Stocks celebrated last week with their best performance in months following a better than expected CPI report for June. Markets now believe the pending July Fed Funds interest rate increase will be the last, and increasingly feel a soft landing is the likely path for our economy. Under such a scenario, the future path for interest rates is lower with earnings moving higher, a nirvana for stock investors.
Some years ago, I learned that to prove a thesis one had to disprove the alternative outcomes. Psychologically, we all want to believe our predictions will succeed. We naturally seek evidence to support our forecasts and often pooh-pooh anything that contradicts our thoughts. With that in mind, let’s look at some possible loopholes in the Goldilocks forecast that suggests inflation has been defeated and recession will be avoided.
First, let’s look at inflation. One can only read last week’s CPI report in an optimistic fashion. Obviously, not every component fell into perfect harmony, but most did. Sharp seasonally adjusted drops in used car prices and airfares certainly helped. We also know that shelter cost increases are moderating. But if one looks at the June employment report, there is a fly in the ointment. Wages keep rising at a rate of over 5% adjusted for some of the biases within the government’s calculation (e.g., low-cost youth replacing high-cost baby boomers retiring). That doesn’t synch with 2% long-term unemployment. Nor does adding over 250,000 jobs per month (the most recent three-month average). If inflation is going to be defeated, wage pressures have to lessen. That doesn’t require a recession, but it does require a softer labor market than we have today.
Second, let’s look at China. Growth there is slowing and the deceleration may be accelerating. Inflation has disappeared. Quarter-over-quarter growth in the second quarter was just 0.8%, less than in the U.S. Youth unemployment is now over 21%. Debt is choking the real estate market. Birth rates are declining despite abandonment of its one-child policy. In China, there is no safety net for seniors. They end up living with their children. U.S. direct investment in China is down 80% over the past year as the Chinese erect barriers to prevent spying. Savings rates are rising to protect against future economic weakness. World economic forecasts now expect world growth in 2023 of just 2.1% vs 3.1% last year. China is on the cusp of deflation. In a way, that might help tame our own inflation as the government there seeks to increase low-priced exports. But U.S. companies have been changing supply chains, moving production to other countries with even lower costs than China. Thus, China’s deceleration is more likely to hurt the growth rates of U.S. multinational companies than it is going to help the fight against inflation.
Next turn to the Federal government, in particular the White House’s spending plans. Congress is not about to give Biden more money to spend. But it has already appropriated a lot, like the CHIPS Act and the infrastructure spending package. Despite a Supreme Court that shot down Biden’s plan to eradicate over $400 billion in student debt, he is taking alternative steps to do just that. 2024 is an election year. If you want to win, hand out money. That goes for Republicans as well. The young and lower wage earners are Biden fans. Why not? During the pandemic he sent everyone with children checks and paid anyone laid off $15 per hour. He forgives loans, wants free pre-school and community college. Most see no downside to the handouts. Trust we will see more of them over the next 12 months. That’s hardly deflationary. Thus, while the Fed might be resolute, the White House is not.
There is a positive side to all this. Workers are starting to get ahead. Wages are finally rising faster than inflation. As long as unemployment hovers around 3.5% and workers feel secure in their jobs, they are going to keep spending despite elevated interest rates. Big banks reported loan growth last week fed mostly by rising credit card debt. As long as the money is still coming in, few worry about spending a bit more and paying 20% or more for the privilege.
Housing is booming again. At least new home construction. The root cause of high home prices is an imbalance of supply of quality homes for sale and the demand to buy. Demand is driven by demographics. The young are forming families. The Boomers are looking for a change toward active adult communities. The solution would logically be lower mortgage rates to incent more buying interest. Obviously, that isn’t happening. Both demand and supply are down. But supply is down more. Few want to give up their 3% mortgages. Those willing to do so are selling 30+ year old homes that will be money pits to young buyers. Thus, the only place to get what a young family wants is a newly constructed home. It may be more expensive today, but buying a smaller home than originally desired is better than staying in a cramped two-bedroom apartment when the third kid is on the way.
Thus, it seems that the seeds for growth in the U.S., a strong labor force, some excess savings still available, solid housing and auto markets, and rising capital spending funded by Washington, suggest a recession, if it comes, is still months away. Inflation is falling, but whether it can get toward 2% without some labor slack is open to debate. The Fed rate hiking cycle may be ending. But with an economy continuing to grow, there will be little pressure to lower rates. With that said, if the economy can grow 2%+ with rates where they are today, why change anything? Said differently, what you see is what you are likely to get for some time. That isn’t so bad.
Finally, let’s look at markets. For months, Cassandras have been talking about the concentration of market leadership in about a dozen big name companies, mostly tech-related. To be fair, the best performers in the second quarter weren’t tech names, they were the three public cruise ship operators, so there has been some breadth expansion. But the gap between the winners and losers has widened and is noticeable. This hasn’t been a homogeneous economic expansion. Regional banks were hurt by several notable bank failures in March. Most report second quarter results this week. The situation isn’t as dire as was forecasted soon after the bank failures occurred, but their earnings models have taken a turn for the worse. Health care companies have had a tough time year to date. Spending related to the pandemic is sharply lower. Patient reticence to go to a hospital for non-emergency procedures is slowly waning. Venture capital for new drug development took a hit last year during the bear market and is evidencing itself in less than expected clinical trial activity this year. The Federal government, the largest payer for health care services, is pushing back hard on everyone from hospitals, to drug companies to insurers. All feel the squeeze in different ways. Demographics strongly suggest rising demand in the future for health care services. How they are paid for and who pays them is open for debate.
There are other large pockets of weakness. The oil and gas industries suffer from lower prices. Food commodities are also in decline. The shift from linear television to streaming is creating economic havoc. A shift toward work-from-home has impacted everything from office buildings to parking lots, to sales of PCs. Consumer spending for goods has suffered as Americans spend more on experiences.
With all this said, let’s look finally at valuations. If 10-year Treasury yields stay within a range of 3.50-4.25%, there shouldn’t be much further adjustment to P/E ratios overall. While the S&P forward P/E near 20 is dangerously high, stripping out the top dozen names brings the P/E back to a bit over 16. Earnings are still falling slowly, largely related to pressure on profit margins. Despite efforts by managements, that trend may continue. Forward earnings estimates remain a bit high. One can also argue that a robust recovery in 2024 is unlikely. If there is a recession, it will be a 2024 event. Even if there isn’t, growth rates next year will be under pressure from the deferred impact of higher rates, slower growth in China, and reduced abilities by U.S. consumers to spend, given the reduction in excess money created during the pandemic and rising credit card balances.
All this argues for a much slower growing stock market in the months ahead. I can’t tell you when today’s momentum will wane. But stocks can’t continue to rise at the June/July pace without fundamental support. Clearly, the remaining earnings reports, plus the CPI and unemployment reports for July and August will be key market drivers over the next several weeks. It should be an active summer. As for next year, beyond current earnings season and the Fed’s gathering at Jackson Hole in August, that will be the topic for Wednesday’s note.
Today, Luke Bryan is 47. Angela Merkel is 69. Camilla Parker Bowles turns 76. Finally, Donald Sutherland is 88.
James M. Meyer, CFA 610-260-2220