Interest rates wavered throughout yesterday’s session but showed little change by the end of the day. This morning started earnings season as JPMorgan Chase# and Wells Fargo# reported. Results beat expectations but the early reaction in pre-market trading was to take some profits. We will see soon whether that reaction is a harbinger of things to come or not. Elsewhere, tensions in the Middle East grow as Iran threatens to retaliate after an Israeli strike in Syria killed key Revolutionary Guard leaders. Simply put, markets appear a bit more skittish than they did prior to Wednesday’s CPI release.
Stock prices are essentially determined by applying a P/E multiple to an earnings forecast. The P/E multiple is a derivative of long-term interest rates. If you invert P/E, you get E/P, earnings divided by price. In plain English, that’s an earnings yield, not far in concept from a dividend yield or a yield on a long-term bond. Yields correlate closely to expectations for both future growth and inflation. For decades, U.S. GDP growth has been centered around 2%, a function of demographics and productivity.
For an extended period, central banks through accommodative monetary policy forced short-term rates to stay either side of zero. In times of financial crisis, such steps were necessary. In other times, the policy was dubious. For years inflation was avoided because there was so much economic slack in the wake of the financial crisis of 2008-2009. But a decade later that slack started to dissipate. As that was happening, Covid struck creating imbalances and supply chain disruptions. We all know the outcome. Central banks took rates back to zero, fiscal policy became even more expansionary, and inflation soared.
Subsequently, too late with hindsight, central banks led by the Fed started to raise interest rates at a pace never before seen in our lifetimes. Eventually, slack was restored and inflation started to retreat. But the slack was nowhere near as much as existed after the financial crisis. While central banks wanted to be restrictive, governments, especially ours, spent at a ferocious pace. Since 2024 is an election year, one shouldn’t expect the pace of spending to slow before Christmas.
Even with the fiscal stimulus and sharp increase in immigration, inflation started to recede. But getting from today to the Fed’s 2% target isn’t going to be simple. In early February, the CPI report for January was hotter than expected. A blip, according to the optimists including many leaders within the Federal Reserve. February numbers still showed inflationary pressures persisting. The figures weren’t quite as disturbing as January, however. Stock prices continued to rally. Then this week the March numbers were reported. Still unsettling. It isn’t that inflation isn’t on a path downward; it’s that the slope of the downtrend is much slower than previously expected. Blame it all on services, everything from airfares, to insurance, to pet care, to the cost of a haircut.
This morning, I want to dig into the March CPI components a little deeper to see exactly what’s happening, recognizing that for any sub-category within the CPI data, numbers can jump around a bit often affected by weather, seasonality factors, and timing of holidays.
In the March numbers, the following stood out:
1. Shelter related costs
2. Hospital Care
3. Elder Care
4. Insurance
5. Fuel
Eliminate the impact of these five and the inflation picture in the U.S. would match the progress being made in the rest of the world. Therefore, let’s look at each one.
Shelter costs are a function of changing rents, changing home prices and mortgage rates. Rents had been coming down. They appear to have stabilized. Home prices continue to creep higher, a function of a shortage of supply for sale. And, of course, mortgage rates are elevated along with the yield on long-term bonds. Without getting into the arcane arithmetic of how the changes in shelter costs are calculated month-over-month, shelter related inflation isn’t headed toward a 2% rate anytime soon. With that said, it has been nudging lower over the past six months. The month-over-month increase in both February and March was 0.4%. Maybe it can creep down to 0.3% soon. But getting to 0.2% will take a lot of time and lower interest rates.
Hospitals were obviously at the epicenter of the pandemic. Its employees were stressed. Many quit for less exhausting jobs. To keep others, hospitals had to pay more. Those cost increases are still flowing through the system. Hospital inflation won’t stay elevated forever, but it won’t come down swiftly either.
