clearly wants greater control over the Federal Reserve’s rate setting actions. Hopefully, the decision of the rest of the FOMC, including two Trump appointees, to move at a more thoughtful pace is encouraging.
Today, Andrea Bocelli is 67.