Stocks retreated yesterday after a second unfavorable inflation report within a week. This time the villain was the February report on producer prices. The yield on 10-year Treasuries has risen by 20 basis points this week, a definite weight on equity valuations. The odds of a first Fed Funds rate cut is now virtually nil next week when the FOMC meets, and is less than 10% that it occurs at the May meeting.
The Federal Reserve has reiterated multiple times that its targeted rate for inflation is 2%. It has also noted that inflation doesn’t have to get to 2% for it to start lowering rates. It only has to be convinced that inflation is on the correct path and that inflation will reach target within the reasonably near future. Given that short-term rates are over 5% and inflation by most measures is now under 4%, there is a real cost to borrow. When one considers that most borrowers pay much more than the Fed Funds rate, there is no question current monetary policy is restrictive. A few small rate cuts won’t change that conclusion. Thus, the Fed can cut rates a few times and still maintain a restrictive policy.
With that said, Fed officials also make a point that the 2% inflation target isn’t 2.2% or 2.5% or 3%. Even though rates would still be restrictive after a few rate cuts, directionally, policy would be less restrictive. That means any cut in rates could induce consumers to spend a little more, hardly the reaction the Fed is looking to achieve. The Fed has a dual mandate to achieve price stability and full employment. At the moment, with the unemployment rate under 4%, the focus is almost entirely about reducing inflation. However, should unemployment start to rise persistently well above 4%, both mandates come into play.
Right now, the Fed’s biggest fear is that inflation reignites. Think of a big fire. After it is seemingly under control, firefighters spend a great deal of time searching for hot spots that might reignite the fire. While the Fed’s policies to reduce inflation are working, it is clear that there are ongoing hot spots. The most recent focus has been on the cost of services, which has been running much hotter than the cost of goods. However, with input costs rising once again last month at a pace faster than expected, it is going to be hard to get inflation down all the way to 2%. Cynics about the high costs of services have for months blamed that largely on the methodology used to compute imputed costs of home ownership. Without belaboring that point, last month that cost came down appreciably from January, yet the headline number for services remained elevated.
I remember talking to one CEO during the peak of the supply chain crisis. He told me that concerted efforts to find a work around to one snarl was quickly followed by a separate logjam that appeared out of nowhere. There is a correlation with that to the fight against inflation. Used car prices started to drop only to see airline fares go up. Airline fares then started to flatten out only to see a pop in insurance costs. All prices don’t escalate at the same pace at the same time. But the pressure is still too pervasive.
There is another major cost to consumers that isn’t even in the calculation of consumer price inflation. That is interest costs. In judging the pace of inflation, interest isn’t factored in directly. It shows itself in other ways such as the imputed cost of home ownership. President Biden and his supporters can’t seem to understand why the public doesn’t give him better grades for how the economy has done over the past four years. They point out that inflation has peaked, the stock market is high, GDP growth is steady, and unemployment is low. All true.
But here’s the issue. All those hard-working Americans still can’t seem to keep up. Yes, wages are up 10-15% over the past 3 years, but the cost of everything is up even more. Moreover, with interest rates at multi-year highs, necessary to combat the inflation that shot higher during Mr. Biden’s term, their monthly costs to own a home have skyrocketed as have the costs to service their credit card debt.
Let me offer a concrete example. Suppose the car that sold for $30,000 four years ago now sells at $40,000. That’s somewhat painful. But then factor in financing or leasing costs. Financing rates have doubled or more over the four-year period. Ditto for leases. Thus, instead of paying $300 per month, the cost today is over $500 per month. The math is simple. The monthly cost to own that car on a lease went up by two-thirds while wages went up by 15%. Now it is pretty clear why Americans are in a foul mood. Yes, the Fed is putting the fire out. But not before a lot of damage has been done. One doesn’t get a lot of credit putting out a fire that one helped to create. Just to stay apolitical, Donald Trump had a helping hand in starting the fire with massive deficit spending during his administration. And Biden can’t be blamed for spending during the peak of the Covid crisis to stabilize the economy. My purpose here isn’t to blame anyone. It’s to make the point that the impact of inflation is insidious. Once the fire is extinguished, there is still damage that has a residual effect.
