Stocks closed higher yet again yesterday as the Dow’s winning streak hit 12 sessions, the longest such streak since February 2017. Last night’s reaction to earnings was mixed with gains led by Alphabet# and losses led by Microsoft#. Both beat expectations which didn’t meet optimistic hopes. Bond yields keep sneaking higher in front of today’s FOMC meeting.
On Monday, I noted that valuation has been anchored by expectations of future long term interest rates, which have been fairly stable within a narrow range lately.
Long term (10 years) interest rates are closely tied to 10-year inflation forecasts. While inflation lately has been elevated, longer term expectations have been reasonably anchored. Look at the two charts below.
The chart at the top shows how well long-term inflation expectations have been anchored over the past several years despite a spike in near term inflation. The chart at the bottom shows the “TIPS spread”, the difference between normal 10-year Treasuries and those of similar maturities that sport lower coupon rates but add in inflation (TIPS bonds). Those yields spiked a few months ago, as the chart at the right shows, but have since retreated a bit. The obvious conclusion is that consumers and investors both believe that inflation is already fading, and should return to levels consistent with past experience over a relatively short period of time.
But is that a reasonable expectation? The most recent CPI report noted, at least in June, an annualized rate of less than 4% at the core level, less volatile changes in commodity food and energy prices. Excluding food and energy, shelter costs are about 45% of the core CPI index. Three quarters of that amount is comprised of imputed rents. Below is the formula that computes imputed rents.
OK, that looks pretty confusing. It is. But before I even attempt to explain it, I need to remind all that the purchase price of a home is not included in the inflation calculation. A home purchase is the purchase of an asset, the same as the purchase of a stock. Inflation is a measure of the change in cost of goods and services. Nothing consumes more of our income than the cost of occupancy. According to CPI computations of core inflation, eliminating the impact of changing prices of food and energy, shelter costs are 45% of expenses. The PCE index, more favored by the members of the Federal Reserve, still finds shelter costs consume close to 25% of one’s expense. Occupancy costs matter. About a quarter of occupancy costs are rents. They are easy to survey and calculate. But what about occupancy costs for a home one owns? That’s where owner equivalent rents (OER), and the calculation above, come into play. Literally, home owners are surveyed monthly to elicit an expectation for the rental rate they could get if they rent their home unfurnished. The month-to-month change in expectations is calculated and used as “owner equivalent rent” changes in both the CPI and PCE calculations. Obviously, this isn’t precise. But what’s important is to recognize the “ingredients” that are used, at least mentally in the process of calculating rents:
1. Property taxes
2. Mortgage rates – higher rates mean an owner has to charge more to cover monthly payments.
3. Rental rates for alternative apartment opportunities.
4. Changes in home prices.
Any homeowner has a rent/sell decision. Today, one can get a 5% return relatively risk-free. If the same person owns a home and is considering renting, the choice is between a cash return on sale proceeds (5% or better), and rents minus the above costs (taxes, mortgage interest, and overhead). If taxes, mortgage interest and overhead are rising, then implied rental rates will rise. In other words, rents and implied rents aren’t necessarily identical or closely correlated. The reason for this exercise is to note that while rents may decrease, as they are in some geographies today, the same may not necessarily be the case for implied rents. Higher interest rates, higher sale prices, and higher home prices affect implied rental prices. For a while it was assumed they would come down as rents are starting to. But home prices have turned higher again, and mortgage rates are elevated. A homeowner needs to achieve higher rents or the sell option comes into play.
The other key to inflation, at least as measured by the CPI, is that goods comprised 27% of core inflation while services are 73%. Labor costs are more critical to service inflation than they are to goods inflation. Whether it be auto repairs, hospital costs, accounting expenses or entertainment costs, all are rising faster than the overall rate of core inflation. Wages are still rising at a 5%+ rate although that pace will decline as inflation recedes.
The bottom line is that occupancy costs are rising, given high mortgage rates, rising taxes and rising home prices, and service costs, closely associated with higher wages are also rising. This says that getting core inflation down to 2% or anything close isn’t going to be easy, especially in an economy close to full employment.
That leads to today’s FOMC meeting. Rates will rise another 25 basis points. That’s already a given. But markets assume this will end the rate hiking cycle. It may or may not. In either case, the likelihood that there will be several cuts next year, as futures markets presume, may be optimistic. While the most recent Fed forecasts indicate a rising unemployment rate that will reach 4% or more by year end, that doesn’t seem likely given the average increase in new jobs of over 200,000 per month over the past quarter. The economy is slowing., but I doubt any FOMC member feels the pace of slowdown is sufficient yet to step back and start loosening monetary policy. The Goldilocks scenario of a soft landing is still possible but only if the economy continues to slow. Normally, I would assume the lag between interest rate increases and economic impact would be sufficient, but we are entering an election year, one where candidates from both sides will try to “buy” votes by passing spending bills that will raise government spending and be a counter to tighter monetary policy. Indeed, there is plenty of authorized spending already in the pipeline led by the $1+ trillion infrastructure bill.
If inflation stays more persistent than currently implicit in a stock market climbing close to all-time highs set late in 2021, then even if earnings hold together, higher rates for longer would suggest further P/E expansion might be unlikely.
Look at the top of the S&P 500. Four of the “magnificent 7” at the top of the S&P 500 have already reported. All beat expectations, but only Alphabet’s stock has risen further. For the rest, expectations simply were too large to warrant further P/E expansion. Meta Platforms# reports tonight. Apple# and Amazon# report next week. Nvidia# doesn’t report until next month. But unlike the past two quarters, the reactions of the first four to report have been underwhelming, suggesting, at least for the short-term, that if the rally is to extend, leadership will have to rotate. Over the past few weeks that is exactly what has happened. One can debate whether the rotation so far has or has not eliminated bargains. Clearly, a dozen consecutive up days for the Dow has made bargains less enticing than they were two weeks ago.
I am not arguing for a return of a bear market. Flat earnings, at least for a few more quarters, and relatively flat interest rates suggest a sideways market more than anything else. Markets don’t move in a straight line. Two steps forward and one step back is often necessary to create opportunity for buyers. Since the start of last earnings season, each of the Magnificent 7 at the top of the S&P 500 has risen by 20% or more. Earnings so far this week suggest that while AI presents great opportunity, the law of large numbers limits the pace of future growth. We’ve had the two steps forward. A step back is probably warranted. Markets and the bulls have priced in the likelihood that today’s rate increase by the Fed will be the last one this cycle. They have also priced in 3 rate cuts by the end of July 2024. If Fedspeak this afternoon changes those expectations, that could be the catalyst for a mid-course correction, one that shouldn’t upset long-term bulls, but one that may create some bargain opportunities in the weeks ahead.
Today, Sandra Bullock is 59. Dorothy Hamill is 67. Helen Mirren turns 78. Finally, Mick Jagger is 80.
James M. Meyer, CFA 610-260-2220