The winning streak continued yesterday with the Dow rising for the ninth straight session, one that offered very little new news or corporate events that could serve as a further catalyst for the market rally. Bond yields held steady.
Economists talk in real terms. They measure growth rates subtracting out the impact of inflation. But the world operates on nominal terms. When a company reports sales, it doesn’t adjust the figures for inflation. It simply reports in nominal dollars. If sales rise 6%, 2% real and 4% inflation, the numbers would be identical if real growth had been 4% and inflation 2%.
But that doesn’t mean inflation doesn’t matter. With proper long term monetary policy, inflation expectations have been anchored in the 2.0-2.5% range for decades. Investors never looked at the inflation of 2021-2023 as likely to be sustained for decades. The Federal Reserve and other central banks are charged with trying to maintain price stability, i.e., a persistent and predictable long-term pace of inflation. Deflation is worse than inflation. If consumers were to assume that prices would actually drop persistently, they would hoard dollars and only spend as necessary. Japan has been fighting deflation for decades while consumers hoarded yen and per capita growth stayed flat. That’s why the target rate for inflation is 2%, a manageable buffer to prevent the insidious impact of deflation.
Inflation is a monetary phenomenon. It reflects an imbalance between supply and demand. It is easy to argue that quantitative easing and an overly expansive fiscal policy for more than a decade ignited inflation. But the real culprit to the dramatic rise in prices post-pandemic was the disruptive impact of broken supply chains. As they healed, inflation returned in the direction of normality. Of course, tighter monetary policy impacted inflation as well.
As investors, our major focus is on earnings. Again, we are looking at earnings expressed in nominal dollars. Companies can’t control inflation. But they do have some control on costs. They can reduce headcount or invest for better productivity, for instance. Moreover, we know that wage growth lags behind any surge in inflation. Wage increases are a reaction to rising prices that workers face. Workers want to at least maintain their current purchasing ability. Without inflation, they would be satisfied with nominal wage growth. With high inflation, they will insist on significant wage increases. But only after the fact. That’s why you see so many strikes and difficult negotiations this year versus the last two years. The cumulative impact of past inflation forced workers to take a stand. With unemployment below 4%, they had the advantage in 2023.
As noted earlier, corporate reported sales growth doesn’t differentiate between real and nominal growth. Managements in many cases try to report “organic” growth, a fuzzy measure of real growth adjusted both for price increases and the impact of acquisitions. But there is no precise definition of organic growth and you can be sure that managements present the numbers in the best possible light.
Inflation raises revenues. A strong economy provides real growth. But as inflation recedes under monetary pressure and real growth rates slow (or turn negative), there is a double whammy effect on the top line. At a time when the average wage is rising at close to 4% and pricing power is eroding, it is likely that margins soon will come under pressure.
Let me turn to a franchise model to make a point. McDonald’s# and others collect revenues from franchisees based on total sales. For the purposes of calculating franchise fees, there is no difference in the mix of real growth and the impact of inflation. Moreover, in McDonald’s case, it charges franchisees rent, also based on a percentage of sales. Here, the company has a distinct advantage because its real estate costs are much more fixed than variable. As inflation drives revenues higher, its real estate revenues will almost certainly rise faster than its real estate costs. There is little question that on the bottom line, inflation is the friend of a franchisor. Of course, McDonald’s is concerned that rising prices might push customers away. But as inflation pinches consumers, the natural reaction is to trade down to get a better value. That also helps McDonald’s. But when inflation goes from 6% to 2%, the growth in franchisee related fees will decline. Perhaps the appearance of a bargain in nominal terms will be additive to growth, but not enough to offset a large decline in the pace of inflation.
While I used McDonald’s and the franchise model to demonstrate a point, the same pressures apply across a wide swath of the corporate world. For many businesses, labor is the biggest expense. Given that wage growth lags inflation growth, the impact of higher wages are only now beginning to be felt. We saw that graphically this week after Fedex# reported. Weaker volumes and rising wages are a toxic combination. Investors had flocked to Fedex after UPS# reached a successful negotiation with its labor unions that will pinch margins for some period of time. But it turns out both companies are facing similar headwinds.
