Stocks nudged higher yesterday building on last week’s improvement, but gains were tentative ahead of tomorrow’s CPI report and the start of earnings season Friday, when several large banks report.
The CPI report for December price movements will be the last one before the FOMC meeting commences at the end of this month. Month-to-month changes can be quite volatile but there have been clear signs of improvement in the fight to lower inflation recently. In particular, goods and commodity price increases have been slowing. In some months there have been actual declines from energy to used cars. But, to win the war against inflation, rising prices for services have to be contained. Thus, investors will focus on the services component of the CPI when it is reported. Housing costs have also been a key inflation component. Within the CPI data there have been no indications yet that shelter costs are decelerating, but real time data suggests otherwise. Home prices are in decline and rent increases have been moderating. That doesn’t show up yet in the CPI data because of quirky ways used to calculate shelter costs, but it will in coming months. When it does, it will have a favorable impact on reported CPI numbers. However, FOMC members will look past shelter costs and focus on inflation forces connected to wages. We all know that. Fed officials have stated as such repeatedly. That’s why the focus tomorrow will be on wage related data.
With that said, part of the market’s strength in recent sessions relates to an expectation that recent signs of moderation, even in wage demands, will show in tomorrow’s numbers. One argument swirling in economic circles is whether the path of wages drives inflation or whether inflationary pressures drive wage demand. There is little consensus. At the same time, Fed Chair Jerome Powell reads history that pertains to inflation. He firmly does not want to repeat the 1970s by giving up the fight too soon. In the 1970s, the Fed, via tight money, stamped out most inflationary pressures three or four times only to see it come back even more strongly after it relented and returned to easy money too quickly. Back then, its mistakes were more about its actions after economic downturns were induced in 1970 and 1973-74 than on forces used to drive inflation lower.
On Wall Street, investors often focus on one key event. It could be the unemployment rate, or changes in the value of the dollar. Back then it was the weekly disclosure of money supply. The big mistake the Fed and Treasury made back then was simply to increase the money supply at a massive pace between battles to fight inflation. The Fed, with significant help from Congress and the White House, repeated the same mistake in 2020-2021 as money supply grew at over 13% while the Fed was buying bonds at the same time Washington was doling out trillions in response to Covid-19 effects. In 2022, as we all know, that process was reversed. The supply of money is now shrinking. The only reason we have not entered a recession yet is that Americans are using massive savings built up during the pandemic with government handouts to support their spending. That can’t go on indefinitely. Thus, the key going forward isn’t how high the Fed will raise short-term rates. It’s how fast it will moderate interest rates and goose the money supply after inflation is subdued. If Mr. Powell is a true student of the past, he will moderate rates slowly and work, with Treasury, to keep money supply growth in the mid-single digit range. Implementation can be tricky, but it is highly doable.
The biggest impediment to a successful transition from tight money to what we might think of as normalization is the fortitude to withstand pressure from markets to remove the lid from the monetary cookie jar once again. Everyone needs to understand that demographics are working against central bankers not only in the U.S., but worldwide. Working age populations are shrinking in Japan, starting to shrink in China, and in decline throughout much of Europe. Here there is still population growth but it has been cut almost in half since the pandemic started. Part is the pandemic itself. More people are dying. The average lifespan of Americans has declined for the past two years. That should be temporary.
In addition, immigration is also falling. That too has been impacted by Covid-19. It has also been impacted by both bureaucracy and by the need to modernize immigration legislation. The chances for the latter are virtually nil in Congress. The bottom line is that moderating demographic growth suggests sustainable real growth in the U.S. cannot be sustained above 2%. Thus, the key issue is whether the Fed or the White House can finish the battle and keep inflation contained while words like “stagflation” and “recession” are all over the airwaves. It’s easy to say it can, but keeping control against a weakening backdrop will be a tough fight.
Most economists still believe a recession is inevitable. The inverted yield curve implies that bond investors agree. Yet financial markets have predicted many more recessions than actually take place. Assuming there is a pending recession, bear markets never end before the recession begins. But what if there isn’t a recession? What if facts show a recession has already begun? There are no simple answers. While there are weak pockets within our economy, there are few signs we are already in recession. One factor that may help to avoid an actual recession is that consumers always have choices. Famously, beef, pork and chicken are all commodities with different cycles tied to the various animal lifecycles. Thus, if beef prices soar, consumers can buy chicken.
One big change today, impacted by inflation and the fight to contain it, is the sharp rise in interest rates. While that increases costs for those that borrow, it can be a boon for savers and seniors. The 2023 cost-of-living adjustment for Social Security is 8.7%. 66 million Americans receive Social Security. The increase will add just about $100 billion to their pocketbooks starting this month. There is also about $1.2 trillion deposited in money market funds. A year ago, interest was nil. Today, that generates close to $500 billion in income. Savers win and borrowers lose. Corporate borrowers may have to eat some or all of those costs. It is hard to pass costs on to the buyer when demand slows. That will impact profit margins. It remains possible that we will see earnings decline without a true recession. Indeed, as we enter earnings season, consensus expectations are for a slight decline amid an economy still growing.
As growth moderates, companies will adjust. We are seeing that especially true today in the tech world. Supercharged growth across the tech spectrum ignited by the emergence of cloud computing and pandemic-induced “work from home” has subsided. Cloud migration continues, but at a slower pace. As for PCs, demand has collapsed as so many users upgraded to support working from home. With business slowing overall, companies are rationalizing capital spending making sure they don’t build zombie infrastructure for demand that doesn’t appear.
We are in a transition. Actually, we are in a set of transitions. Short-term interest rates are still rising while longer term rates appear to have peaked. Pandemic-caused shifts in demand across industries are moderating. Americans are still paying up for experiences and less on discretionary goods. Even Washington is in transition as Republicans take over the House. Typically, transitions increase market volatility. We may see more during earnings season, but clarity is going to increase as 2023 progresses. If there is a recession, it should be mild and could end before 2024. The Fed will achieve peak short-term rates within months. Once the smoke starts to clear, corporations can manage for the future with greater clarity, but future clarity must incorporate real costs for money, and slower long-term growth. That’s true for both businesses and investors. To grow, corporations are going to have to grab a larger percentage of consumer wallets. That will only happen with better products, better service and better execution.
Finally, don’t lose sight of valuation. The stock market today is near fair value. Any burst higher should be viewed a bit skeptically. Any sudden decline creates a buying opportunity. Don’t let short-term emotions overwhelm these sober realities.
Today, Mary J. Blige is 52. Ben Crenshaw turns 71.
James M. Meyer, CFA 610-260-2220