Stocks continued the post-FOMC meeting rally yesterday. While the outcome of the meeting- no change in the Fed Funds rate, was as expected, the outlook of FOMC members changed dramatically in the twelve weeks since the September meeting. Inflation expectations dropped by about 50 basis points over the interim. Markets reacted quickly, pushing 10-year Treasury yields down from about 4.2% to just over 3.9%.
Let’s look back before looking forward. All recent measures of inflation show much faster deceleration than most believed. And that is without much difference in the rate of change for rents. The slowdown in rental increases (and lately in some cases decreases) has yet to flow through the CPI data. All isn’t perfect however. Wages are still rising at close to 4% and labor intensive services are also rising in price faster than the Fed’s 2% goal. But wage increases always lag the pace of the overall economy and inflation. They are reactive to the recent past, not proactive in anticipation of rising prices. As for the economy itself, in the third quarter, it grew about 5% in real terms, aided partially by a build up in inventories. That rate is likely to fall to a 2-3% range this quarter. November retail sales rose a surprisingly strong 0.3%. Most economists expected sales to have been flat or fallen slightly.
Thus, where we sit today, inflation is receding and the economy continues to prove resilient. At the same time, continuing unemployment claims are trending upward, a sign that finding a new job is significantly more difficult than it was a year ago. The number of workers quitting one job for a better opportunity elsewhere is also down meaningfully.
A year ago, the consensus was that 2023 would be a year of slower growth or even recession as the Fed still had to tighten monetary conditions to bring down inflation associated with a mismatch between supply and demand. Why did that forecast prove so wrong? The Fed stopped raising interest rates in July. As inflation receded faster than expected, the real cost to borrow rose even without more rate increases. Shouldn’t that have slowed economic growth? It turns out several signals were missed.
1. Much of the inflation was due to supply chain disruptions. The mismatch in supply and demand resulted from a combination of too little supply and too much demand. It appears markets assumed too much demand was the bigger problem when, in actuality, with the exception of travel and leisure, the issue had been lack of supply. Once supply chains healed, price increases slowed dramatically. Look at the auto industry. When there were virtually no new cars available on dealer lots, the price of late model used cars for a time actually exceeded the sticker price for an equivalent new car. Those days are over.
2. The power of all that excess savings built up during the pandemic was underestimated. Many argue those savings are still higher than normal. But there are signs that consumers are starting to feel some pressure. Given the low unemployment rate, it stands to reason that this isn’t the year to be Scrooge at Christmas time. But credit card balances are rising as are loan defaults. Will the consumer exuberance continue once Christmas is over? That’s an important debate.
3. Immigration, both legal and illegal have risen dramatically over the past two years, adding nearly a full percentage point to our population. While some may believe that immigrants stay in this country and just live off of welfare and handouts, that clearly isn’t close to reality. They work because they want to and because they need to. They rent, they consume goods and services, and they pay taxes. Documenting the economic impact, particularly from those illegally crossing our Southern border, is difficult. But clearly, it is additive and will continue to be additive as long as the borders remain open.
4. Our federal deficits keep rising. Part of it is expansive spending programs. The impact of bills passed two years ago (e.g. infrastructure) are just starting to work their way through the economy today. Adding in the additional costs for entitlements and debt service leaves us with massive and growing deficits. The deficits mean, economically, that we borrow today in order to spend more whether it be for infrastructure or debt service.
As we look to 2024, what’s about to change? Supply chains are almost all healed by now. Consumers will almost certainly exhaust excess savings no later than mid-2024. At the same time, immigration will keep rising and so will our deficit. The bottom line is that growth will slow. But it may not end up in recession territory.
That’s where the Fed comes in. The FOMC decision making process relies heavily on data. Chairman Powell espouses data dependence constantly. While the Fed constantly canvases for real time anecdotal information which impacts decisions to a degree, it’s the data that generally drives decisions. By definition, data is historical. It is backwards looking. The net result is that the Fed is almost always late in raising or lowering rates as needed. It didn’t start to raise rates until March 2022 even though all signs pointed to an overheated economy driving inflation higher months earlier. Similarly, today the Fed wants more evidence supporting the conclusion that inflation will fall to 2% and stay there before loosening its monetary grip. A 5.25% Fed Funds rate has a real cost of a bit over 1% if inflation is 4%. If inflation is 3%, the real cost doubles without any change in rates. The Fed stopped raising rates in July. Inflation has slowed since. Thus, the real cost to borrow today is higher than it was four months ago.
At Wednesday’s FOMC meeting, the attendees penciled in three rate cuts in 2024, up from two the last time they did their dot plots. Markets, however, were pricing in up to seven cuts next year. They still are although the odds of a March cut have slipped slightly. I would only note that March is a long way off. The Fed has two mandates, to stabilize prices and promote economic growth. If it views inflation under control by March and economic data suggests any further weakness, a first cut may be called for then. But again, remember the Fed is almost always late, particularly at transition points. It is not an unlikely scenario to see the Fed wait until May and begin with a 50-basis point cut.
Under almost any scenario, one should expect the Fed Funds rate a year from now to be well below where it is today. The logical end point, assuming normalized growth near 2% and inflation also near 2%, is for a Fed Funds rate higher than 2%, probably closer to 3%. It is also logical to assume a 10-year Treasury rate around 4% or near where it is today. In October I argued that a 5% (or higher) 10-year yield made no economic sense. I would argue strongly that those expecting the 10-year yield to fall well below 3.5% and stay there are wrong as well.
Markets advanced earlier in 2023 as growth sustained itself and 10-year yields stayed below 4%. But from July to October, the 10-year yield went from about 3.75% to 5% almost in a straight line. Stocks retreated. Once bond markets reversed, stocks rallied sharply. Since October, 10-year yields have fallen back below 4% and stock indices are now at all-time highs. With that said, earnings are close to the expectations of four months ago, while long-term yields have returned to where they were then. However, with stock prices back to record highs, valuations are once again stretched.
As noted by everyone, we are in a very favorable seasonal trading pattern for stocks. Taxable investors don’t want to realize more capital gains until after December. Companies have been actively buying back their stock. All that will change soon. Taxable investors are not necessarily going to sell on the first trading day in January; they will wait and see if momentum continues. But if it doesn’t, they will start to sell. Meanwhile corporations have to halt buyback programs soon as the fourth quarter comes to an end. They will be on the sidelines until after they report 2023 earnings in the second half of January. The conclusion is that this might not be the best time to chase this rally. One may argue, “what if the 10-year Treasury yield falls to 3.5% or lower?” I would counter that such a case would reflect a softer than expected economy more than a further sudden reduction in long-term inflation expectations. If that were to occur, 2024 earnings forecasts would have to be lowered.
Thus, as the sharp rally this past June and July took most of the wind out of the markets’ sails, I would think the October-December rally has left few bargains on the table. I am not predicting a bear market or even a significant correction ahead. But I do think some degree of caution here is prudent.
Today, actor Don Johnson is 74.
James M. Meyer, CFA 610-260-2220