Nursing homes historically have been funded by Medicaid; state programs often supplemented by the Federal government. For years now, states have taken steps to rein in costs. Often, they have hired third parties, private enterprises to oversee their programs. The most expensive care was in a nursing home. It used to be that getting into a nursing home was easy. Today, you need to be almost totally unable to care for yourself. That means one can’t dress, bathe or feed oneself. And then there are the Alzheimer patients. Covid raised the cost of care. The math is easy. Costs rise 5% a year, funding increases 2% a year and before long you have economic disaster. Between 2020 and 2030 an estimated 50%+ of skilled nursing beds will disappear. The alternative is care in place. The patient stays home while aides come a couple of times each day to feed, dress, bathe and deliver medication. Doctors and nurses come as needed. It’s a cheaper way to deliver care. Obviously, one can argue about the quality of care. All this is a prelude to the fact that the costs to deliver that care are rising. Insurance may cover the cost of the aide and medicine. But it doesn’t cover food and other necessities. Moreover, the population of aides hasn’t grown as fast as the population of those needing care in place. The result is rapidly escalating wages. Elder care costs increased in March more than any other CPI component.
The twin insurance culprits were auto and homeowners’ insurance. Auto insurers have raised rates to offset the sharp rise in the price of used cars during the pandemic, higher repair costs, and higher tort or legal outlays. If there is good news, it’s that the prices for used cars are now declining and new car prices are increasing at a slower pace. Homeowners insurance is another story. The higher costs are related to climate change. More disasters. It’s not for me to debate the causes of climate change, but rather to simply calculate the impact of hurricanes, floods, tornadoes and wildfires. As those costs rise, insurance premiums will follow. Add in the inflated prices of houses and home repairs and you have a recipe for future premiums rising faster than inflation as far ahead as one can see. A few years with better disaster profiles might help. But already forecasters are expecting an active hurricane season this year, supported by warmer ocean temperatures.
The impact of higher fuel costs is obvious. The direct costs, like the cost to fill your tank, are backed out when calculating core inflation. But the costs to move goods, or heat a manufacturing plant are ultimately passed on to the consumer. Oil prices generally rise through the spring in advance of the summer driving season. Don’t expect any relief for a few months.
Finally, there is one last factor that isn’t a direct contributor to CPI and that’s interest. Any business that borrows has higher debt service costs today than they did a year ago. Small businesses are especially hurt because they are more dependent on expensive lines of credit.
All this suggests it’s too early for the Fed to think about cutting rates, at least until it can see a few consecutive months of improvement on the inflation front. Wall Street and the financial media seem fixated on when the Fed will start cutting the Fed Funds rate and how often it will cut this year.
It doesn’t really matter.
Short-term rates don’t fit into the calculus that determines the price of a stock. Long rates do. What matters isn’t that the Fed Funds rate today is right where it was nine months ago. What matters is that the 10-year Treasury yield sits above 4.5%, a full 60 basis points higher than when it started the year. To the extent short-term rates impact long-term rates, they matter. But changes in short-term rates are almost always a reactive step by central banks to adjust to what is happening in the real economic world. Changes in short-rates won’t cause a change in future inflation expectations; they will be a reaction to changes in inflationary pressures. Or changes in the pace of economic growth. Or both.
As an investor, you can’t listen to all the Fedspeak. They have a hard time looking 2-3 months ahead, no different than the rest of us. It’s the price of 10-year bonds and the price of gold that give more meaningful input as to future inflation expectations. For the moment at least, the message is not that the Fed Funds rate will be higher for longer but that inflation will be higher for longer. Markets have no conclusion whether the Fed can get to its 2% target. But rising rates and the higher price of gold suggest skepticism. Will the Fed declare the battle won with inflation closer to 2.5%? Will rates stay high for too long causing a recession? Will the Fed give up the battle too soon and watch inflation reignite? These are all possibilities but unanswerable today.
For now, here is what we do know.
1. Long-term inflation expectations are higher today than they were three months ago.
2. Growth continues at a faster pace than was expected three months ago. There are signs of weakening. We will learn more as first quarter earnings are reported.
3. Valuations don’t appear to have adjusted yet to the higher rates. Either the rate hikes are transitory, earnings changes are due to surprise to the upside, or a valuation adjustment may be necessary.
Day-to-day and even intraday volatility has picked up this month. That could be a simple pause or a sign of pending change. We will learn more over the next three weeks as corporations present their first quarter earnings and full year outlook.
Today, Claire Danes is 45. David Letterman turns 77. Herbie Hancock is 84.
James M. Meyer, CFA 610-260-2220