Stocks closed out the first quarter with another strong performance. The S&P 500 gained over 10% in the three-month period while the NASDAQ rose 9% and the Dow Industrials a bit over 5%. Stocks expressed broad optimism that inflation will continue to moderate and economic growth will be sustained without a recession.
While a recession can’t be ruled out, if there is to be one, the causes aren’t obvious. Housing and auto sales, two huge chunks of the economy which along with retail are the likely sectors to be hit by high interest costs, appear stable. EV demand is weakening but is offset by sustained demand for traditional gasoline fueled cars. Americans appear to have adjusted to higher mortgage rates. Housing starts near a 1.5 million annualized pace are not far off their multi-decade average rate. To be sure, shortages of quality existing homes for sale are affecting turnover rates, but this isn’t new. It has been ongoing for years and finds its roots not in the high cost of money today but the absurdly low rates for mortgages taken out before the pandemic. Over time, there will be fewer and fewer of those ultra-low mortgages left. But the process of rolling them over will take years, not months.
To be sure, retail sales have been spotty as credit card balances, now costing well over 20%, rise. That will reverse a bit once the Fed starts to lower short-term rates. I don’t plan to enter the debate this morning when that might begin. I can make a case for June or none until 2025. But what I can say with conviction is that the next change will be toward lower rates and that will bring down the cost of short-term borrowing.
It isn’t common for stocks to rise each of the first three months of the year. When that happens, over 90% of the time, stocks end the year higher than when the year began. Equity markets look ahead. While crystal balls aren’t always right, when the outlook is bright, markets generally respond positively.
There is always the issue of valuation. No one can argue that stocks are cheap today based on any historic indicator. The S&P 500 today sits at over 19 times 2025 estimated earnings, about 15% above historic norms. With that said, there is no reason that has to correct itself immediately. One way for that to happen is for earnings growth to accelerate. For that to happen, productivity has to increase. It has been rising lately and there is hope that artificial intelligence will help to further increase worker productivity. So far, however, there are few concrete indicators tying AI to sustainable productivity gains. That doesn’t mean it won’t happen. It probably will. But to date, there isn’t sufficient data tying the two together.
For several months the 10-year Treasury yield has stayed within a narrow range, mostly between 4.00% and 4.25%. The stability suggests market optimism that inflation will eventually recede toward the Fed’s 2% target even if it takes a bit longer than some desire. If there is a risk to the market’s optimism, it will be centered around this consensus thought. Oil prices have been creeping up once again. A good part of that is seasonal. When inflation is measured, most economists look at core inflation which excludes the direct impact of changing food and energy costs. That partly relates to the notion that interest rate policy can’t impact those prices. The cost of a quart of milk or a gallon of gasoline aren’t directly impacted by changes in short-term interest rates. Second, these commodity costs can be highly volatile in the short run and confuse the inflation picture. But with that said, the cost of a barrel of oil rose by 15% in the first quarter, and normally peaks around Memorial Day. Although, as I just noted, the direct changes in energy costs are deducted to determine core inflation, rising prices for fuel do seep in. Getting goods from A to B is impacted by rising fuel prices and will be passed on to the extent possible. They also directly impact air fares.
Oil prices aren’t the only inflationary headwind. The cost for services keeps rising at a pace well over 4%. That partly reflects higher labor costs although productivity gains should moderate that impact. Rather, services inflation continues because service providers have pricing power. Whether it’s your dog groomer, the cost to insure your home or car, or the price of a concert ticket, so far consumer resistance isn’t halting the pace of services inflation. That will have to change soon. Both January and February CPI increases were a bit hotter than forecasted. Most slough that off as temporary distortions. Remember a few years ago when the Fed labeled inflation as “transient”? Another month or two of hotter than expected inflation readings may change the market’s mood, if only temporarily. Inflation doesn’t have to fall to 2% by the end of this year to make investors and the Fed happy. But it probably needs to be running below 3%, especially if one wants to see the Fed start to cut rates sooner rather than later.
While market pundits focus on the timing of the first rate cut, a case can be made that the market doesn’t really care that much. As noted, the 10-year Treasury yield has stayed within a narrow range since January, a sign long-term inflation expectations have stayed well anchored, a bit above 2%. Part of the economic strength over the past 12 months has come from an extraordinary rise in the pace of immigration. The Biden administration talks about taking a tougher stance to secure our Southern border, although there are few indications yet of sustained changes. Congress, particularly the Republican-led House, are playing politics with border policy making any sustainable changes unlikely. But to the extent there are changes, they will likely serve to limit traffic across the border. As for legal immigration, it is also likely that last year’s pace of over 1 million new immigrants arriving through traditional channels will slow as well.
As we all know, besides the economy, immigration is likely to be one of the major issues for this Presidential campaign. It’s pretty clear where both candidates stand. Normally, we overrate the importance of the Presidency. A President can only do so much without Congressional support. Courts also weigh in. And, of course, monetary policy has more impact on financial markets than Presidential decisions. But immigration is likely an exception. No law forces the U.S. to accept immigrants. Rather, changes in border control security or the pace of processing immigration requests don’t require Congressional approval. A material change in immigration numbers will have a material impact on economic activity.
While service price inflation is concerning, there are several deflationary forces that are constant. One is productivity. The more each worker can produce lowers unit costs. Sustainable productivity doesn’t happen because employees work harder. It is because technology helps us produce more. Whether it be a kiosk replacing an order taker, a self-service counter, Internet shopping, or speedier and better execution powered by AI, productivity is a key driver to reducing costs. Second is the declining cost of technology itself. Moore’s Law still holds. Semiconductors are roughly 20% cheaper or 20% more powerful each year. What took a wired and cooled room to do 30 years ago, now can be done by your phone or even your watch. Dick Tracy was simply 50 years too early. Finally, many developing world nations plus China thrive because they can produce goods substantially cheaper than we can. Where your clothing used to say “made in China”, it now says made somewhere else more likely. At the same time, China’s declining growth rate is forcing it to push more production to the export market driving prices down further.
Thus, while services inflation may stay hot for a bit longer, the deflationary forces just noted will win out in the end. As long as the Fed or Congress don’t cut rates too far or increase spending by too much, the battle against inflation will be won. Markets began celebrating in November. While the pace of gains can’t be sustained at 10% per quarter, and a modest correction can occur at any time, the path of least resistance still appears to be higher.
Today, Rachel Maddow is 51. Ali MacGraw turns 85.
James M. Meyer, CFA 610-260-2220