Last week was one of the best for equities. It came on the heels of comments from Federal Reserve Chair Jerome Powell that any thought of an increase in interest rates was off the table. Judging from Fed Fund futures, there had been little expectation of any rate increase over the next several months, even with inflation proving more stubborn than previously anticipated. The old saw says actions speak louder than words. But in the case of the Fed recently, markets seem to react more to the words than the actions.
The reality is that the Fed wants to find a reason to start lowering rates. But sticky inflation, focused on key service-related components, has prevented that from happening. I have noted several key sticky areas. Insurance costs have continued to escalate as rates continue to catch up to rising prices of the cars and homes needing to be insured. Similarly, hospital rates are rising to offset rising personnel costs in the wake of the pandemic, and the movement of the burden away from Medicaid and Medicare, given the low rate increases CMS allows on government insurance. Shelter costs have also remained stubborn, courtesy of high mortgage rates, and escalating prices resulting from lack of supply. All of these are lagging impacts. Hopefully the pace of escalating costs will slow, allowing rates and pricing to rise at a slower pace. The reality is that inflation is slowing, but it simply is going to take time for all the post-Covid cost increases to be fully reflected in prices.
With that said, let’s remember that inflation measures the rate of change in prices today. The cumulative effect of prices over the last several years has no impact on inflation today. That’s why Americans feel so miserable about the economy even as the pace of price increases today is slowing. And we see that dichotomy in the sales and earnings currently being recorded. Starbucks traffic is down 7%. Traffic is down almost everywhere in the retail world save a few cult leaders still increasing traffic. But those few are becoming fewer every day. It hasn’t affected earnings yet. Price increases are still offsetting past cost increases. That helps earnings. But the pressure on traffic will hurt future growth, something equity investors never want to hear. Over the next week or two, retailers will be reporting earnings. Collectively, they are less than 20% of the S&P500. But the consumer is 70%+ of GDP. If retailers are squeezed, ultimately it impacts all the way down the supply chain.
A common long-term theme is “don’t fight the tape”. The tape says “all’s good.” Stocks are back within a percentage point or two of all-time highs. The Dow Industrials are pressing 40,000. Why not step back and enjoy? There’s a simple answer, apart from a normal level of skepticism. GDP growth is slowing. It was 3%+ in the second half of 2023. It was 1.6% in the first quarter. Even excluding inventory adjustments and rising imports, it was 2.5%, clearly a decline. All signs suggest growth decelerated through the quarter. Might it slow so far that it will turn negative, maybe leading to a recession? Possible, but hardly a scenario one can prove today. Thus, for the moment, we’ll stay with the soft landing thesis.
But whether there is a soft landing or not, Wall Street is expecting an acceleration in earnings growth not only in the second half of 2024 but even more so in 2025. If stocks are going to validate those expectations, either there has to be an acceleration of profits over the next 18 months, or there has to be a rationalization of moderating growth, assuming long-term interest rates remain anywhere near 4.5%
One should remember that the S&P 500 is currently dominated by a handful of companies in the tech sector whose near-term fortunes are tied to the growth in spending to support the escalation of artificial intelligence applications. Soft landing or not, that will continue, although as the economy weakens, it will impact the pace of growth corporations are willing to spend on new initiatives including AI.
With all this said, until there are signs any slowing might have a negative impact on the pace of future earnings growth, investors will keep their positive bias. They won’t get anything from the Fed. It has said its piece. It will not raise rates under any circumstance, at least under current conditions, and will look for data supporting its first cut. Europe will likely cut first as its economies are weaker and inflation less virulent. But those signs are not likely to support a rate cut before July at the earliest. It is quite possible that the first cut won’t come until the end of this year. If GDP currently slows, the new thought of no rate cuts until next year is probably an overreaction.
Thus, the near-term course for the stock market is going to hinge on any rate of change in earnings growth. Given the economy is 70% consumer centric, comments from retailers over the next couple of weeks will be the best source of near-term information. That will determine whether new highs are ahead, or further backing and filling is necessary.
Today, Stephen Colbert is 60. Former NBA player with a life outside basketball more interesting than inside, Dennis Rodman is 63. Stevie Wonder turns 74.
James M. Meyer, CFA 610-260-2220