Stocks rallied Friday on the backs of favorable earnings reports from Microsoft# and Alphabet#. The NASDAQ materially outperformed the rest of the market. While both Microsoft and Alphabet are software companies, the tech heroes last week were the semiconductor producers. In a world now fixated on next generation AI applications, the platforms that will be used by companies to implement AI remain in a race to build adequate capacity to meet future needs. At the same time, many companies are pausing to reassess how much capital they need to invest to incorporate AI into their business. The answer we have gotten over the past two weeks is that AI is for real but the frantic moves to race into the AI world are being replaced by more rational behavior trying to focus on what needs to be done now and what should be deferred until there is a better image of what the future will look like.
AI was hardly the only focus last week. A preliminary look at first quarter GDP showed slower growth than expected but more inflationary pressure than forecasted. Reported growth of 1.6% was materially below forecasts but if one removes the impact of trade and inventory changes, the growth was 2.5%, only slightly below projections. But it was yet another sign that inflation was not headed to 2.0% quickly that spooked the bond market sending 10-year Treasury yields to their highest levels since early November before easing back a touch. As the 10-year Treasury was crossing 4.7%, analytical reports surfaced everywhere suggesting that rates will stay higher for longer and the neutral rate, that which neither feeds nor retards economic growth, may be higher than previously anticipated. Big academic studies try to predict the so-called neutral rate. It seems to bounce around, at least in the heads of economists. Some attribute the stubbornness of inflation not to interest rate policy, but to aftershocks of the economic impact of Covid. Hey, it’s hot in the summer and cold in the winter. There are dry seasons and rainy seasons. But some summers are hotter than others and it can often rain when and where it’s not supposed to. Witness recent flooding in Dubai. The reality is that neutral rates are probably more of a concept than a precise reality. Today, it’s fair to say that consumer expectations regarding inflation are different than they were five years ago. Certain industries like housing are seeing unconventional supply/demand characteristics brought about by bad monetary policy five or more years ago that kept rates too low for too long.
It isn’t nice to fool with Mother Nature. Yet here we are in an election year facing more inflation than incumbents want to see. That creates action, or at least the hint of action, to suppress inflation. States are considering steps to prevent institutional purchases of homes to rent them out. This goes back to the George W. Bush era where home ownership was the American dream. Then steps taken ended up creating the financial crisis of 2008-2009. Is home ownership the ideal and home rental a stigma? The house is the same. If today’s prices are viewed as too high, perhaps rental is a better option. When inflation reared its ugly head in the 1970s, governments took many steps to implement price controls. They didn’t work. What did work ultimately was Fed policy to tighten monetary policy. Inflation is a monetary phenomenon, nothing more or less. It’s a balancing mechanism between supply and demand. It serves to reallocate capital. High inflation means higher interest rates which force less bargaining, less activity, and, ultimately, lower prices. The message to governments, both state and Federal, is that free markets are the best allocator of capital. If they choose to interfere anyway, they will only disrupt natural forces (and tight monetary policy) that are going to work in the long run as long as correct policy is allowed to work.
That brings me to reports last week that some Trump insiders are working to allow him, should he be elected, to have the final say on changes in the Fed Funds rate and other steps taken by the Fed. Exposed to the public, that idea met almost universal condemnation. But it does expose some underlying themes. Trump has always been a big borrower both in his own real estate ventures and as President via ballooning budget deficits. To him, zero interest rates are ideal. But while he knows all (at least more than the generals), allowing one person, President or not, to have veto power over monetary policy is dangerous. It isn’t about to happen. But that wouldn’t stop him from persistently jawboning for lower rates. Presidential pressure isn’t the same as veto power, but it does have impact. Second, the thoughts of consolidating more power within a Trump White House isn’t limited to Fed oversight. For some time, at least since President Obama, majorities within both chambers of Congress have been slim, which has limited legislation. The current Congress is on a path to pass the smallest number of bills in decades.
While investors may like gridlock, Presidents don’t. They want to be viewed positively for actions they take. Executive actions take over. Sometimes, the White House or agencies overstep and courts have to rein them in. We see that now with Biden regarding student loans, green initiatives, and anti-trust actions. Should Trump be elected we will see it in other ways. When a new President takes office, they almost immediately reverse the Executive orders of the prior President before starting anew. It’s still a bit early for markets to deal with possible changes forthcoming given that polls suggest a tight race. But as the election gets closer, there will be market impacts. The pushes from Biden will be much the same as they are today. He would continue to fight to limit harmful emissions, reduce student debt, and accelerate anti-trust activity. In a Biden second term, the regulatory burden would only increase as would deficits. Under Trump, deficits would also rise although Trump himself may verbally set a different tone. Immigration would slow materially and tariffs on imported goods would be higher. In all cases, the words will sound more impactful than the actual outcomes. Major economic shifts generally follow legislative and central bank actions. No reason to expect the next Congress to be any more productive than the current one. The nuthouse gangs on both the left and right are likely to be present in 2025 keeping the level of insanity high and legislative productivity low.
Earnings season peaks this week. We still have to hear from big names like Apple# and Amazon#. But the tone is clearly set. Earnings estimates for the S&P 500 have barely changed over the last two weeks. Stocks still sell near 21x 2024 estimated earnings, high by any standard. It’s hard to expect a further robust rally from here. The economic message of slowing growth and modestly slowing inflation don’t add up to more significant advances in equity prices. On the other hand, so far there are few signs of pending recession. Final GDP, ex-inventory and trade, still suggests moderate growth. AI will be a meaningful stimulus. At the same time, housing remains weak, housing prices look toppy, auto sales are sluggish, and manufacturing activity rides the flat line. Yet slower growth doesn’t equate to recession. No obvious reason for a serious bear market.
That drives the focus to the 10-year Treasury yield. It was near 5% last fall, under 4% by year end, and now threatens to revisit 5% again. As long as inflation continues to drift lower, at whatever pace, and the economy avoids recession, the 10-year yield should stay in a 4-5% range. Indeed, looking out a bit longer, once the Fed feels comfortable lowering rates toward whatever it perceives as neutral plus a small real cost of doing business, we could see a world where the Fed Funds rate drifts toward 3% and the 10-year rate stays in the 4-5% range. If one looks back 100 years, such a picture would look very normal. It would also be very healthy relative to central bank activity that jerks short-term rates around violently as has been the case for the entire 21st century to date.
What would likely trigger a correction larger than what we have seen in April is higher rates. What would trigger another large extension to the rally in place since October, is an acceleration in earnings. Since neither seems likely in the near term, the old adage “sell in May and go away”, meaning a flat but volatile market between May and October, may be the best advice for this year.
Today, golfer Justin Thomas is 31. Jerry Seinfeld turns 70. Finally, Willie Nelson is 91.
James M. Meyer, CFA 610-260-2220