Stocks have acted in more volatile fashion in recent weeks reacting to the ying and yang of economic data that indicates a slower economy one month and a robust economy the next. That was punctuated Friday with a stronger than expected employment report following weaker than expected numbers for August. The report set off a solid one-day rally that has been somewhat reversed according to early morning futures trading. Friday’s report most likely solidified the case for a further cut in the Fed Funds rate of 25 basis points at the next FOMC meeting just after Election Day. While traders genuflect over every Fed Funds nuance, the most important considerations are a) when will the pending series of rate cuts end and, b) where will Fed Funds settle when that time arrives. We have no idea when that will happen and neither does anyone else.
It isn’t just employment data and the Fed Funds rate that has led to increased volatility. Economic activity, while slowing at a very modest pace, is still moderating. Inflation expectations are also receding. While short-term rates are in decline marching to the tune of FOMC decisions, longer term rates react to a combination of expected earnings growth and inflation. With the odds of a soft landing seemingly increasing amid softening inflation, the yield on 10-year bonds have increased modestly over the past few weeks. Stock prices and the value of other long-term assets key off these rates. Yet, despite a slight uptick in rates, a depressant to stock valuations, equity prices have marched higher buoyed by a belief that earnings growth will now accelerate through 2025. How long that rally can continue while the yield on 10-year Treasuries continues to rise is concerning.
While the overall economy is still growing, results are likely to vary greater industry to industry. Overall earnings could increase approximately 10% over the next year, pockets of technology, notably those connected to artificial intelligence, are growing at several times that pace while manufacturing, transportation and low-end retailing are struggling to stay ahead. Over the past several months there has been obvious rotation in the stock market as the AI frenzy may have gotten ahead of itself. Money has flowed toward utilities, consumer staples, REITs and small caps.
Does all that make sense? Whenever irrational exuberance pops up, some sort of correction is inevitable. But I believe that’s too simplistic an answer. AI is not going to be a winner for all tech companies AI is going to be as big an economic force or bigger than the advent of PCs or the Internet. As voice queries yield quicker and better results, and as users find the benefits of AI to speed software development, enhance creativity, and solve complex problems sifting through immense stacks of data, there will be winners and losers. Some of the losers are going to be companies that were disruptors themselves in the not too distant past. In many cases, packaged software solutions will give way to intuitive sets of queries enhanced by digital agents specifically focused on certain vertical markets. Instead of going to a real estate listing site to find homes for sale, you could simply ask your computer (or phone) with verbal instructions to find a 4-bedroom home with you selected characteristics within X miles of a particular location in a particular price range. If the results of that query aren’t satisfying, you simply adjust your query until the results suit you. You can use your own imagination to sort winners and losers as AI revolutionizes behavior. Activities now generic like search, document preparation, and social media will change dramatically over the next decade. AI will also radically raise productivity shortening product development cycles while removing inefficiencies created by hierarchical menus that often lead the user nowhere. Simply said, you will scream “agent” a lot less in the future as AI solves a problem rather than lead you in circles. When you lose your credit card and call, the last thing you are interested is your outstanding balance.
While tech stocks have took a breather, some are once again setting new highs while others are 10-20% below frenzied peaks. If you go back over the past 50+ years, you will find graveyards filled with mainframe, minicomputer, PC, and software companies left behind by subsequent disruptors. Many of yesterday’s winners will continue to thrive but not all. New giants of the AI world will soon appear in the public domain. By the end of this decade some will even penetrate the S&P top 10 stocks based on market capitalization.
Away from tech, the sharp moves in utilities, consumer staples, and REITs coincided with a sharp decline in 10-year Treasury yields from 5% in October 2022 to close to 3.6% just a few weeks ago. But now prices of those stocks sell at yields like many tech darlings. Can that continue? Only if 10-year yields continue to fall significantly. That would only be likely in a recession. While that are reasons for caution, there are few signs that recession is imminent. Friday’s employment report solidified a belief that growth will continue as short-term rates decline. This morning, 10-year bond yields are back over 4% for the first time since August, a headwind for the stock market winners of the past three months. As we enter the fourth quarter, traditionally a time of optimism as investors start to focus on the following year, I would expect the leaders of the first half of 2024 to reassert themselves. That would lead to momentum traders moving money back out of safe havens toward those companies with the best growth prospects through 2025.
