Despite a CPI report for February that showed inflation a bit more persistent than expected, stocks continued to rise yesterday even as bond prices fell. It was another record day for the S&P 500.
The message of the market yesterday was that even though the persistence of inflation almost ensures no interest rate cuts in March and perhaps May, investors are yelling in unison, “who cares?” Markets focus on two things, long term interest rates, which are instrumental in setting P/E ratios, and earnings growth. The Fed also has two mandates, to maintain price stability, and to foster employment growth. Most believe inflation is in decline. For the moment, markets don’t seem to care when inflation gets close to the Fed’s 2% target as long a it moves towards it directionally. Yesterday’s CPI report throws some cold water on the belief that inflation will continue to move in the right direction allowing rate cuts to begin this summer. But when the data is combined with an easing in labor market tightness and persistent above average GDP growth, yesterday’s strength argues that investors don’t want to quibble about whether the first cut comes in May or July. Just that it comes.
As for growth, it continues, but it is slowing. After two quarters late in 2023 when GDP growth exceeded 3%, current data suggests forward growth closer to 2%. That is consistent with the soft or no landing thesis. The recession thesis essentially requires one of two things to happen (or both). Either inflation has to show signs of reacceleration despite a restrictive monetary policy, or the Fed, waiting too long to cut rates, ignites an economic slowdown that few now see coming. One can always cobble together facts supporting the notion that a recession is just around the corner. The yield curve is still inverted, money supply is still shrinking, the unemployment rate is rising, and credit default rates are creeping up. But these are factoids within an otherwise favorable backdrop. Productivity is rising, population growth is accelerating, housing prices are flattening, and consumers are still spending. And, of course, there is the AI boom sparking billions of new investments.
Of course, equity prices can’t rise forever simply on repeated optimism. Interest rates are steady with the 10-year Treasury remaining within a 4.0-4.3% range. GDP growth is slowing. Except for the massive increase in spending to support AI initiatives, growth is rather anemic and profit margins are getting squeezed as corporations lose pricing power in a softening growth economy. For stocks to keep rising, either longer-term rates have to come down below 4% and stay there, or profits have to reaccelerate. Without a recession, the latter is more likely but hardly obvious.
Over the past few weeks, I have noted the rise of speculation. Bitcoin is setting new record highs this morning and the prices of the stocks craved the most by investors are rising again after brief hesitations over the past few weeks. I have tried not to equate rising speculation with a bubble about to burst. That eventually could happen. Warning signs are in place. But speculation can continue rising for some time before there is any serious threat about a bubble bursting.
While bubbles are always associated with a rise in speculation and a journey into euphoria, true bubbles burst not just because euphoria becomes excessive, but because the underlying thesis that created the bubble in the first place was flawed. Look at recent bubbles. Go back to the 1980s when Japan was about to take over the world. That never happened and it took three decades for the Japanese stock market to return to its previous highs. Look at China. While the rest of the world experienced a financial collapse in 2008, China flourished with high single digit real growth. But that growth evaporated as its population started to shrink and its government shifted its focus away from growth to a different political agenda.
The biggest bubbles of my lifetime in the U.S. happened in 1973-74 when oil prices spiked, igniting inflation that couldn’t be controlled until Paul Volcker implemented tight monetary conditions years later. A bubble in 1987 burst as bond and stock prices moved in opposite directions for many months. It was the only bubble in my lifetime that was purely based on excessive valuation. In the 1990s, expectations about the impact of the Internet created a bubble that burst in 2000. Directionally, the expectations proved to be right. But the timing was way off. Most of the companies that really benefited from the emergence of the Internet weren’t even born in the early days of speculation. In a sense the Internet bubble of the late 90s can be compared to the EV craze of 2021-2023. Electric vehicles are coming but the economic proposition to buy one still isn’t there. There are a few companies like Tesla in the U.S. and BYD in China that actually make money selling EVs. But both have to cut prices to attract more buyers. Lower prices are always key to exploding markets. Low prices made computers affordable to the masses. But the EV industry has many problems to solve. Most manufacturers still lack scale to survive, and charging issues still have to be resolved. Virtually all companies in the EV space have seen stock prices fall in recent months. Many won’t survive at all. Until the EV economic proposition improves, these stocks will stay in the doldrums. The lesson of the EV world is a harbinger of what will come to other bubbles not supported by fundamentals.
The last and greatest bubble was the notion that every American in a thriving market deserved to own a home. Couple that with the notion that a home is always one’s best investment and you see the cracks that led to the collapse of our whole financial framework in 2008.
And that bring us to today. The AI leaders are spending tens of billions of dollars to support a coming surge in demand. For artificial intelligence to work it will require enormous computing power. But are these companies ahead of demand? Will all the capacity being built be used? Cables under the ocean which were laid in 1999 lay dormant for decades as Internet demand slowed. For now, it appears that AI will lead to a true surge in economic activity. When the iPhone first appeared, none of us knew how it would be used a decade and a half later. That depended on software. We travel using Waze. We are all amazed that a piece of software can tell us to turn left in 500 feet. But it works. So do all the mobile apps that supplant our need to use our desktop computers. The cameras are many times better than the older ones occupying shelves in the back of our closets. I don’t know the killer AI apps that will emerge. We see hints with ChatGPT just as AOL told us “You’ve got mail”. But AOL wasn’t the ultimate winner.
The bottom line is that the AI boom seems real. Might it be a bit ahead of itself? Maybe. But maybe not. Growth won’t continue at today’s torrid pace with so many jockeying for leadership position. But the opportunities are simply too juicy to ignore. Thus, whether it be the semiconductor companies supplying the high-speed chips, or the date center companies hosting the demand or the software gurus building the ultimate solution, no company today can afford to ignore the advantages AI promises.
When a new technology emerges, there is a rush to stay ahead. That can lead to excessive or misguided investment. Clearly, not all participants in the boom will succeed. That’s capitalism. Because the capital costs for those providing AI services are high, there are barriers to entry. But there are less capital intensive opportunities in software or vertical market solutions. Just as with the emergence of the Internet, some of tomorrow’s winners aren’t visible yet. Some haven’t even been born. We can’t decide whether current valuations in the stock market are too high or not. That will be resolved ultimately by matching today’s expectations with tomorrow’s reality.
As for the rest of the economy and the rest of the stock market, AI will be a tool used to accelerate growth. In some cases, AI will improve growth or productivity gains that justify higher valuations. For others, the benefits will be marginal, leaving future growth dependent on other internal or external forces. Equal weight stock market measures show growth year-to-date of over 5% and close to 20% year-over-year. All of that relates to higher P/Es, consistent with the drop in 10-year Treasury yields going from 5% to 4.2%. As noted earlier in this note, future growth will require a resurgence in profits or a further decline in rates. At the moment, it’s hard to make a case for sharply lower rates if there is a soft landing. But a soft landing could support a return to profit growth.
For now, with the CPI report behind us and a strong consensus that the Fed will do nothing at its FOMC meeting next week, there are no obvious catalysts to move stock prices meaningfully before first quarter earnings reports begin about a month from now.
Today, actor William H. Macy is 74. JPMorgan Chair Jamie Dimon turns 68.
James M. Meyer, CFA 610-260-2220