Stocks soared after the release of a favorable CPI report showing further signs that inflation is ebbing at a moderate pace. There is still a way to go before reaching the Fed’s 2% target, but the path is increasingly clear. Bonds also soared although yields on maturities of one year or less remained well above 5%, a clear sign markets now expect rates to stay elevated well into 2024, perhaps to mid-year or beyond.
If you are a golfer, you know what a false front means, a green whose front is sloped back toward the fairway. If your shot doesn’t hit that part of the green with enough momentum, it will stop and roll back down toward the fairway. If the grass in front of the green is slick fairway, the ball will roll all the way down to a flat area. But if the fringe area has longer grass, the ball won’t reach the bottom. While it is almost always better for one’s next shot to be shorter than longer, a good golfer can get a short chip, whether it be 10 yards or 20, close to the hole.
Apply this to the economy. The Fed seems to be winning the battle against inflation, but it is also clear that high rates are having an economic impact as well. Continuing unemployment claims are rising, an indication that workers are having a harder time finding jobs. High interest rates are impacting housing and auto demand. Inventories are elevated. 30-day loan delinquencies are rising. For many months we have been debating recession or soft landing. But how much does it matter? The ball falling off the green may stop short (soft landing) or go all the way to the bottom of the hill (recession). But just as a good golfer can handle either consequence, a good investor can look past a moderate period of slow or no growth if the long-term future is bright.
Why did markets apparently bottom a couple of weeks ago? If you simply look short-term, you can argue that stocks were oversold, that the September employment report was too robust, or that Treasury had to raise too much money. You could have been focusing on the auto workers strikes, the absence of a House Speaker, or a possible government shutdown. And, of course, there were two wars to worry about. But stocks look ahead. Almost all of the above would end up fading away soon. The recent stock rally certainly obliterated an oversold condition. The strikes are ending, the House has a speaker, bond yields are down as investors lengthen duration, the government probably won’t shut down, and while the wars continue, their economic impact isn’t great.
Markets are forward looking. Markets that bottom in October presume the economy should bottom about 9 months from now, perhaps around the third quarter of 2024. If there is a soft landing, there is no bottom ahead. According to analyst estimates, always a bit high, the third quarter of 2023 will be the low for earnings with year-over-year growth exceeding 10% by the second quarter of 2024. Clearly, if there is a recession, those expectations will be too high, but they may not be as out of synch as one might expect. Many sectors have already been through their down cycle for earnings even as the economy continued to grow. By now you all heard the explanation that post-Covid Americans traded spending on goods for spending on experiences. In simple terms, they traveled and went to concerts wearing clothes from their closets rather than buying new outfits. Several industries that benefited from Covid experienced a vacuum of demand once the world normalized. We bought PCs in 2020 and 2021 for our home offices. We didn’t need to buy them in 2022 and 2023. We lined up for Covid shots and boosters in 2021 and 2022. There are no lines for Covid shots today. Ditto for test kits. We raced to Home Depot# and Wal-Mart to fill our needs in 2020, while many stores were closed. We ate at home and took up golf. By 2022 and 2023, we traveled everywhere, and went to weddings and family gatherings. All this time, costs rose faster than companies could adapt. Margins got squeezed. Commodity producers enjoyed the spike in prices in 2021 and 2022 but felt the pain as prices started to recede. Thus, every industry has gone through its own economic cycle impacted not only by the overall economy, but where it stood in relation to Covid impact and its after-effect.
Look at the stock market this year. Let’s start with AI, a burgeoning technology that caught the fancy not only of investors, but of all forward-looking companies looking to enhance productivity and the customer experience. AI-hype, real or not, pushed a few dozen high profile names higher. Those have now been labeled the Magnificent Seven. For everyone else, 2023 has been a slow slog. Some did great, especially those benefiting from soaring consumer spending on experiences. Some felt the post-Covid relapse and suffered, especially those in healthcare and those that benefited earlier from spending related to stay-at-home. High dividend stocks suffered as shares repriced to offer investors higher yields consistent with higher bond rates.
Now we look to 2024. Inflation is slowing and so is the economy. Almost by definition, that means corporations will mostly have reduced pricing power. To maintain or improve margins, companies will have to increase productivity. Technology can help, but it is unlikely to be the entire answer. Productivity is measured by output per manhour. If one can generate the same sales with fewer employees, productivity rises. If one adds workers but sales don’t rise, productivity falls. While the U.S. economy continues to add jobs, in recent months it has been doing so at a slower pace. Last month, accounting for prior months downward adjustments, fewer than 100,000 new jobs were created. That is consistent with a slow growth economy. If we are to have a mild recession, the job creation number will turn negative for a brief time.
2024 is an election year. For an incumbent running for reelection, there can be no worse economic sign than an economy losing jobs. I realize the Fed wants to stand pat and hold rates high for as long as necessary to ensure inflation not only falls to 2% but stays there. But in an election year, if job creation turns negative, it will be under enormous political pressure to relent. The President certainly doesn’t want Bidenomics (whatever that is defined to be) to mean fewer jobs, more inflation and exploding deficits. There is a lot of political noise out there and if Trump is the Republican nominee, the noise level will be elevated. But, in the end, Americans vote with their wallets first. Look at the reelection bids of Jimmy Carter and George H.W. Bush for affirmation.
The Fed is designed to be apolitical but is anything in Washington apolitical? I doubt it. The Fed doesn’t have to bring short-term rates crashing down to appease the White House should job growth turn negative. But if inflation stays on the right path, should job growth turn negative, it could, at a minimum, put future rate cuts on the table. More than likely, it would start cutting rates, albeit at a slow pace some time around mid-year, plus or minus a couple of months. Politicians will have their reactions but almost assuredly Wall Street will welcome the first utterance that the Fed Funds rate is on a new path toward normalization.
Indeed, that is exactly what’s happening today. The rally we see now reflects a vision I just projected, that the economy, recession or not, will start to be seeing blue skies by mid-2024. It sees that while earnings may not grow at a 10%+ rate now projected by analysts, they will soon start to grow faster than they have in2022 and 2023.
The speed of the rally over the past two weeks has been shocking. One can easily argue that short-covering plus fears of missing out gave markets a short-term boost aided in addition by the return of corporate buybacks and the end of the mutual fund fiscal year. There may be some retracement ahead, but I am convinced that the October bottom will hold. With that said, leadership is likely to rotate over time. Initially, investors flock to what was working before the recent correction. But the valuation gap between big-cap tech and the rest of the market is as large as it has been since just prior to the bursting of the Internet bubble in 2000. Every one of the big favorites in 2023 has seen their stock price rise at least 35% and all saw stock prices rise faster than earnings. Meanwhile, at the other end of the spectrum, there are hundreds of companies selling at less than 10x earnings that will experience growth in 2024. Indeed, usually after a big stock market correction, many of the stocks beaten up the most are the best performers early in a subsequent recovery. Thus, in your hunt for bargains, look beyond big tech.
Today, actor Sam Waterston of Law and Order fame turns 83. Beverly D’Angelo, who played Chevy Chase’s faithful wife in the National Lampoon comedies turns 72.
James M. Meyer, CFA 610-260-2220