Stocks staged a sharp rally yesterday. Was it a one-day wonder, accelerated by short covering, or did it signal the end of a brief retreat? We’ll learn more today. As we end the second quarter, bond yields remain at the upper end of recent ranges, signs that inflation is still with us and markets believe the Fed will keep raising rates. Thoughts of a rate cut before the end of the year are waning.
Economically, the biggest theme in recent months has been “where’s the recession?”. As Fed Funds rates were approaching 5% this past spring, futures markets were pricing in two rate cuts before the end of the year, a signal that the consensus believed both the economy and inflation would slow dramatically before the end of 2023. That doesn’t seem to be happening. The average American is employed, seemingly secure in their job, and still enjoying the savings accumulated during the pandemic. While the decade that followed the Great Recession was characterized by low inflation and plenty of slack both in the labor force and in productive capacity, the period following the pandemic has used up most of the slack that existed, thus keeping upward pressure on inflation.
Nowhere is that more apparent than in the housing market. Economics 101 tells us that higher rates should depress demand particularly within interest-sensitive industries. Given that housing is so dependent on mortgage financing, the obvious conclusion was that higher rates would reduce demand and eviscerate home prices that had skyrocketed during the pandemic. That didn’t happen. For sure, demand fell. Higher rates did their job pricing potential buyers out of the market. But higher rates also reduced supply. No one with a 3% mortgage was anxious to sell and buy a new home with a 7% mortgage. Indeed, the root cause for the surge in home prices in 2021-2022 was a shortage of supply. Going back to the Great Recession and the subsequent flood of foreclosures, demand was so slow that homebuilders could barely build enough to replace antiquated supply being leveled, let alone meet new demand accelerated by record low mortgage rates.
Thus, we are left with a perverse outcome. The housing shortage persists and promises to get worse if interest rates decline and buyers return. The buyers who are active in the market despite high mortgage rates have little interest in the fixer-upper homes available for sale. Both young buyers and baby boomers are avoiding homes that are viewed more as money pits than bargains.
The perverse impact of higher rates isn’t limited to housing. Auto dealer lots have more inventory than a year ago, but they are hardly full. There is an ongoing mismatch between what buyers want and what is on the lots. Thus, some discounts are returning but vehicles in high demand still sell above sticker prices. Meanwhile, supply chain hassles remain. Cars sit outside manufacturing plants rather than on dealer lots because of a lack of railroad capacity to move the added production.
As a result, inventories are building, and sale/inventory ratios are rising. At the same time, consumers are eating into their savings enjoying the post-pandemic boom. Savings rates are below normal and credit card balances are rising. So far, that hasn’t stemmed the urge to travel. Delta’s CEO thinks there is still $1 trillion in excess savings to work through. That may be a bit of a biased conclusion, but the bookings numbers suggest the party isn’t over yet.
The fact that we haven’t seen a recession yet doesn’t mean one won’t happen. But rotating pockets of strength and weakness suggest that any recession is likely to be mild. With that said, the real question is whether inflation is on a path to return to the Fed’s target of 2%. Perhaps the answer is yes but not any time soon. There is very little slack in the economy, particularly when it comes to labor. Participation rates have risen in recent months, but demographics strongly suggest that labor participation rates are in permanent decline as our population and that of most of the rest of the world ages. People are working longer, but the percentage of people working in their 60s is well below those in their 40s or 50s.
But there are deflationary forces as well. China is by far the world’s second biggest economy, and it will be growing slower and slower. Population there may already be in decline. Some suggest other countries like India and Saudi Arabia will pick up the slack, but China’s GDP is more than 4 times that of India and Saudi Arabia combined. Moreover, in this century, China flooded markets with cheap goods, often below cost. It dumped everything from steel to t-shirts. That impact will recede. Technology will continue to be a price deflator. But can it offset the inflationary forces of a tight labor pool, and higher borrowing costs? “Free money” fostered by central banks for over a decade, created excesses that now show up as empty office space and store counters that virtually give away hand sanitizer. While some commodities, notably gasoline and lumber are coming down in price, others such as beef are rising. Cruise ship operators and airlines are enjoying higher fares that accompany strong demand. But costs including labor and marketing still pinch profit margins.
The Fed will win its current battle. It may have to raise rates a while longer but it will win. The real question, however, is whether it wins a battle or a war. Is inflation simply going to come down for a short period of time only to reoccur as soon as the Fed takes its foot off the brake? We don’t know the answer yet. A lot depends on future Fed behavior. But one thing is certain. The economic slack that existed a decade ago is unlikely to return any time soon. Thus, to keep inflation contained, central banks are likely to keep interest rates higher for longer. That isn’t exceptional behavior. If one looks back to the 20th century, it was normal. Higher rates will change behavior. So will tighter labor supply. Free cash flow will become increasingly important. So will dividends. Technology will benefit. Anything that reduces unit labor costs will take on increasing importance. As for stock prices, higher rates will bring about lower P/Es. Today the S&P P/E based on forward earnings is approaching 20. But take out the 7 largest components of the average and the forward P/E is closer to 15, about where it should be. A secret to good investing is to find mispriced assets. I would assume looking at stocks selling at 10-12x earnings will be more fertile ground than chasing a glamorous name selling at 50x or more.
Today, Elon Musk is 52. Kathy Bates is 75. And Mel Brooks turns a lively 97.
James M. Meyer, CFA