Stocks closed mixed yesterday with the Dow down and NASDAQ up. This morning, futures point in the opposite direction with NASDAQ stocks lower and the Dow slightly higher. Overall, markets appear to have entered a sideways pattern as earnings season comes to a close. Barring an outlier number in next week’s employment report or February inflation numbers to be reported in about two weeks, the Fed is almost certain to increase the Fed Funds rate by 25 basis points. That’s already priced in. Since last April, the S&P 500 has traded within a range bounded, in round numbers, by 3500-4300. This morning it sits roughly in the middle of that range. With that said, many stocks are up more than 15-20% over that interim while others are down as much or more. It has been a very bifurcated market.
Probably the biggest influence over that gap of time has been the rise in interest rates. The market, according to Fed Funds futures suggests a high likelihood that the FOMC will raise rates 25 basis points in March, May and June. That’s already priced into both stock and bond markets. It forms the basis for today’s yield curve, peaking just over 6 months out. The 10-year Treasury yield has risen close to 50 basis points, the difference between the market’s judgment of one remaining rate increase in January, and today’s thought that three are coming. The yield does not reflect any substantive change in the outlook for long term inflation which is still anchored below 2.5%.
As for earnings, they are starting to decline modestly as sales growth slows and pricing power is eroded. There are still some very strong pockets of strength within the economy, notably related to travel and leisure activity. Commodity prices continue under some pressure.
With that all said, January data showed unusual growth. According to government figures, over 500,000 new jobs were added. The Fed’s favored core CPE inflation data showed prices up 4.7% year-over-year, three-tenths of a percentage point higher than forecasted. Retail sales boomed after a demure December while personal spending rose a robust 1.8%.
January was good, but the data smells a bit fishy. The January employment report includes an unusual number of adjustments. Probably the biggest factor in the shockingly high number reported was a delay in laying off temporary Christmas help. Fearing future labor shortages many companies are loath to lay off skilled workers, but private sector job posting data shows a notable deceleration under way. There can be wide swings in the Federal data. Indeed, the employer survey and the household survey data, released simultaneously often disagree. We should learn more next week when we see February numbers.
As for inflation, the biggest component is shelter costs. It is over 35% of the CPI alone. Shelter expenses have been rising at an 8-10% rate, as reported, for several months. That will change. Housing prices are falling. Private sector data suggests rents are falling as well as a huge amount of new supply hits the market. But the way government data is computed using higher interest rates to impute an expense to home ownership and looking at year-over-year changes in rents rather than sequential changes, the impact of lower housing prices and rental rates won’t show up in the data for another couple of months. When it does, you will see a noticeable impact on inflation.
That leaves us with the following conclusions, already priced in:
1. Inflation has been running a bit hot and labor markets have stayed strong a bit longer than expected.
2. That has kept inflationary pressures higher for longer. Markets had hoped, falsely it now seems, that inflation was slowing at a faster pace based on late fall data. Markets were wrong. The Fed’s outlook for a series of 25-basis point rate increases seems to be on target. Markets have now adjusted and are pretty much in synch with the Fed.
3. Growth remained stronger than expected through January but shows signs of slowing. Most notably, as companies issued yearend earnings numbers, managements warned of pending slowness. Only in a few pockets of the economy does strength appear to be sustained.
4. China is starting to reopen from its Covid lockdown. The impact is starting to help.
5. Nonetheless, earnings expectations are creeping lower.
6. The impact of slightly higher interest rates for longer, and minor downward adjustments to earnings offset each other, although that can vary greatly company-to-company.
7. The net result is a flat market outlook, with pending volatility around key economic and inflation reports.
On the backside of all this, once inflation seems contained, it is unlikely the Fed will be tempted to drop interest rates dramatically. The Fed Funds rate is headed for 5% or higher. Anyone old enough to remember norms for short-term rates before the financial crisis of 2008, will note that short-term rates are designed to have a real cost, one that will prevent the economy from overheating again. In 2009, on the backside of the financial crisis, there was a huge amount of excess capacity. Data shows that it takes about a decade for that excess to be absorbed after a crisis. That proved to be true this time around. The economic impact this time was distorted by the impacts of Covid on both supply and demand over the past three years. That is starting to normalize. Capacity utilization is still reasonably close to 80%. The unemployment rate is 3.4%. Neither allows much slack that will allow the Fed to do much, if anything, to boost demand after the current slowdown ends.
Thus, we are headed for many years of slow growth with, hopefully, modest inflation. Borrowing rates will remain high enough to impute a real cost for money. Demographic trends, both in the U.S. and overseas, are negative. Nominal GDP growth is likely to remain below 5% for the foreseeable future. For companies to grow faster, they either have to gain market share, or expand market opportunities with new products or acquisitions. There isn’t going to be a tailwind lifting all boats. One other note of caution. The Dow Jones Industrial Average is comprised of 30 companies. None are original members of the Dow. Companies don’t have infinite lives. Successor managements of well-run companies may not be successful. Competition and new products may change the landscape. Retail America was quite different before Wal-Mart and Amazon#. The personal computer and smartphone have changed our lives in many ways. As an investor, standing pat rarely works. One certainty is that tomorrow’s world will be quite different than the one we lived in just a few years ago. Your investment portfolio needs to adjust to these changes.
Today, Justin Bieber is 29. Russell Coutts, who has captained New Zealand’s winner America’s Cup yacht team five times, turns 61. Roger Daltrey is 79. And sticking with singers, Harry Belafonte turns 96.
James M. Meyer, CFA 610-260-2220