A stronger than expected jobs report sent stocks lower early Friday but an afternoon rally erased most of the losses. The rally demonstrated the market’s current strong momentum. We are once again at a time on the calendar when there is relatively little in the way of corporate or economic news, at least until next week’s FOMC meeting. That suggests trading should be relatively tranquil. However, it also means any surprise takes on outsized importance.
Investors seem to be settling in on the message from the Fed that the pace of future interest rate increases at the short end of the curve is going to be slower but that the ultimate rate peak will be guided by the persistence of inflation next year. The bond market seems to be betting that inflation will come down relatively quickly precluding the need to send Fed Funds over 5%. I read that conclusion from the fact that yields on 10-year Treasuries have fallen persistently for three months. No number is more closely aligned to the pace of expected inflation than the yield on the 10-year Treasury. Of course, the market isn’t always right. Friday’s jobs report showed wage inflation still over 5%.
Yet in a world of uncertainty, one thing is certain. As long as the Fed is committed to bringing inflation back toward its 2% target, it will succeed. What we don’t know is how long it will take or what economic collateral damage may occur as a consequence of Federal Reserve actions. Judging from the stock market rally since September, investors seem to be more confident than they were in late summer that the Fed can get the job done in 2023 with only modest economic damage. At the moment, that’s a guess, one written in pencil, not ink. We’ll see.
But there is no debate that persistence of higher interest rates, attaching a real cost to borrowing, will slow the pace of the economy. That hasn’t happened yet for a few reasons. First, rates only got high enough to squeeze growth rates in the past couple of months. The impact of higher rates takes time to cause actions to change. Second, Americans are still living off the $3 trillion bundle Washington handed out during the pandemic at a time when spending was restricted either by mandate or medical-related fears. One can see by the low current savings rate that consumers are starting to eat into that stash. One wouldn’t expect the spending spree to stop before Christmas especially since the unemployment rate is only 3.7% and jobs are plentiful.
That is not to say that pockets of weakness are beginning to show. Spending has drifted from goods to experiences. Instead of buying PCs and TVs, Americans are spending the money to travel. High interest rates have weakened housing demand although construction activity has remained strong due to strong backlogs. Layoffs are rising in Silicon Valley not due to economic weakness per se but to excessive optimism that technology growth rates would continue at double digit rates forever. These are pockets of weakness. Overall, economic growth remains solid, at least for now.
Thus, investor views are consolidating around a conclusion that (1) the Fed will win the battle to beat inflation, (2) it can be completed relatively quickly, and (3) the collateral economic damage can be contained. What hasn’t been discussed much is what lies on the other side, after the battle to reduce inflation ends.
From the start of this century through 2018, the U.S. population grew every year by at least 0.8%. In 2021 and 2022, that rate has be cut by more than 50%. In 2020 and 2021, Covid deaths had an impact, but there is more to the story. Birth rates are down. Immigration, at least legal immigration, is way down. The reasons are many. For this discussion, the fact that immigration is down is the only fact I need to deal with at the moment. Long-term economic growth is a product of population growth times gains in productivity.
As you can see from the chart above, productivity growth is below zero. It has only been this low post WWII in times of recession. Even if one tries to explain away the negative productivity of the moment, looking back over the past decade, the average improvement in productivity averaged around 1%. Add something less that 0.5% for population growth to a productivity of 1% and it is easy to conclude that sustainable growth will be something between 1% and 2%.
The Federal Reserve has two mandates, maintaining the purchasing power of the dollar, and maximizing employment within the constraints of the need to control inflation. Once equilibrium is restored, i.e., inflation is reduced toward 2%, what is the Fed likely to do? The best response would be for it to reduce short-term interest rates to a level that neither constrains growth nor stimulates it to the point of reigniting inflation. There is not one precise rate that corresponds to that wish, but suppose the rate is in the range of 2.5-3.0%, a level that would attach a real cost to borrowing should inflation stay close to 2%. The Fed could then make small periodic adjustments to keep inflation stable and unemployment low.
That, at least to me, would be the ideal. But will markets, the White House, and Congress tolerate growth of 1-2%? Won’t there be pressures to goose the growth rate? In the 1970s, the Fed fought and won the short-term battle against inflation 3 times only to respond with too much stimulus in the aftermath. This time, at least so far, the Fed has held to its game plan. In the 1970s, money supply grew at double digit rates. In 2022 it is declining, but to date, we haven’t seen any significant economic damage. If layoffs expand or there is some sort of mini-crisis in financial markets, the Fed almost certainly will add liquidity. As long as the increase is moderate and brief, that would be proper.
Thus, after the battle is over, we face two possible worlds. One is a world of slow growth dictated by lower population growth and tepid gains in productivity. Growth would be slower than in the past simply because of factors outside the control of Congress or the Fed. Even slow growth, however, would fulfill the Fed’s mandates of low inflation and full employment. The second possibility is simply that markets won’t accept that conclusion and will push for stimulus to accelerate growth. Depending on how much slack is rebuilt by current central bank tightening, such stimulus might work for a short period of time, but ultimately it will reignite inflation leading to a path that mirrors the 1970s, although hopefully not to the extreme seen back then.
For now, markets aren’t focused that far ahead. But as long-term investors, those possible consequences shouldn’t be ignored. Stock selection should be done with an eye to the likelihood that the tailwinds of future economic growth will be modest. Growth will have to come from gaining market share or from the creation of new opportunities that don’t exist today. Looking backwards, McDonalds# and Costco# are examples of the former while Google# and Amazon# are examples of the latter. The winners of the past are not necessarily the winners of the future.
Today, opera star Jose Carreras, one of the “Three Tenors” turns 76.
James M. Meyer, CFA 610-260-2220