We are now 4 weeks from Election Day. While voters say the economy and inflation are the two most important issues, clearly style and personalities will matter more than normal this time around. The lovefest debate between Vance and Walz probably changed no one’s mind although it gave the media something to talk about for a few days. Escalating tensions in the Middle East have pushed oil prices higher. With that said, even if Iranian oil were cut off in part, there is plenty of supply to prevent the sort of escalation in oil prices that would derail economic growth. The pending port strike was suspended until January 20, the day the next President is inaugurated.
As noted often, I limit my comments to the economic side of the Presidential debate. From January 20, 2017 to January 20, 2021, the S&P 500 rose by close to 70%. Since January 20, 2021 it has risen just under 50%. Thus, the Trump years were slightly better for investors. But both administrations saw equities grow at or above historic rates. With that said, inflation in the Trump years average slightly less than 2% while it has averaged close to 5% during the Biden administration. Thus, real returns in the Trump years were over 10% while they have been roughly half that under Biden. Famed Wharton professor Jeremy Siegel has long postured that stocks over time return 6% plus the rate of inflation. They have achieved approximately those returns under Biden but significantly better under Trump.
Was that due to Trump policies or some other factor? It is easy to argue that the Trump tax cuts, and lax regulatory environment were boosts to stock prices. But so was a zero-interest rate policy. The Fed Funds rate was near zero at both the start and end of Trump’s term. The 10-year Treasury yield was 2.5% at the start and just a shade over 1% at the end. One could easy argue those were tailwinds derived via Fed policy more than fiscal policy. Obviously, the jump in both short- and long-term rates during the Biden administration were a response to the spike in inflation over that past four years. Trump planted some of those seeds, but Biden added a lot more.
Perhaps the most important indicator to the average American is the unemployment rate. That was 4.7% at the start of the Trump term and 6.3% at the conclusion. It is 4.1% today. It would be unfair to blame Trump for the higher unemployment rate given the impact of the pandemic. But it would be fair to say that the employment picture under Biden was certainly no worse than it was in the Trump years.
The conclusion would seem to be that while if one were voting strictly on the basis of the economy, there would be a modest advantage in Trump’s direction. However, the messages from both campaigns are overstated as is usually true with political campaigns. The economy and the stock market enjoyed good times during the Trump years and have performed fine during Biden’s tenure. What is true and has been true since the end of the Great Recession coincident with zero interest rate policy is that owning stocks and homes that appreciated greatly as a result of those policies was an immense positive. The obvious offset is that Americans not invested in the market who don’t own their own homes have struggled to stay even. It’s easy for readers of this letter, to view the prospects over the next four years through a much different lens than one who sees rents rising faster than wages and no savings cushion to fall back on should a crisis occur. It’s certainly one reason our society is so bifurcated and why those struggling, not to survive, but simply trying to improve their standard of living feel they aren’t being heard. The average American doesn’t focus on tax rates or credits. He or she focuses on one’s own well-being. Promises of future change are mostly ignored. What have you done for me lately takes precedence. Voters don’t want to hear that disrupted supply chains caused inflation. All they care about is that inflation hurt over the past four years. That might have been buffered by rising stock and home prices. Obviously, given the backdrop of the last four years, the views of both the past and the future are painted very differently depending on how one is situated today. No wonder the polls are so close and likely to remain so through the next four weeks.
Normally, I end my letters citing birthdays. But today is different. As Americans, certain dates are hard wired in our brain. July 4th.January 6th. 9/11 (No one ever says September 11th). One year ago today, over 1200 Israelis were massacred. Over 100 hostages taken that day are still in captive hands, many probably dead. Over 40,000 Palestinians have been killed over the past year. Instead of celebrating birthdays today, perhaps a moment of silence for those killed and prayers to end that war and return the hostages would be more appropriate.
James M. Meyer, CFA 610-260-2220