Friday was a dull session without much movement or news.
Let me start this morning with a few statements of either fact or conclusion. Then I will try to pull it together.
1. Earnings growth in the second quarter, especially compared to a year ago, will be outstanding, maybe the highest year-over-year growth rate I will ever see in my lifetime as we compare to the abyss of the pandemic.
2. Inflation will also be at a peak, year-over-year. However, there are signs in some commodities, like lumber, grains and copper, that price increases could moderate in the months ahead.
3. Stock prices are forward looking. Much of what I just said is already discounted.
4. Most of what was expected to reopen is now open or will be fully open by the end of summer.
5. Vaccines and pent-up demand have stimulated growth in excess of what most companies expected. That has led to higher prices, at least temporarily, and some shortages. Government policy (stimulus checks and extended unemployment benefits) have accelerated those trends and increased the stress points.
6. Long-term growth rates are set by population and productivity growth. While productivity growth is high early in any post-recessionary period, once additional workers are hired it generally reverts to historic means.
7. Some of the dislocations may cause growth for some companies to fall short of expectations because of either failure to deliver or sharply higher costs necessary to meet demand.
In short, it will be a glorious summer. But once we all get to reunite with our families, return to offices, buy our new wardrobe, and get back to normal, the economy will gravitate toward its trendline. Since the Great Recession, that has meant roughly 2% real growth and something slightly below 2% inflation. The primary factors affecting inflation in the future will be wage rates and rents. Right now, the number of job postings actually exceeds the number of unemployed workers. That isn’t a complete rarity, it has happened before. But it is uncommon. It clearly means that there is an obvious mismatch between those seeking work and the qualifications needed to be employed. While there are ways to close that gap, should it continue to be difficult to hire workers, the primary remedy will be higher wages. Look at the TSA. Today it warns that labor shortages could lead to 3 hour waits at some airport security lines this summer. I will conclude that the public will not tolerate that. The solution will be a crisis solved by raising starting salaries and raising wages for those already employed under some emergency declaration. It takes a crisis for government to move. Non-government businesses are already facing the same dilemma.
I would note that rents are 41% of Consumer Price Index calculations and 18% of Personal Consumption Expenditure computations. They are just starting to rise in the wake of the surge in home prices. They rose at a 3.6% annual rate in May according to recent CPI data. That number isn’t about to move lower.
This all leads me to believe that while commodity shortages will dissipate, inflationary pressures will rise as the economy approaches full employment.
Inflation alone doesn’t dictate interest rates. Like everything else, bond prices are affected by the laws of supply and demand. Deficits between now and 2026 are expected to average $2 trillion per year. If the Fed stops tapering, someone is going to have to buy $300 billion in bonds each month to fill the gap. There are a lot of moving parts to the bond market. If rates, for instance, turn more negative in Europe, that would create more buyers for U.S. debt. My guess, however, is that to get $300 billion additional from buyers might require paying higher rates. The Fed might be able to influence the rate of increase by the speed of its tapering process. The alternative, which I believe to be quite likely, is that the Fed may start tapering next year, but it won’t get very far. Higher rates and decelerating growth will spur the Fed to actually buy more, effectively monetizing the new debt issued. Indeed, the Biden budget assumes most of the new debt is bought by the Fed. That in turn will increase the amount of excess money sloshing around. Negative real rates, almost by definition, force bad investment decisions, whether it be another unneeded office building or another poorly conceived SPAC.
Last week, the market crept to new highs after distilling record earnings, and an inflationary surge greater than what was expected. 10-year Treasury yields fell. Obviously, the bond market is looking past May’s transient inflation data and presuming inflation readings quickly fade, at least over the near term. It also assumes that while growth may slow in coming quarters, it will remain well above average for several more quarters. From 2008 to 2020, 10-year Treasuries sported yields of 1.3-3.0%. Most of the time, the yields were in the 1.75-2.50% range. If we return to normal, with inflation somewhat near 2%, that is not an unexpected future range. It is unlikely inflation will be far lower, not with all the stimulation in place. It could be higher if the Fed stays silent too long and higher wages force costs higher. But that is a scenario the market isn’t ready to tackle, nor should it.
Short term, with 10-year Treasuries now down below 1.5%, I see minimal further downside to rates. With inflation likely to recede in the coming months, the recent highs of around 1.75% should remain a near-term ceiling. Looking into next year, should wage rates rise persistently, a return to 1.75-2.50% makes sense. Where in that range rates settle depends on how active the Fed remains. My own guess is that with both growth and inflation rates declining, the Fed will taper very slowly, still buying substantial bonds a year from now.
The last key will be Federal spending. For now, I consider the Biden dream a wish list. The $4 trillion proposals will be cut at least in half, if not more. Biden is quickly learning that getting anything controversial done in Washington is hard. When you can’t afford to lose even one vote within your own party, it gets that much harder. Joe Manchin and Bernie Sanders don’t agree on much, especially when it comes to spending money. Biden appears likely to press ahead with just Democratic support and hope for the best. The best is likely to be no more than half of his wish list. It could be a lot less.
Thus, as we look ahead, earnings growth rates, near record levels at the moment, should continue well above average for several more quarters. However, as the Fed starts the tapering process, pressure on rates will increase. The two conflict. The obvious conclusion is a choppier stock market. So far this year, the surge in earnings, the benign behavior of interest rates, and the speed at which Covid-19 has dissipated in the U.S. helped to lift stock prices, particularly over the first four months of the year. Despite the fact that leading averages are setting marginal new highs, progress since early May has been slower. Equity markets could be even choppier in the months ahead as the Fed finally begins its tapering process.
But demographics ultimately dominate. Growth far in excess of 2% cannot be sustained without a major secular change in the rate of productivity. Although technology continues to be a force in that regard, the movement toward cloud computing, the advent of the age of electric cars, and Zoom conference calls don’t have the impact on productivity that occurred when the car replaced the horse and buggy or airplanes became prevalent.
As we saw from 2009-2020, from an equity investor point of view, there is nothing wrong with 2% growth and 2% inflation. The key is keeping inflation in check. Stocks did so well from 2009-2020 because interest rates stayed so low. I don’t see them staying below the 2009-2020 range persistently going forward. Most investors would be happy if they stayed in that range. If they can do so without Fed intervention that would be even better. That remains to be seen.
Without a recession anywhere near the horizon, the overall external pressure should be a slight tailwind, generated by earnings growth and modest productivity. Maybe technology can goose productivity a bit. But a return of regulatory pressures could be an offset. The slight tailwind should keep the bull market going, but the rate of ascent won’t likely match the pace of the past decade.
Today, Boy George is 60. Donald Trump turns 75.
James M. Meyer, CFA 610-260-2220