Stocks moved higher late yesterday, following optimistic comments from Speaker Kevin McCarthy that a compromise could be reached before bumping up against the debt ceiling. Congress still has to write and pass bills, and that is likely to cause some tension that could still upset markets over the next two weeks. But the odds of a solution without significant consequences seems to be increasing.
The odds of catastrophe have always been relatively small. No incumbent from the White House on down wants to incur the obvious wrath that would follow. Once the crisis is averted (hopefully!) attention will once again return to the economy itself. That picture is somewhat muddied. We aren’t in a recession yet. There are still significant pockets of strength. Companies are still hiring. While wage pressures are receding, they are still too strong. They will remain stronger than the Fed would like until job growth softens much further. That’s the economic tradeoff ahead. A soft landing would be nice. Who wants to live through a recession. But until there is slack in the economy that shifts pricing power from seller to buyer, there is going to be elevated inflation. Even if the economy weakens past an inflection point such that inflation falls back to target at or near 2%, any subsequent stimulus will reignite inflation. That is exactly what happened in the 1970s. The Fed crushed inflation, created recessions, returned to monetary expansion, and then faced more inflation. The cycle ended when Paul Volcker not only created two back-to-back recessions, but boldly kept away from the temptation to stimulate the economy out of recession rather than allow the normal forces of productivity and demographic growth to do the work for him.
Simply said, a mild recession would do what the Fed wants; create the necessary slack to lick inflation and keep it at bay. Then, the Fed has to avoid the temptation to stimulate. It will be OK to cut rates. After all, the recession, should it arrive, will be the result of tight monetary policy. Once inflation fades, the need for tight policy will fade. But rates will still have to stay high enough that there will be a real cost to borrowing. The days of zero Fed Funds rates are gone forever. If the inflation goal is 2%, the Fed Funds rate will have stay above that level to keep inflation at bay.
But I am getting ahead of myself. The first question is, will there be a recession? So far it has been elusive. What has complicated the process isn’t that rates aren’t high enough. It’s the after effects of the Covid disruptions including the massive monetary handouts the government used to cushion the economic impact of the pandemic. It has taken a long time for supply chains to be restored. Car dealers are still short inventory. And car buyers are still waiting. I suspect that once lots fill, buyers may become scarce. Then you will see price cuts. No more buying above list prices. Look at the PC market. Demand surged during the pandemic. Everyone worked from home. They needed more robust computers. Now they have them. No more are needed. Demand today is down 20-30%. That isn’t the new growth rate. The long-term growth rate for PCs is more likely 0-2%, a bit under workforce growth because new computers are better and last longer than old ones. It will take another year or so for everything to even out. PC sales aren’t really impacted by change in rates. Rates have some impact but the overwhelming factor is the impact of post-pandemic behavior. That post-pandemic boom and bust (or bust and boom in many cases) will probably begin to even out in 2024. Right now, the boom in travel continues along with the bust in PCs. The catch up in new car demand offsets the sharp decline in housing activity. And so on.
With all that said, it appears a recession is coming. It will likely appear in the second half of this year and last into early next year. How does that impact the stock market. We learned a lot this week as retailers reported. The first biggie to report was Home Depot#. Its results weren’t very good. Tepid buyer demand, sharply lower lumber prices, and the terrible weather in California hurt demand. But Home Depot also forecasted weakness ahead. It never rains in California in the summertime. So, that wasn’t the reason for the tepid outlook. The first reaction from investors was a 7% pre-market decline but within 48 hours the losses were reversed and the stock was higher. Wal-Mart reported pretty good numbers but a weaker than expected forecast. Same reaction. An early loss became a nice gain.
When stocks react positively to disappointing news, it strongly suggests, the bad news was already discounted in the stock price. Forget that analysts lowered earnings and price targets. Most don’t look ahead far enough. The stocks tell you the story. Look at the stocks of homebuilders. They are near all-time highs. Why? Because markets are screaming that the worst is over. Go to model home communities and look for yourself. They are busy and people are buying. The inventory of existing homes for sale is low and the quality of homes for sale is poor. Millennials may not like the price they have to pay but the kids are growing up and they don’t have the patience to repair older homes themselves.
It’s May, and 9 months from now will be early 2024, probably well past the mid-point of any recession we face. That’s what is being discounted today. That is not to say that it’s all clear for equity investors. Some safe haven sectors of the market are overpriced. Indeed, the market overall seems fully priced at 18x earnings. But even that is a bit deceptive. The largest companies at the top of the S&P 500, like Apple# and Microsoft#, trade well above 18x earnings. More than half of the S&P sells for 13x or less. A lot of those deserve to sell for less. Regional banks face tough sledding. Earnings forecasts are too high. Loan problems are only starting to appear. Commercial real estate is funded with non-recourse loans. If cash flow can’t cover costs, it’s the lender that will be the loser.
The bottom line is that markets are more efficient than we believe. They get distorted at times, mostly due to swings in momentum. At times there are real fundamental changes as well. The failures of three mid-sized banks weren’t anticipated months ago. But, for the most part, markets are fairly efficient. Near term, should debt ceiling negotiations bog down, there could be a short-term decline. With that said, leadership in both parties understand the implications of default. There are members of both parties who will act stupidly in the days ahead to be sure. But they aren’t a majority and won’t stop the process. June 1 is the earliest possible default date, not the most likely date. That will be refined as we get closer. It is in no one’s interest to default. That’s what makes it unlikely and that’s why markets to date haven’t had a hissy fit.
In summary, the actions of key retailers this week remind us that markets are discounting a slowdown ahead. Homebuilders, a classic early cycle group, is highlighting a view that any recession will be brief. As always, markets will behave in heterogenous fashion with some groups leading and some lagging. You can’t look backwards. Many recent winners can’t justify much higher prices. Safe havens like consumer staples are richly valued. Cyclicals demand attention but not all cyclicals will recover evenly. Some may never recover. It’s a stock picker’s market.
The Who’s Pete Townsend is 78 today. I don’t normally highlight people no longer with us but today is the birth date of Ho Chi Minh, and Pol Pot. Quite a rogue’s gallery.
James M. Meyer, CFA 610-260-2220