Stocks meandered back and forth on Friday with the major averages closing mixed. Bond yields continued to creep higher. 10-year Treasury yields have now climbed back above 3.75% after briefly falling close to 3.40%. The rise in yields is a headwind for growth stocks. As a result, NASDAQ constituents were the worst performers last week.
Just a few weeks ago, as sloppy December retail and manufacturing numbers were reported, the consensus among economists was that the odds of a recession during 2023 were as high as 80%. This conclusion was confirmed by a strongly inverted yield curve, but that all changed with the employment report ten days ago that showed astounding strength in the labor market. The odds in favor of a soft landing increased. Today, there is even talk that we may have already seen an economic bottom.
All this flies in the face of Federal Reserve policy. No one wants a recession, but the task at hand is to defeat inflation and return to a stable pace of 2%. Prior to the Covid pandemic, we lived in a world of low unemployment and low inflation. It was also a period when interest rates were exceedingly low, below zero in real terms. Indeed, rates since the Great Recession have spent much more time close to zero than at any level that would impute a positive cost to money. Free money stimulates demand, but it also stimulates supply and investment. For quite a few years after the financial crisis of 2007-09 ended, there was plenty of economic slack, enough to absorb the higher demand without any hint of higher inflation.
Cheap money didn’t inflate the price of goods, but an excess of money flooding the system, a key attribute of the Fed’s quantitative easing policy, helped to inflate the value of assets. At first it was reflected in higher prices for financial assets, both stocks and bonds. Eventually, it made its way into real assets, most specifically the price of homes. Then came the pandemic. Supply chain snarls crimped supply. While demand also fell briefly when we were all quarantined, once the doors opened demand exploded, overwhelming supply. The impact was shortages and higher prices. Once the Fed realized the problem wasn’t “transient”, it stepped in belatedly and started to raise interest rates while shrinking the supply of money.
That brings us to today. Most of the supply chain issues are being resolved. Demand is moderating, supply increasing, and inflation is easing. But is it that simple? The unemployment rate is now the lowest in over 50 years. Wage pressures, which accelerated in response to inflation approaching double digit levels, has come down a bit but remain elevated. In a world where there are still two jobs listed for every person unemployed, the balance still favors the employee over the employer. Commodity spikes have gone away and car lots are refilling. The insanities of used cars selling above list price or homes for sale attracting multiple bidders above asking price in a matter of hours are gone, but the auto and housing markets appear to be reaching some sort of equilibrium. Some of the commodities that fell sharply after a Covid spike are stabilizing or moving back up. Inflation may be moving in the right direction, but there are few signs that the 2% target is going to be hit anytime soon.
That creates an investment dilemma. On one hand, renewed growth is great for earnings. On the other hand, it is hard to see how inflation falls further or approaches Fed targets anytime soon if demand resumes before the war against inflation is over. This all plays into current Fed policy, one that, at least for the moment, seems appropriate. The February increase of 25 basis points in the Fed Funds rate was the lowest in almost a year. Another seems almost certain in March, although that needs to be confirmed by data over the next few weeks. Beyond that is more of a guess, but another 25-basis point increase could happen in late May. Will that be the end? As I have noted often, the actions of each meeting are data dependent. Right now, we only have some data to predict March accurately.
But we can reach some conclusions:
1. For equity prices, it’s the 10-year Treasury rate that matters more than the Fed Funds rate. The 10-year rate is the market’s judgment of the long-term inflation outlook. If inflation is going to remain elevated for longer, the 10-year yield will push higher. We, meaning both investors and the markets, know that the Fed will eventually defeat inflation. The 10-year yield represents the market’s best current guess as to how long the battle will take.
2. Once Fed Funds get to a level that slows the economy enough to bring inflation back to a pace that the Fed finds satisfactory, then investors can dwell on when rates can be lowered. Over the past several months, the resilience of the economy in the face of steadily rising rates and lower money supply has surprised economists. That may be due to less monetary pressure than needed, but more likely it has reflected both a surfeit of excess cash sloshing around, combined with the fact that the 96.6% of the labor force with jobs doesn’t feel a lot of pressure to reduce their spending habits.
3. Once the Fed does win the battle (and it will!), the question becomes how far can it bring rates down to create an economic equilibrium whereby demand and supply stay in balance, keeping inflation close to target. It is hard to see how that equilibrium rate can be far below 3%. Recall that between 1965 and 2000, the effective Fed Funds rate was over 3% for the entire time except for one month. If Fed Funds are 3% or more in a world of modest growth, it is almost certain that 10-year Treasury yields will be higher.
That is why I keep harping about valuation. At last week’s high, the S&P 500 was selling at 18.5x 2023 estimated earnings. That is materially above long-term averages. That may work in a world with Fed Funds rates near zero and 10-year Treasury yields near 2%, but that is a world we are unlikely to see for many years.
Over the past month, there has been a surge in speculation. We see it in crypto prices. We see it in meme stocks like GameStop or even Bed Bath & Beyond. We see it in the surge of Tech stocks, especially those tied in some way to the emergence of generative artificial intelligence (AI). Generative AI is for real and will be a huge catalyst for future growth, but it will be expensive to develop, it’s not ready for prime time yet, and most of these stocks have overreacted. If there was a lesson to be learned last year, even if you can identify the future winners, you can’t ignore valuation.
I don’t want to sound overly negative. I think the 10-year Treasury yield should remain within its trading boundary of the past several months (3.40-4.25%). As I have said all along, I am not convinced we face a recession, and if we do, it is unlikely to be severe. I think there is a high likelihood that the October lows are the lows for this cycle, but I don’t think stocks right now are particularly cheap, and I caution that growth over the next several years is likely to be very slow or inflation will rear its ugly head once again, reminiscent of the cycles in the 1970s.
Between 2009 and 2021, the S&P 500 rose at about 18% per year annualized. That’s an incredible pace, more than twice long-term averages. But many investors only have short-term memories. They don’t remember that from 1966 to 1982, stock prices went nowhere. 16 years of volatile sideways motion. Of course, there were some companies that grew exponentially during that time period. Index funds exploded in popularity after the Great Recession. Why not, if you could get 18% per year without a lot of thought? The next ten years are not going to be the same. That doesn’t mean 1966-82 has to be replicated, but it does mean that 2009-2021 won’t be.
If real GDP can average close to 2% and you add 2% inflation plus a 2% dividend, a 6% return seems achievable. If a particular company can gain some market share, introduce an attractive new product, become more efficient, or buy back some stock at a good price, 7% or higher is quite probable for many. 6% is 0.5% a month. That includes dividends. In January alone, stocks rose 6%. 0.5% per month is a bit like watching paint dry, but it adds up. Going forward will require more discipline. There won’t be that tailwind we saw in the last decade fueled by easy money. Find the right company at a fair price and you will succeed. It isn’t that hard, but controlling one’s emotions is.
Today, Peter Gabriel is 73. Jerry Springer is 79. Kim Novak turns 90. I don’t normally note people who have already passed, but there are two notables born on this date worth mentioning. William Shockley, a Nobel laureate for his work on inventing the transistor, was born in 1910. And one of the first to try and marry demographics to the economy was Thomas Malthus. Born in 1766, his 1798 book “An Essay on the Principle of Population” opined that too much abundance would literally starve future generations, vastly understating the impact of productivity and future invention. Only a relatively few years later, the cotton gin and steam engine (just two examples) disproved much of what he concluded.
James M. Meyer, CFA 610-260-2220