Stock prices surged ahead again this week in anticipation of a favorable CPI reading to be released at 8:30 this morning. Core inflation, the key number within the CPI report, has advanced 0.4% month-over-month for the past three months. Annualized, that is a rate close to 5%. Investors know shelter related costs, the largest component of the index, are coming down. Hopefully, that will evidence itself in today’s report.
One monthly improvement is probably not going to be enough to prevent the FOMC from raising rates again at the end of July. But a string of improved inflation readings for three months could signal the end of the cycle of rate increases before the next FOMC meeting in September. You can’t have a string of improved readings without a good start today.
Up to now, core inflation has remained stubbornly close to 5% largely due to elevated shelter costs. Those costs are most impacted by rental rates and by a fabrication that the Bureau of Labor Statistics uses to apply a rental equivalent to home ownership, an imputed shelter cost. Together, these numbers comprise close to 40% of core inflation. If our government measured inflation as the Europeans do, inflation today would be much closer to 3%.
But that doesn’t mean the battle is over. Commodity prices have weakened in recent months, particularly oil. Commodity food price increases have also moderated although packaged product prices keep rising. The stickiest part of inflation relates to services. Auto repair costs, professional services, and hospital expenses continue to rise at an accelerated pace. These have in common a high labor component. Wages continue to rise at an annualized pace close to 5%. The Fed is winning but the war isn’t over. The key question is whether the interest rates now in place are adequate to get the job done. Markets this week are signaling that they believe the answer is yes.
For months, economists have been forecasting recession. The yield curve inverted, rate increases pinched housing demand, and a weaker dollar dampened export demand. But the economy keeps growing. Predictions now suggest it grew at an annualized rate of over 2% in the second quarter. If there is a recession pending, few see it happening before the fourth quarter at the earliest.
The key question is why, with all the monetary tightening, is the economy still growing? Look at the chart below that plots M2, the favored measure of money supply.
You can see the consistency of growth from 2016 to 2020, the start of the pandemic. If I started the graph in 2010, that line would be just as straight. I extended the line to date in red. What you see graphically is a huge gap created by the government whereby the Fed increased the size of its balance sheet enormously while Congress allocated huge additional funds to offset the economic impact of the pandemic. The gap is all the excess money created, money consumers are now using to travel and go to Taylor Swift concerts. The gap is a lot smaller than a year ago, but it still hasn’t closed.
When will it close? Assuming the Fed continues to reduce its balance sheet at today’s pace, the lines should come together in about a year. If the Fed can manage to get both lines in perfect synch, perhaps there will be no recession. Perhaps the glide path for inflation gets down to 2% in a year or two. But more than likely, the landing won’t be perfect. Consumer revolving debt, mostly related to credit card borrowing, is rising at a 12% pace. And that debt costs 20%+ for many! Savings rates are down. So was labor productivity in Q1. Thus, there are signs of stress. But signs of stress don’t mean recession. As noted, GDP likely continued to grow in Q1.
While investors are concerned about the growth of the overall economy, stock prices are based on earnings, not GDP. Earnings fell the past two quarters and are expected to fall again this time around. The key is profit margins. Pretax margins peaked late last year at over 13% and could fall to close to 11% this quarter. Companies have not been able to pass on all the costs related to inflation. Growth overseas is slowing, particularly in China. Dollar weakness has curbed export growth.
A big focus will be on the tech leaders that top the S&P 500. In general, revenue growth has moderated. All have reacted by focusing on reducing expenses. Short term, that will help profits, but no one achieves long-term success simply through cost-cutting. AI is the new rage. It won’t come about by magic. Companies such as cloud providers AWS and Azure are going to have to spend lots of money to expand capacity and capabilities to support user demand. Thus, while Amazon# might be able to moderate headcount growth at its retail warehouses, it will have to spend to support its cloud services businesses. If you can recall last fall, the pillars of the S&P suffered as revenue growth slowed faster than expenses. Conversely, in the first quarter, investors applauded expense discipline. What will happen this time? Expense discipline is still in place. But investors will want to see signs that revenue growth might reaccelerate.
Thus, after today’s CPI report, the focus will quickly move to earnings. Earnings results matter but future expectations matter more. It isn’t just about tech. The best performing stocks in Q2 were the cruise ship lines. Passengers are back. Adjusted for all the stock the cruise companies had to issue to raise enough cash to stay alive, and the additional debt they had to borrow, the market cap for the three largest companies is now back close to record levels. In the stock market, the celebration has already taken place! Will new travel records be set in 2024?
In the stock market, 2023 to date has been a mirror image of last year. What worked last year as rates were rising, inflation surging, and Covid costs still elevated, was energy, health care and consumer staples. They are among the worst performers this year. This year, last year’s losers, especially high-tech names, surged ahead. Is there another pivot ahead? If the economy continues near today’s pace, cyclicals such as industrials and retailers should do better. Tech has had a great run which could continue. But the pace of improvement is unlikely to match the first half of the year. If interest rates are near a peak, yield sensitive stocks like utilities and REITs can do better. But the all-clear siren hasn’t sounded. There are still stress points from commercial real estate to the outcome of the entertainment streaming wars. In sum, look for another pivot. Don’t be afraid to rotate your investments accordingly.
Today, WWE star Brock Lesnar is 46. Cheryl Ladd is 72. Bill Cosby turns 86.
James M. Meyer, CFA
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