It appears the first half of 2023 will go out with a bang. Stocks rose yesterday and futures point to further gains today. This all comes about as interest rates edge higher, in anticipation of at least one more rate increase by the Federal Reserve in July. While signs continue to point toward a slowing economy and lower inflation, there appears to be no recession coming in the near term.
History strongly suggests a strong first half in the stock market is followed by an upward sloping second half. There have been notable exceptions with 1987 being the poster child, a time when stocks rose, and bond prices fell for the first 7 months only to reverse course sharply beginning in late summer. 1987 proved to be purely a valuation correction. A 40% peak-to-through decline was reversed in little over a year.
Economically, there is little news today and none is likely early next week as Monday will be a ghost town in front of the 4th of July on Tuesday. The big news yesterday all related to Supreme Court decisions and more expected today led by the fate of President Biden’s student loan forgiveness program.
The obvious conundrum facing investors as we move to the second half is to evaluation the strength of the stock market in the face of weakening economic data and higher interest rates. While the odds of a rate cut coming before Christmas are shrinking amid strong current economic data, futures and most forecasters are predicting multiple cuts next year. Right now, it appears four are priced in. Depending on how many rate increases are left this year, that would put the Fed Funds rate late in 2024 somewhere in the 4.0-4.5% range. That makes sense with or without a recession assuming the path for inflation continues to moderate. Ultimately, if inflation gets close to the Fed’s 2% target, the Fed Funds rate should retreat to close to 3%.
There are two keys to future Fed success. The first is wages. I don’t expect wage growth to retreat all the way to 2%. Assuming some improvement in productivity it doesn’t need to. But labor force participation rates are in permanent decline governed by aging demographics and compounded by weak legal immigration. While unemployment and wages are probably not as closely linked as the Taylor Rule might suggest, declining wage increases are critical to restoring price stability. While Biden is out touting his economic successes, one plain fact is that the average worker has lost 3.6% in pricing power so far during his administration. Until that loss is restored, pressure will remain for higher wages.
Second, is shelter costs, the largest component of any price index, CPI or PCE. Shelter costs are expected to decline and will be aided by a large increase in new apartment completions over the next twelve months. But a housing shortage persists as demonstrated by strong demand for new homes. Higher mortgage rates also make housing more expensive. There is little reason to presume that home prices are going to go down further in this environment. The rate of change, which is what inflation measures, may recede a bit. But can it fall to 2% and stabilize there without a surge in new home supply? That is a key question.
Thus, over the second half of 2023 the keys to financial market performance will be the pace of decline in the inflation indices, the rate of change in shelter costs, and changes in wages. If inflationary pressures fall as fast or faster than currently perceived, if only for the near term, stocks will continue moving higher. But if inflation proves persistent, further headway will be difficult.
Two factors aided the first half of this year. One was the fascination with generative Artificial Intelligence. The second was the surprising drop in energy costs that helped to moderate inflation significantly. AI will continue to fascinate but now companies associated with AI will have to prove themselves via accelerating profits. As for energy, it’s a fool’s game to guess near term price changes. But gas prices are down about $1 per gallon over the past 12 months. Will they decline a lot further? If not, what disinflationary pressure will rise to take its place?
Next week is a big holiday week. There will be lots of economic date Wednesday-Friday to chew on. Earnings season will follow. As the current vacuum of inflation is replaced by data, stock prices will follow. I don’t expect major earnings surprises in earnings season, but individual stocks may make meaningful moves.
Today Mike Tyson turns 57.