The big question one needs to ask during this euphoric rally is how much of the combined pressure of slowing growth and reduced inflation on corporate top lines is reflected in what are now clearly elevated expectations. Investors are celebrating what they perceive as increased odds that recession can be avoided without recognizing the pressure on both top and bottom lines of slower growth and reduced inflation.
I mentioned earlier the pernicious impact of deflation, why it must be avoided at all costs. But in the real world, we face deflation every day. We can all afford personal computers today because prices have come down to levels that make them affordable. The price per megabyte of computing power in semiconductor chips has changed our lives. Not only do we all use PCs, but we carry smartphones, watch TV on cheap flat screen TVs, drive much safer cars, stream videos, etc. all due to the dramatic and perpetual reduction in cost of the engines that drive all these products, the price of a semiconductor chip. Some of the best and brightest companies in the world operate in this theater of sharply decelerating costs. Moore’s law that a perpetual 20% annual decrease in costs can be regained by even faster revenue growth has proven to be correct. While there is an obvious end game to the advantages of sharply decelerating unit costs, that doesn’t appear to be in sight yet. Artificial intelligence only appears likely to accelerate the gains.
But few businesses can achieve the cost savings that technology affords similar to what we see in the TV and smartphone arenas. Technology can offer some productivity gains that could alleviate the impact of 4% wage growth. But, for most corporations in businesses that change or evolve much more slowly than those impacted by AI, the question is whether the technological impact on productivity will offset the twin headwinds of slowing real growth and receding inflation. S&P earnings are currently running at an annualized pace of about $230. That puts stocks at over 20 times earnings. Consensus forecasts show growth accelerating next year with S&P earnings rising toward $245. If true, that would still put the P/E over 19, high by any historic measure. But what if the pressures exerted by slower growth and receding inflation make earning 6-9 months from now closer to $200? That would return P/Es to their 2021 peak. I am not yet predicting that sort of decline. But I am not willing to dismiss a medium-term reduction in earnings. Growth within technology sectors could offset some of the impact. That is why the Magnificent Seven still hold up at their lofty valuations. But even they are not immune. Smartphone sales are no longer growing. Social media depends on the growth in advertising revenue. For decades, the social media companies have benefited from a shift in ads away from traditional media like newspapers, radio and linear TV. But the bulk of that shift is behind us. The overall dollars spent on advertising is a function of total retail revenues. Will people who spend 4 hours per day on social media soon spend 6 or 8? Assuming the time for sleep, work or school doesn’t change dramatically and further assuming technology can’t make the day longer than 24 hours, there is a limit.
As an investor, one does best when correctly assuming the consensus is wrong. Right now, the consensus says the economy will continue to grow without a recession. It further assumes inflation will fall toward 2% faster than previously anticipated. Finally, it is assuming earnings growth continues and actually starts to reaccelerate in the second half of 2024. Lastly, it assumes the pending Presidential election will generate much more angst on the front page rather than the financial page of the newspaper. I would concur with that conclusion, at least until we see the makeup of Congress for 2025 and beyond. But my major quibble is that I see the double whammy of slowing economic growth and lower inflation being more hurtful to corporate margins than companies perceive today. That suggests higher unemployment and a shift in Fed focus away from fighting inflation to one that focuses on shoring up economic growth rates in 2024. The key therefore is whether monetary easing can happen fast enough to keep earnings elevated. Given the time lag between implementation and impact of monetary policy, I think the risks to growth over the next several months will need to be reevaluated in the first half of 2024, suggesting markets will face stronger headwinds in the first half of the year than in the second half. Stocks could finish 2024 higher than they are today but only if investors feel earnings are starting to reaccelerate before next year ends.
Today, Dick Wolf, the TV producer who has given us such shows as Miami Vice and Law & Order, turns 77.