Stocks rose again Friday after a robust January employment report. After accounting for prior month revisions, the U.S. created more than 400,000 net new jobs. However, with the strong jobs report came higher interest rates. More employed workers suggests more capital needed to fund the expanded growth. On “60 Minutes” last night, Fed Chair Jerome Powell reiterated that the Fed was in no rush to reduce rates. The program was recorded before the Friday employment data was released. What he did say, however, was that the Fed’s focus has clearly shifted toward when to start lowering rates rather than concerns that further rate increases might be needed. Given that rates haven’t been raised since early last summer, that was a rather obvious conclusion. Before last Wednesday’s FOMC meeting, futures markets were giving a 45% chance that the first rate cut would be in March. The odds of a March cut today are 15%. The most likely date for the first cut has been pushed back to June. That would seem to be in synch with Fed commentary. All this assumes data trends remain on today’s glide path.
Perhaps the biggest economic surprise of 2023 was the nation’s pace of growth. Early last year, economists were predicting growth of less than 1%. They were evenly split between recession and soft landing. By the end of the year, however, it appears growth was over 3%. And that occurred as short-term interest rates followed almost exactly the path predicted at this time a year ago. So, if interest rates followed a path designed to slow the economy, why didn’t it slow? There are probably two answers. The first, the one talked about all year long, was the robustness of consumer spending fed by government handouts during the Covid pandemic. That was accelerated by rapidly rising deficit spending. The second reason is talked about less, immigration.
When trying to explain the economy, there is usually no better place to start than demographics. One measure of GDP growth combines the growth in the working age population and increases in productivity. Both surprised to the upside last year. Legal immigration totals increased over prior years that were held back by Covid concerns. Roughly 1 million people entered out country legally through traditional channels. Then there are the so-called illegals, mostly entering through our southern border under asylum claims. While over 600,000 were immediately deported, about 2.4 million were released pending hearing dates which could be years away. Congress is currently debating ways to limit those numbers. I don’t intend to get into the politics of that discussion. But the economics support better growth than had been anticipated. While precise data isn’t available, it’s safe to say that those entering from the south skewed younger, poorer, and less skilled than the average American. But with that said, over 3.5 million additional bodies relative to the 332 million Americans already here adds close to 1% to the workforce. Combine that with productivity gains at least a full percentage point ahead of expectations and one can understand why growth in 2023 exceeded expectations.
While growth was over 3% last year, earnings didn’t follow suit. A slightly deeper look yields something obvious. Last week, five of the six constituents of the Magnificent 6 (it was 7 but Tesla isn’t so magnificent at the moment) reported earnings. Including projected earnings for the seventh, Nvidia#, the six reported earnings gains of 63% in the fourth quarter. As for the other 494 members of the S&P 500, they are now expected to post a decline of 8.6%. Overall, the 500 grew earnings by a projected 1.6%. If you want an explanation of why stocks have behaved as they have over the last year, you don’t have to look much farther than the data I just presented.
3% real growth was closer to 8% nominal growth. Compare that to the 8.6% decline I just alluded to in Q4. Obviously, something is amiss. There are several factors.
1. International growth was far below U.S. growth.
2. China’s problems in particular hit some companies hard. That includes Apple# by the way, the second largest of the Magnificent 6, which saw a 13% decline in Chinese revenues during its latest quarter.
3. Pricing power dissipated for many, as consumers resisted further increases after the inflation spike of 2020-2022.
4. Regulatory costs rose while Federal funding supported by the infrastructure bill and the CHIPS Act was slow in being released.
5. The strong dollar hurt reported earnings as did added interest costs.
Hopefully, in 2024 some of these problems go away. Interest costs should decline. Inflationary pressures on costs will decrease. International economies should see some improvement although China is still an issue. Funding for infrastructure should slowly increase.
Obviously, the marked differences between the Magnificent 6 and everyone else hasn’t gone unnoticed. Meta Platforms# surged more than 20% after its blowout earnings report while Amazon# rose more than 7%. But the picture was less bright at Alphabet# and Apple#. While Apple resumed growth in the quarter, it wasn’t at a pace far different than the average American company.
As I note often, when it comes to investing in equities, it’s all about how earnings match up to expectations. The reason the Magnificent 6 did so well last year was a combination of better than expected earnings matched up against lowered expectations resulting from lack of cost control in 2022. This year, expectations are much higher setting a high bar for possible future gains. But as Meta and Amazon showed last week, there is still upside, at least for some. As for the other 494, there is no single answer. The factors surrounding homebuilders, retailers, airlines and industrials are all very different. Homebuilders last year showed what can happen when very low expectations match up against a positive reality that far exceeded forecasts. It turned out that while overall demand for homes was low, most of that demand went in the direction of new homes. Low expectations, low valuations, and better than expected results are the perfect combination. Don’t expect homebuilders to match 2023’s performance although further increases are likely if prices hold up. In 2024, there is certain to be another low multiple group or two where expectations are unreasonably low amid improving economics. One group already attracting attention is insurance. Climate change is the big villain here, but 2023 saw fewer catastrophes than in 2022. Meanwhile, rates have spiked reflecting a catchup and the likelihood of future climate related claims. There are plenty of other megatrends to watch including reshoring, infrastructure needs, the need to upgrade electrical grids and capacity to support EV and AI needs, restocking our military in the face of multiple wars, and, of course, artificial intelligence the 800-pound gorilla today. Every company will say they are embracing AI but only a few will do it effectively enough to separate themselves from competitors. Nonetheless, there is a fertile hunting ground out there.
One final point. Size matters. More specifically, large free cash flows are a differentiator. Achieving leadership in today’s world and continual expansion of that leadership requires a lot of capital. Companies with the money, particularly in a world where debt costs are high and the monetary base is shrinking, have a huge advantage. Having that advantage doesn’t mean one will be successful; the capital still has to be deployed wisely. But whether it is Microsoft in AI, or Caterpillar in industrial equipment, having the massive capital to grow is a humongous advantage.
Today, soccer stars Cristiano Ronaldo and Neymar are 39 and 32 respectively. Do you remember Nolan Bushnell? Back in the 1970s he was a household name famous as the inventor of Pong and Atari. I recall playing Space Invaders as Tug McGraw struck out Willie Wilson to seal the 1980 World Series for the Phillies. Today, Mr. Bushnell celebrates his 81st birthday.
James M. Meyer, CFA 610-260-2220