Stocks fell Friday. For much of the day markets seemed stalemated after the release of a monthly employment report containing both good and bad news for equity investors. The “good” news was that employment growth moderated. We no longer seem to be in an overheated economy. The “bad” news was the pace of wage increases plus an increase in average hours worked. The inflation dragon isn’t going to be slain with wages rising close to 5% year-over-year amid a very tight labor market.
All of the interest rate increases and the decline in the size of the Fed’s balance sheet have yet to create the economic slack required to release pricing pressures. It still seems idyllic to expect no economic decline while slack is created that will bring inflation back near the Fed’s 2% price target. There are some who believe that this time is different (haven’t we heard that multiple times before?) and that the Fed’s inflation target should be closer to 3%. Hogwash! The 2% target is closely tied to long term history which demonstrates that 2%, or a rate very close to that, is needed for price stability. The difference between 2% and 3% doesn’t sound like a lot, but over time, a one percent change in long term inflation, or inflation expectations, becomes a big deal.
There are lots of reasons to suggest a systemic decline in inflation. Technology advances are deflationary. Look what the Internet has done for price discovery. New productivity tools will push inflation lower. We may be at, near, or even past peak demand for oil. While crude prices may or may not decline from here, the longer-term trend should follow the trends for other commodities in permanent decline like coal.
There are also demographic trends. The primary trend is one of lower long-term population growth. Without dramatic increases in long-term productivity rates, non-inflationary long-term economic growth rates will decline as well. That is a reality policy makers will have to accept. After the Great Recession, world economies had enough slack to allow extended spending and monetary easing to work. But it only worked until excess capacity was used up and labor slack disappeared. That happened in 2021 and 2022. Inflation was inevitable. Now we collectively are asking central banks to recreate slack without inducing recessions. Possible? Maybe. Likely? No.
The message Friday, which the markets came to grips with by the close, is that what Fed officials have been saying for weeks is probably true. That despite an increase in short-term borrowing rates of five percentage points, the level of economic activity still remains too high for inflation to recede. Indeed, even though commodities from oil and gas to eggs and beef are in decline, the inflation rate is still well above target. As noted last week, going from 6% to 4% is a lot easier than going from 4% to 2%.
If you remember back to supply chain induced shortages post-pandemic, when one snarl was unwound, another appeared. It took an extra year or more to return to normal. In some cases, normal still hasn’t returned. Go to your supermarket. Yes, the price of eggs and beef have come down. Sky high prices scuttled demand and prices reacted. But now go to the center of the store and look at the prices of everything that comes in a box or a can. Commodity price relief helps those producers as well. But higher wages, the increased prices for those cans and boxes, and more regulation is still putting upward pressure on prices. Skyrocketing prices will induce lower demand, but what it really induces is demand shift. If steak prices soar, one shifts to chicken.
Look at housing. Soaring prices and post-pandemic demand lifted prices at a near record pace. That ended in mid-2022 as soaring interest rates stopped demand in its tracks. Since no one wants to buy a home when prices are in free fall, buyers retreated for reasons other than high mortgage rates. But the decision to buy a house isn’t just affected by mortgage rates. More often than not, it’s a lifestyle choice. Your family is growing beyond the capacity of your two-bedroom apartment. Conversely, empty nesters don’t want to stay in the 5-bedroom home by themselves. The 6%+ mortgage did stifle demand, but it also stifled supply. No one wants to move and be forced to pay 7% for the pleasure of moving. Those forced to sell (e.g., job relocation or family death) end up putting a 30–50-year-old home on the market in desperate need of renovation. Thus, what we ended up with was not a housing market where supply swamped demand leading to lower prices. What we got was a more balanced market with lower demand and lower supply. Moreover, the root problem, a shortage of quality housing stock, is not being solved by high rates. New home demand is strong given the lack of quality supply, but the imbalance is not disappearing quickly. When rates do start to come down, demand will rise and so will pricing pressure. Inflation isn’t going to be defeated easily.
This has been called the most hated bull market in history. June’s 6%+ gain in stock prices lifted equity values more than 20% from the October 2022 bear market lows. Thus, in technical terms, the bear market is over, and a new bull market has taken its place, at least until the next 20% decline. But labels don’t really matter. Bull or bear, what matters to investors is what lies ahead. This bull market is unique in that 8 stocks now account for 30% of the value of the S&P 500. Each rose by an annualized rate of over 50% in the first six months of the year. Thus, while the S&P 500 is now in bull market territory, the Dow and other equal weighted indices are not. Can these 8 stocks replicate their first half performance in the back half of the year?
Earnings season is upon us. Consensus expectations are for a year-over-year decline of over 7%. Note that while 8 stocks comprise 30% of the value of the S&P 500, they account for a far smaller percentage of S&P 500 earnings. Indeed, some of the 8 pillars will likely report year-over-year earnings declines. The first half of 2023 was all about rising expectations. A big boost came from rising enthusiasm related to artificial intelligence. Hype can always get bigger. We saw that in the late 1990s before the Internet bubble burst. But at some point, reality takes over. We are nowhere near the speculative fever that accompanied the last IPO and SPAC boom. But clearly part of the gain earlier this year relates to an increase in speculation.
One also has to recognize the market impact of quantitative investing and the attendant impact of institutional momentum. Just look at last week. The ADP projection that job growth would be well over 400,000 seemed to jolt stocks Thursday leading to a 1%+ decline in prices across the board. When the number came in half that pace on Friday, shouldn’t that have led to some sort of reversal? I think the news Thursday stole the headlines, but the real story is that quantitative models concluded the June surge was over and induced a wave of selling which continued Friday. Obviously, there are times fundamentals matter. Last week wasn’t one of them. There was little fundamental reason last week to support any change in earnings forecasts. The rise in bond yields was a clear negative, hence, the correction. Rates are little changed this morning. So are futures.
Wednesday will witness the release of June’s CPI report. Beyond that, earnings season begins at the end of the week. As noted, it is likely to be bumpy. There will be pockets of both strength and weakness. One focus will be on profit margins, which have been in decline for several quarters. Will that decline accelerate? It depends on where you look. Air fares certainly haven’t declined. With strong demand, restaurants, airlines and hotels have pricing power. But other sectors are seeing weakening demand and lower prices. Even in technology, prices of PCs and memory chips are lower.
Earnings season should set the tone for the rest of the summer. In late August, the Fed’s annual Jackson Hole meeting will get attention, but until then, the focus should be on earnings. It’s hard to keep that June enthusiasm going.
Today, Jessica Simpson is 43. Sofia Vergara turns 51.
James M. Meyer, CFA
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