Stocks continued to rally yesterday after a favorable PPI report showed commodity inflation slowing. That really should have come as no surprise. Markets were also boosted by a stronger than expected earnings report from Walmart#. The strength came from essentials, like groceries. Discretionary items such as apparel and electronics were weak. This morning, Target’s numbers disappointed. The biggest difference between Target and Walmart is mix. Walmart’s mix is skewed toward groceries, while Target’s is skewed toward apparel.
The consumer is still spending, using in part accumulated savings built up from Covid and the handouts from our Federal Government during the pandemic. But they are going beyond savings, motivated by job security and rising home equity values. Close to 90% of homeowners either own their home outright or have a low-interest mortgage. As a result, turnover is down. Instead of buying a new home, Americans are enjoying experiences. Travel continues to boom. At the same time, the average age of an American home is the highest since World War II. These are all repercussions of both Covid-19 “free” money, and excessive fiscal spending surrounding the pandemic. The Federal Reserve is seeking to normalize the economy via rate increases that impose a borrowing cost, but the impact will take time.
Inflation has been the by-product of this situation over the past year. The goods side of inflation is already corrected. Many of the supply chain snarls caused by the pandemic and excessive demand have been resolved. There are few ships sitting at West Coast ports waiting to unload. The biggest problem today is what to do with all the excess containers piling up everywhere. As a result, the problem has evolved from a swollen supply chain with billions of dollars of goods stuck on a boat at sea, to an inventory issue with all those goods finding their way to their destination just as demand for those goods was slowing. We see the problem in apparel today. We are likely to see it in the auto industry next year as dealer lots are restocked amid a possible recession. Want to buy a new car? Wait a few months.
How does this play out in financial markets? The future is never composed entirely of facts, but some conclusions are inevitable. As long as the Fed keeps raising interest rates, growth will slow. We can only argue how fast and how far. Home Depot#, the world’s largest retailer of housing related products, reported solid earnings and sales for its October quarter yesterday. Same store sales rose briskly, but the entire gain and then some came from price. For six straight quarters, the volume of goods sold declined. The question, obviously, is what happens as the Fed begins to win its inflation battle? Will consumers buy more goods with the same dollars, or will they buy the same resulting in little or no sales growth expressed in dollars?
Consumer behavior will be dictated by many factors. Inflation itself pulls demand forward. Why wait until tomorrow when prices will be higher? Job security encourages spending. As long as money is coming in, it’s OK to spend. Rising home values mean higher net worth, an asset that can be borrowed against if necessary.
Home buyers complain about high mortgage rates. After all, it is the monthly payment that determines how much home one can afford, but the same consumers complaining about mortgage rates are extending their credit card purchases. You think a 7% mortgage is expensive? Try 20%+ on some credit cards!
However, if the economy starts to soften, companies will be less likely to hire. In Silicon Valley, where they have been drinking the hypergrowth Kool-Aid for years, companies are now so swollen that earnings have become elusive. Hiring freezes are now turning to layoffs. So far, the layoffs have been modest in total, but they are accelerating. People with good jobs today are a lot less eager to run to a new start-up with dubious financing.
Wall Street is encouraged by Fedspeak that soon the pace of interest rate increases will slow. Given the time lag between implementation and effect, that isn’t a bad decision. The Fed wants to slow the economy, not wreck it, but the optimism may be a bit of an overreaction. Inflation isn’t going to be defeated until the pace of price and cost increases in the service side of our economy begins to wane. There are few signs that is happening yet. There are still close to two job openings for every applicant. No musical chairs to grab the first job available today. Interest rates will remain elevated for some time. Demographics suggest that sustainable real growth in the US is 1-2%. Without more immigration, it will be closer to the lower number.
Stocks today sell for over 17 times optimistic forecasts for 2023 earnings. They sell for 18x+ if those earnings estimates are too high. That doesn’t leave much upside. Normal is close to 16x. Interest rates are elevated, courtesy of Fed action, but they aren’t very elevated related to history. If the Fed decides that the long-term path for interest rates should be levels that build in a real cost to money, the Fed Funds rate won’t be far from where it is today.
Investors remember the most recent past most vividly. The most recent past includes a recession in 2020 that could be measured in weeks, not months, and a financial crisis in 2007-2009 that led to a long recovery from a very impaired financial base. Prior to that was the bursting of the Internet bubble in 2000, an event that kept the tech sector out of investor favor for more than five years.
What I see going forward is not one homogeneous economy, but a set of sub-economies. The core doesn’t change a whole lot. Banks, consumer staples, health care, utilities, etc. will continue to function as they have for decades. Real growth will be low single digits with some obvious differentiation company-to-company or sector-to-sector. Housing may be an undersupplied opportunity, but only if the cost of ownership correlates with buyers’ abilities to pay. There will be pockets of excess that will require consolidation, a process likely to take years. Streaming is one example. The economic model to date, all subscription-based, doesn’t work. There are not enough subscriber dollars to support programming and customer acquisition (and retention) costs. Thus, the movement to the use of advertising. Ultimately, the savior will be consolidation, a combination of merger and bankruptcy. The same applies to social media. Twitter is all over the news. Are there going to be enough $8 per month subscribers willing to pay to post whatever they want? Will advertisers come back not knowing whether their ads are placed next to a Kanye West (or whatever his name is today) incoherent moment of nastiness? Or a Donald Trump post? Or a fake Donald Trump post?
Without belaboring the point, the tech world is filled with too many pretenders that have to be whittled down. Too many retailers pushing product that don’t make a dime (do I have to tell the Peloton story again?). Too many advertisers that won’t be in business two years from now. Too many companies trying to sell cars on the Internet. Too many crypto enterprises. Remember the SPACs of 2021. They raised hundreds of billions of dollars, money now all spent and gone. In 2002, I noted that the biggest competitor Cisco faced for its routers and switches was its own routers and switches on the secondary market. The same is likely this time around. The list keeps going. Too many companies making electric cars. Too much crypto mining.
Meanwhile, the rest of the U.S. will see patches of blue, benefitting from reshoring, expanding infrastructure spending, extensions to ObamaCare, elevated defense spending, and benefits from true innovation. Manufactured products will be smarter. More servicing can be done remotely. Opportunities will be vast; they just will be in different places.
Stocks today are fairly valued. So are bonds. That says to me that the next 5% move can be up just as likely as down, but a sustained bigger move in either direction is unlikely until either the economic downturn end is in sight or a more serious recession occurs than expected. Stock picking will be important, and as noted many times, the top of the S&P 500 is unlikely to outperform the rest, as was the case in 2010-2020.
Today, actress Maggie Gyllenhaal is 45. The Cosby Show’s Lisa Bonet is 55. Portuguese novelist and Nobel laureate Jose Saramago is 100.
James M. Meyer, CFA 610-260-2220