Stocks fell yesterday in reaction to a CPI report showing inflation continues to ebb at a slower pace than most want to see. Bond yields also rose in response. Thus, equities remain slaves to changing bond yields. That may moderate somewhat as earnings season begins in earnest today with several big banks reporting results.
While the increase in the CPI was slightly higher than expected, the culprit was a 0.6% month-over-month increase in shelter costs. Shelter related expenses account for over 40% of costs once one strips out the volatile and uncontrollable food and energy components. Because of the methodology used to calculate rents and imputed rents for owner-occupied homes, there is a lag between what is shown in the CPI reports and real world data. Rent increases have been decelerating for months even as year-over-year increases are still elevated. In the coming months I would expect the shelter components of the CPI to show this impact. Thus, while I would have liked to see a more modest increase in the CPI for September than the one reported yesterday, I think, taken in context, the news won’t change either Federal Reserve policy or signify any forward inflation forecasts. This morning, part of yesterday’s increase in rates has already been reversed.
The current earnings season should resemble the last one. It is likely to get off to a slow start, as first out of the gate will be the banks led by giants JPMorgan Chase# and Wells Fargo#. Higher interest rates, an inverted yield curve, tighter regulation, and slow business loan demand all work as headwinds for the banks. While all this is known, investors will be looking for forward guidance. I don’t see why bank officials have much reason to be particularly optimistic looking out to the near-term future.
In contrast, the big tech names won’t report until next week and the following week. They have plenty of good things to say despite the threat of a weakening economic outlook. To combat a slower economy and upward wage pressure, companies want to improve efficiency and productivity. That is done through technology. Not all tech company stories are painted with the same brush. Demand for computers and smart phones has been sluggish to be polite. But the tech companies themselves are flush with cash (earning juicy interest income) and see growing opportunities whether it be AI or industrial robots. For years, leading tech names spent money with abandon trying to accelerate growth opportunities. Some of that money was well spent. A lot wasn’t. We are entering a world where software can speed processes. But we are not quite ready to collectively walk down the street wearing goggles filled with images of some goofy avatars. As many of the leading names got larger, the law of large numbers kicked in. Government regulators are taking aim, making sure they behave within legal confines. For a time, spending and reality got out of balance. But in 2023, most have realigned their businesses to better match revenues, expenses, and the scope of future investments. That will show as they report later in earnings season.
For that reason, what is typical is that investor reaction to earnings early in the reporting season is tepid, but it gathers strength as more companies report. I see no reason the same pattern won’t reoccur this month.
With that said, let me make a few comments randomly about other subjects affecting markets.
Labor disputes – The two biggies, the auto workers and actors, still look far from settlement. Both face identical problems. Workers want a bigger piece of a smaller pie. For a long time, electric cars will be far less profitable for the Big 3 auto manufacturers than traditional vehicles. The more the workers make, the longer it will take for these companies to profit from the manufacture of EVs. I am not taking sides here. There is no good answer. It is quite possible a decade from now, one or more of the Big 3 will be an afterthought in a world dominated by EVs. The actors face an identical dilemma. Hollywood spent too much money trying to grab a toehold in the streaming world. Ex-Netflix, they all lose money in streaming will little prospect of being profitable any time soon. Thus, both sides face the same dilemma trying to grab a bigger piece of a shrinking pie.
Speaker of the House – In a world as divided as Congress is today and a literal handful of just 5 votes can stop everything, it is virtually impossible to govern if just a few Representatives insist on “my way or the highway”. Republicans have been pulled to the right by a handful of outcasts, just as Democrats have been yanked left by an outspoken few. Wouldn’t it be ironic or poetic justice if, to finally arrive at a speaker, Republicans are forced to work with Democrats to select a compromise candidate more centric? That may sound crazy. But if the Republicans end up picking someone too extreme, nothing is going to be done anyway. Republicans regained control of the House in 2022. So far, they have absolutely nothing to show for their success. The next election is just over one year away. It’s time for them to get their house (pun intended) in order. That may not happen if the mavericks can’t find a way to compromise.
Israel – The nation has to walk a tight rope. Rightfully, it would like to see Hamas crushed. But it also doesn’t want a multi-front war. America doesn’t want to get involved directly and it serves few if Iran gets involved. No more to be said here other than to note that should war escalate, the consequences are likely to be bad for all. As a sidebar, we are likely to pressure the bad actors supporting the terrorist groups fighting Israel. Today, sanctions meant to slow Russia’s ability to export oil are being tightened. Expect more actions against Iran. The immediate consequence will be higher oil prices in a market where supply is already tight. Good news for the oil companies; bad news for everyone else.
The Southern Border – Obviously, the Biden administration’s policies continue to encourage a flood of illegal immigrants crossing the Rio Grande. With the House out of action, Congress can’t do anything to help even if it wanted to. While headlines point to the hardships of housing the mass inflows, and others try to link the rise in fentanyl use to the border crisis, it is also true that, over time, many find their footing and start working. Given the decline in our birthrate, maybe some of the surprising and enduring strength in our economy comes from the unplanned economic contribution of immigrants, both legal and illegal. That isn’t to condone what’s happening at all. Rather it is a conjecture of an economic consequence of immigration. A rational policy is always preferred over an irrational one. But even an irrational policy can have positive consequences.
The Presidential Election – The same two candidates continue to lead as both seem to become less popular with the electorate. Are leaders of both major parties simply going to sit back and accept what’s happening? Biden’s problem isn’t his age; it’s his policies. Real wages declined again in September. Trump can’t stop trying to make every news story, even the horrors from the Middle East, all about himself. I don’t know how we escape this dilemma but I am sure the majority of Americans hope it can be done. Investors would love a better choice than the one they are facing.
Soft Landing or Recession – Still too close to call. Clearly, the economy is starting to slow. Increasingly, economists believe that the Fed has created enough pressure to win the battle against inflation within a couple of years. What isn’t discussed often is the Fed’s program to reduce the size of its balance sheet by a trillion dollars per year. The actual size of the balance sheet is irrelevant. The net change in the size of the balance sheet is relevant. Reducing its size is restrictive not only to economic activity but also to market liquidity. You see it today in the volatility in the bond market. If the FOMC is done raising rates, I see no reason why it shouldn’t stop reducing the size of its balance sheet as well.
Today, Alexandria Ocasio-Cortez is 34. Football legend and suddenly spokesperson for everything, Jerry Rice turns 61. Paul Simon is 82. Finally, happy birthday to my wonderful wife, Susan, who describes herself as ageless.
James M. Meyer, CFA 610-260-2220