That is why the threat of recession hasn’t completely disappeared. For a time, one can eat into savings or borrow more to support escalating costs on necessities. But that can’t go on forever. Stock market bulls salivate looking at record money market balances, a source of future funds that will be drawn into the stock market as the bull market continues and speculative fever expands. But there is a problem with this hypothesis. So far, it isn’t working. Inflows into money market funds continue at a record pace, faster than the first few months of 2023.
This morning there is an interesting article in The Wall Street Journal highlighting the increase in social media scams trying to lure money into “investments” suggested by the likes of Bill Ackman, Cathy Wood, or Ray Dalio among others. Don’t blame this on AI although more sophisticated software makes many scams seem so real. These scams would never happen at the bottom of a bear market. They only work when the prey is receptive to the lure of riches. It is yet another sign that speculative fever is getting worrisome. Again, as noted many times in recent notes, no one can pinpoint when a bucket of water will be thrown on the speculative fire. It could be days or it could be years.
Yet, as we have seen so far in 2024, everything isn’t going up in unison. Even among the stock market’s elite, there are chinks in the armor. Among the so-called Magnificent 7, Apple is down over 10% so far this year as iPhone sales flatten overall and plunge in China. Alphabet is barely above water trailing the overall market, and some of its early AI initiatives rushed to market show embarrassing flaws. But the real loser is Tesla, down about 35% in just a bit over two months and down 10% year-over-year. Telsa is still selling more cars than it did a year ago, but it has to cut prices and margins to get there. Management warns that more cuts may be needed. Bulls suggest new models to come late next year will right the ship. But will they? And at what margin? One thing the Tesla bulls ignore is the used car market. In the case of Tesla, the value of cars already on the road is collapsing, a combination of slack demand for EVs in general, the impact of multiple price cuts, and the fact that EV batteries don’t last forever. Since there are no Tesla dealers and Tesla stores won’t buy back used cars, the aftermarket for Teslas is totally dependent on consumer demand. Used car prices are falling as dealer lots refill. Tesla used car prices are falling even faster. When one buys a car, new or used, the residual value matters. The bottom line is that Tesla has its problems and investors are figuring it out.
But my point this morning is not to knock Tesla but to make the point that investors are still differentiating good from bad. Last night Adobe#, one of the 2023 tech darlings, reported results that were in line with expectations. Guidance was lukewarm at best. That’s not what you want to hear from the management of a company selling for 35x earnings. This morning its shares are down over 10% in pre-market trading. And that is on top of a modest decline over the past two months. Thus, while speculative fever continues to rise, it isn’t yet at a state where craziness (e.g. SPACs or meme stocks) overwhelms rational behavior. There are warning signs to be careful to be sure, but it isn’t time to panic.
As I noted earlier this week, serious bear markets need a combination of excess enthusiasm with deteriorating fundamentals. Speculation has risen and growth may be slowing, but there aren’t the ingredients of a major reversal ahead. Rather, the rise in bond yields, the bumps experienced by the likes of Tesla and Adobe, and the silliness highlighted this morning about increased social media scams are the seeds for a reasonable correction. I can’t point to one catalyst that will set off a correction. It could be a further rise in bond yields, or a reversal in bitcoin prices. It doesn’t matter what it is. The problem today is that valuations are a bit stretched and need either lower interest rates or escalating earnings to right the ship. Given that an FOMC rate cut is still likely months away, that catalyst would seemingly have to be a reacceleration of earnings. We will learn more about that possibility in about a month.
Today Eva Longoria and will.i.am of the Black Eyed Peas are both 49. Actor Judd Hirsch turns a more mature 89.
James M. Meyer, CFA 610-260-2220