Stocks continued to surge after Wednesday’s FOMC meeting left interest rates unchanged, while suggesting the first of three 2024 rate cuts might start in June. While stocks jumped, bond yields have shown hardly any change since the Wednesday meeting.
So why the surge in stock prices? Obviously, I was fooled. On Wednesday I outlined a meeting outcome that was almost precisely what occurred. No rate increase. The Fed acknowledged that inflation was stubborn but showed limited concern about the January and February CPI data. They were simply speedbumps. The future route toward lower rates was three cuts this year starting in June both before and after the meeting.
Perhaps the real issues for the Fed lie deeper below the surface. There are two components of inflation, inflation affecting goods, and the rising price for services. The Fed’s primary tool to fight inflation is its control of short-term interest rates. That’s the interest rate that affects the purchase of goods. One may borrow to buy a home, a car or some needed clothes. One doesn’t borrow to finance a hospital visit or pay a lawyer.
Goods tend to be more essential than services. We have to eat, wear clothes and have a place to sleep. We don’t have to buy Taylor Swift tickets. Ok, let me simply say I don’t. Today there is a dramatic difference between goods and services inflation. Over the last several months, one can argue that deflation is setting in for the price of goods. Commodities like natural gas are near their lowest price in decades. Import prices are falling as China boosts exports to buttress its own economy. Regardless of why, if the Fed was only looking at the cost to buy goods, it logically should have begun cutting rates months ago.
But now look at services. Services are impacted by Fed policy but not nearly as much as is the case with goods. We have to eat and seek shelter. If one needs to borrow to fulfill those needs, that is an added cost. If your 10-year-old car dies and you have to buy a replacement on credit, the monthly cost differential will be shocking. That money has to come from somewhere. There is little doubt that what is happening with interest rates is hurting lower income Americans much more than affluent ones who can afford not to borrow. Thus, the Fed sees rising default rates and the pain of lower income Americans as a warning sign that rates may have stayed too high for too long.
On the other hand, the rising price of services, still well above 5% by some measures, cannot be ignored. These costs have less of an interest cost component and more of a labor cost component. Labor costs are still rising close to 4%. There are other costs imbedded here that get scant attention. One is regulation. The Biden administration has ratcheted up regulatory requirements. To the extent possible, the attendant costs are passed on to consumers. Another is climate change. Without getting political regarding the causes and the cost to combat it, climate change affects us all economically in many ways. Perhaps the most obvious is the rising cost of insurance. Hurricanes, floods, and fires cause a lot of damage. The costs to repair and replace are imbedded in our insurance rates. Warmer climates affect agriculture. Crops can be planted a lot further north today while, at the same time, excessive heat limits crops in other areas. Parched grazing land increases the price of beef.
There are two messages here. First, the Fed has to be careful not to be too tight for too long while recognizing that its battle isn’t over until services inflation moves a lot closer to 2%. The second message is that equity investors don’t care about the politics or the social side of the equation. They care about interest rates and earnings. They see interest rates ready to decline and earning set to rise. So, they are buyers.
There is another factor in play we haven’t spent much time talking about. Equity prices are a function of supply and demand. Most of the time we discuss reasons to buy or not buy equity shares. That is all about demand. But not about supply. In 2021 markets peaked after a year of record IPO offerings, about $1.6 trillion worth. In 2022, when the speculative fever broke, IPOs fell to just over $10 billion. IPOs add supply. So does the issuance of new shares to employees. The offset is stock buybacks. In recent quarters, those have averaged close to $200 billion per quarter. IPO volume today is at a run rate of a little over $100 billion per year. While there are signs the IPO market is starting to percolate (look at Reddit yesterday), we are still in a situation where supply is shrinking. Mergers and takeovers also reduce supply. One can argue easily that reduced supply is helping to elevate the price of stocks. Until there is a real IPO boom, the reduction of supply will be ongoing, particularly in good economic times when cash flow is available to buy back more stock.
One note of caution. Companies are restricted as to when they can buy back shares. We are nearing the end of the first quarter. While managements don’t know exactly what they earned, they have a pretty good idea. Thus, companies have rules in place that will limit buybacks and insider sales until after earnings are released. Those rules vary company by company but all companies on a calendar fiscal year will be out of the stock buyback business before the end of next week.
The bottom line is that the current short-term win streak for equities will probably slow or end over the next few days giving way to more sideways trading until earnings season begins. If you look last night at some of the earnings reports that came from companies not on traditional calendar years, there are distinct messages. Lululemon and Nike got clobbered not because earnings didn’t grow, but because they didn’t grow fast enough. Slowing consumer growth and more competition are affecting both. High multiple stocks that don’t exceed expectations get punished. We saw that with Adobe# last week. On the other hand, Fedex# shares are soaring this morning in pre-market trading even as it forecasted a decline in packages to be delivered for the rest of 2024. Once again, it’s all about matching reality to expectations. In the case of Fedex, expectations were modest. In the case of Lululemon, they are high. I expect to see a lot more of that when first quarter earnings unfold. What we learned from all three companies that reported last night is that the growth rate for the sale of goods to consumers has slowed in the first quarter and should continue to slow in the months ahead. If that message is pervasive, I don’t think it is fully priced into what is a very optimistic stock market today.
Today, Reese Witherspoon is 48. Composer Andrew Lloyd Webber turns 76. Author James Patterson is 77. Finally, William Shatner is a ripe old 93.
James M. Meyer, CFA 610-260-2220