While markets were closed Friday, the government issued the March employment report. Numbers were close to consensus but probably still too strong for the Fed to end its string of interest rate increases. Fed Funds futures this morning still lay odds close to 2:1 that the Fed will move rates up another 25-basis points when it next meets May 2-3. Beyond that, it’s still too soon to make a constructive call. At the moment, markets are betting the May increase, should it occur, will be the last one. However, if employment gains continue at a pace of over 200,00 per month, it may not be the last.
There was good news within the report. Wage growth is slowing, now barely over 4%. Factoring in normalized improvements in productivity, that kind of growth can be consistent with inflation of close to 2%. The report also showed slowing growth within hot sectors of the economy, namely restaurants and travel. The data for the report came from the week of March 8. Thus, any negative impact from the bank closings last month wasn’t reflected. There is still the CPI report for March to come this week. Any outlier number could influence the Fed’s rate decision, but more likely, a significant change in the stability of the banking industry between now and the start of May will be the only significant item that would derail the move toward a 5% Fed Funds rate.
Markets seem to take all this in stride. They are trying to look past the peak, to a period of lower interest rates, and for equities, possibly a higher P/E ratio. But stocks are already richly priced, based on both 2023 and 2024 estimated earnings. The surge year-to-date in growth stocks supports the notion that markets are fixated on inflation waning and interest rates falling in coming months. The 10-year Treasury yield sits near its lowest level since last fall, well below prior peaks, including a push above 4% in March.
Stock markets seem to be forecasting either no recession of a very mild one. A sharp decline in earnings clearly is inconsistent with market behavior year-to-date. Bond markets appear more pessimistic. Beyond 5 years, the yield curve is coming out of its long-term inversion pattern. The spread between 5-year and 10-year yields is down to less than 10 basis points. The front end of the curve remains sharply inverted, consistent with the belief that the Fed will move rates up again in May. A 10-year yield close to 3% also assumes that inflation will quickly fall toward Fed goals.
If you look back to the 1970s, the key mistake the Fed made was to ease monetary policy too aggressively when the economy began to unravel. It has been a consistent flaw of Fed policy for decades. We even saw it as Silicon Valley Bank and Signature Bank failed. Obviously, if the Fed failed to step in and fully back the non-insured deposits of the two banks, companies with funds locked up and potentially lost at the two banks would have had serious short-term problems. On the other hand, if policy dictates somehow that the government will backstop all banking errors, such a decision would skew the risk-reward equation, allowing bank managements to take greater risk knowing the government provided a backstop. That is simply bad policy. Make that awful policy. Thankfully, no one, at least not yet, is suggesting that all bank deposits, insured or not, be protected in some manner. By the way, the failure of Silicon Valley Bank will end up costing the government well over $10 billion, part of its fire-sale agreement to sell pieces of the bank at steep losses.
I want to make one last comment on the banking crisis before moving on. When a system is stressed, as the current one is by the impact of sharply higher short-term rates, increasing interest rates and shrinking the money supply can only add to the stress. How that stress evidences itself in the future is unclear. It’s akin to guessing where the levee will break in a severe storm. You don’t know. What you do know is that the more it rains, the greater the risk the levee will fail. The Fed thinks/hopes that what we have seen to date is the end of the current crisis. I wouldn’t bet the Fed is right.
After this week’s inflation numbers are reported, the focus will quickly shift to first quarter earnings. Companies will once again beat estimates. They always do, but that isn’t the key. Managements work on analysts massaging their numbers in a way that they continually beat forecasts. The key is the forecasts. Earnings have now declined for two straight quarters. Beating estimates for Q1 while lowering guidance for the rest of the year is hardly a winning formula. World economies have held up well to date. Remarkably well. But the headwinds continue to increase. Higher rates. Financial stress. Where that shows up is in deteriorating pricing power, and that means lower margins in the future. Over the weekend, Tesla once again lowered prices, this time mostly on its higher-end cars. Tesla can afford to do this given its uniquely high margins for an EV manufacturer, but lower prices mean lower profits. It’s that simple.
What we will be listening to as managments report Q1 earnings is what has changed since the last time they reported in January. Then, expectations were extremely low. High profile companies, particularly within the tech sector, noted softening demand. Their response, to lay off workers and cut costs, was rewarded. But cutting costs can only go so far. Growth requires rising revenues. In the short run, adjustments can protect profits. One can work on reducing the fat, but once that happens, future cuts reduce muscle. That has more negative consequences. The NASDAQ is almost 20% higher than it was in January. It has already reflected the decision to trim the fat. Without ongoing revenue growth, the story starts to fade.
April is normally a good month for stocks, but the strong first quarter may rob April of some of its luster. Stocks aren’t remarkably overpriced, but valuation-wise, they are on the high side of normal. The economy is probably continuing to grow, but not across the board. There is ongoing strength within travel and leisure. Consumer spending patterns are spotty, with pockets of both strength and weakness. Manufacturing activity is slowing. Banks are tightening lending standards. Consumer confidence is low and fading. Companies are losing pricing power. Auto dealers are giving discounts. Homebuilders are offering concessions. Stores are having more sales. Restaurants are getting pushback on pricing.
Thus, my conclusion is the same. Don’t let a week or two of better stock market action lull you into complacency. Short-term interest rates may be near a peak and inflation may be abating, but the economy is still moving south and financial conditions are stressful. Stay with quality, focusing on companies that can control their own destiny with persistent positive free cash flow. Great companies gain the most share in the toughest times.
Actress Mandy Moore is 39. Stephen Seagal is 71. Cabaret singer Marilyn Maye turns 95.
James M. Meyer, CFA 610-260-2220
