Stocks were mixed on Friday although the Dow managed to eke out its 10th straight up session, the longest such streak since 2017. Futures point higher again this morning. Bond yields are down slightly this morning but remain within a narrow range approaching this week’s FOMC meeting.
What is the Fed likely to do on Wednesday? According to Fed Funds futures, the odds of a 25-basis point increase are 99.8%. That’s as close to 100% as I have ever seen. Thus, the issue isn’t the rate decision, it’s all about what the Fed says going forward. The next FOMC meeting isn’t until mid-September. Between now and then there will be lots of data on both the economy and inflation. Besides the normal influences like monetary and fiscal policy, this summer has witnessed the negative effects of scorching heat vs. the economic steamrollers named Barbie and Taylor Swift. But seriously, the Fed is unlikely to say much this week that has any real meaning beyond noting that (1) inflation still hasn’t been defeated, and (2) future decisions on rates will be data dependent. The Fed holds its annual get together at Jackson Hole in late August. For anyone looking for future policy hints, that will be the first time anything meaningful is likely to be said about September actions, if any.
Markets don’t wait for the Fed, Futures markets price in forward-looking expectations. Right now, they are saying the July increase stands a good chance of being the last one. Whether it is or not will receive a lot of speculation in the press. But such discussion is almost meaningless. Whether this week’s increase is the last or there are one or even two more to come, won’t move the economic needle much. The Fed has done most of its heavy lifting. Right now, market consensus believes that in early 2024 there will either be a soft landing or a mild recession. Beyond that, the economy’s backbone has shifted. A year and a half ago money was free, adjusted for inflation. Yields overseas were largely negative. Free money promotes spending, much of it stupidly spent. The excesses helped to keep inflation down but it also created inefficiencies that kept productivity down as well. The sharp contraction in the economy early in the pandemic, combined with excessive Federal largesse created an expansive pool of money in consumer hands that has fed the economy over the past two years. Higher interest rates worked to retard growth but were offset by the strength in consumer spending fed by the excess cash.
There are signs that this is starting to wind down. Bank commercial lending demand is pretty punk. While new home sales are robust, the total number of homes being sold is down measurably. Consumer credit is expanding despite high rates. Student loan repayments will have to restart in the fall. I don’t want to overstate the shift. It’s still moderate by historic standards and the economy is still growing. But the impact of excess cash is waning and the impact of higher rates is not. Thus, expect further slowness in the months ahead.
This is the heart of earnings season. This week will be the biggest week in terms of number of companies reporting. Tomorrow after the close both Alphabet# and Microsoft# report. Those will be among the most watched numbers. After the modest negative reaction last week to Tesla and Netflix, investors will watch to see whether these two can match lofty expectations or not. A lot will depend on how each explains the economic benefits of artificial intelligence to them over both the near and long term. At the moment, Wall Street is expecting a lot.
But Alphabet and Microsoft are only two of the companies reporting. Close to half of the Dow components will report this week. So far, managements have shown great skill coping with both inflation and a slower growing economy. They have pivoted toward strengths and shorn up or disposed of weaknesses. In the long-term scheme of things, whether the overall economy grows 1% or contracts 1% for six months will have little impact on long term values.
With that said, valuation still matters. An extended rally, as we have witnessed over the last several weeks, attracts many who jump aboard for fear of missing out. Retail investors, at least according to survey data, are much more enthusiastic than institutional players. The different outlooks probably don’t reflect a differing macro view. But institutions are likely to pay more attention to valuation and not chase high prices they believe might not prove sustainable. Using $215 and $240 for S&P earnings this year and next, the index sells for just under 19 times next year’s estimates. If one believes that a slowdown or recession early next year will be followed by robust recoveries in 2024 and 2025, solid growth could bring prices back toward normal fairly quickly. But that could be an optimistic assumption. While earnings often show outsized year-over-year gains early in an economic recovery, if we end up emerging from a soft landing, there won’t be a rocket ship recovery. How does one expect a robust 2024 and 2025 starting from a time of elevated consumer debt, full employment, deteriorating demographics, and slower growth in China?
History says Year 3 of a Presidential term is historically the best for stocks. Next year, at least for now, we face the prospects of a Biden/Trump rematch, something more than two-thirds of the country doesn’t want to see. By now, everyone knows where each stands on the issues. The state of the economy, the health of each candidate, and Trump’s legal fights are likely to determine the winner. Wall Street will be more concerned if the winner’s party controls both chambers of Congress. I will only note that the strength this year is happening in the first year of a split Congress. The press hates gridlock. Wall Street loves it. Obviously, it is much too early to make any predictions about the 2024 election, but the outcome will prove important. With that said, what the Fed does will carry more economic impact than what emanates out of the White House.
Bringing this all back home, earnings over the next two weeks will matter to individual companies. The tone at the top of the S&P will have important near-term meaning. Breadth and leadership have both rotated in recent weeks suggesting tech dominance is fading a bit. That doesn’t mean the top tech names are in for a fall. But it does suggest that they won’t provide outsized leadership to the overall market in the second half of this year. IPO markets are reopening slowly, a good sign. However, with all this said, perhaps the biggest unknown for investors is where 10-year Treasury yields land at year end. That will be determined by changes in long-term inflation expectations between now and then, a subject I will talk more about in Wednesday’s note.
Today, Jennifer Lopez is 54. Lynda “Wonder Woman” Carter is 72. Comedienne Ruth Buzzi is 87.
James M. Meyer, CFA 610-260-2220