Despite a favorable inflation report, stocks fell again yesterday. The S&P 500 is now down 6 of the last 7 sessions. The NASDAQ Composite fell for the fifth day in a row. The last time it fell 6 consecutive sessions was in August 2019. Despite the recent weakness, the Dow and S&P 500 are still within 3% of all-time highs. The selling has been quite orderly with no panic.
I say often that interest rates and earnings are the prime determinants of stock prices. Interest rates are not the culprit this time around. The 10-year Treasury continues to hover around 1.3%. Any sign that inflation is moderating gives the Fed ammunition to defer the start of its bond purchase tapering efforts.
No, the problem today is earnings. Not that earnings are bad or the economy is about to go into the tank. What is happening is that a combination of the impacts of the Delta variant and supply chain disruptions are forcing both corporate managements and analysts to modify their near-term earnings expectations. For the first time since stocks began to rally once the economy shut down in early spring of last year, future expectations are being modified lower.
Although we are not headed back into a quarantine state, there are some schools going virtual again as Covid-19 sets its sights of younger children. Corporations who a few months ago announced plans to bring workers back to the office after Labor Day are now deferring those steps to 2022. As for supply chain, delays unloading cargo from ships in port are further clogging distribution systems. China can’t export enough due to Covid restrictions and a lack of shipping containers. Even when goods are unloaded, a lack of truck drivers is causing more trauma. While goods ultimately move, the costs to get from A to B increase and the time delays create their own havoc. Last summer, it was hoped the supply chain problems and shortages would clear up by the fall. Certainly, by year end. Now it is hoped that clearing happens in 2022.
One of the problems is too much demand. Even as supplies start to increase, they can’t meet the higher demand. Gasoline prices are not supposed to rise in the fall, but they are. Copper and aluminum, key to both construction and the electric vehicle industries, are seeing spikes in prices. So why the benign CPI report yesterday? Used car prices have settled down. Instead of rising 10% per month, they are now about flat. With prices of some used cars above their original sticker prices, buyers are limited to those that must buy a car today, not to those that simply want to. The other factor that helped to moderate reported inflation was a 9%+ drop in airline prices. That clearly is a result of the rise in Delta variant cases triggering less demand for air travel.
Another factor that helps keep inflation moderate is the rise in productivity. At the start of an economic recovery, demand rises faster than the size of the labor force. Employers don’t hire new workers until they are sure demand is persistent. Sure enough, productivity has spiked since the end of the Covid shutdown. There are now 11+ million job postings and less that 8 million job seekers. The other source of improved productivity comes from technology. Robots replace factory floor workers. Kiosks replace order takers. Some of that is happening as well. To continue requires a persistent increase in capital spending. With corporations awash with cash, that is starting to happen although confusion about future tax rates and other fiscal considerations may slow that temporarily.
The obvious question is how long do these problems persist? When do commodity prices start to recede? Indeed, some already have. Food price inflation has moderated a bit, but as noted earlier, persistent high energy prices continue to take a toll. Economists and analysts like to ignore food and energy costs when looking at inflationary trends because both can be so volatile, but they are real. An extra $10 to fill your gas tank means $10 less you can spend on something else. As for supply chain issues, certainly the spike in the Delta variant has delayed solving that problem. But it appears the Delta spike has passed in much of the country and should peak elsewhere within weeks. That doesn’t mean auto dealers will be flush with inventory any time soon, but the path forward is visible.
The more basic question is the course of inflation even when supply chains are repaired. From the Great Recession until the surge of Covid-19, the buyer had the upper hand. Oversupply was everywhere for the past decade. Too many goods, too much capacity, too many available workers, and way too much money. Only the latter persists today. Today, the buyer no longer dictates prices. The seller can say take it or leave it. When you want a new car and the lots are empty, you don’t have much bargaining leverage. Home prices have surged because of lack of inventory for sale. The frenzy of last spring has passed. There was actually a lull over the summer, but buyers are back out there.
Finally, wages are increasing at an accelerated pace, a function of 11 million available jobs and less than 8 million unemployed. Workers are quitting and moving to new jobs where conditions and pay are more to their liking. Many workers want to continue working from home and commute less. As mentioned before, productivity gains help to moderate the impact, but pressures are still rising.
As I have noted in the past, it is hard to find good news today likely to propel stocks higher. Earnings forecasts are moderating, supply chains remain disrupted, taxes are likely to rise, and bad weather events are causing disruptions. The Fed is likely to begin tapering bond purchases before the end of the year. That means (finally!) less money will be pumped into markets. The future of long-term interest rates is hazy. Again, none of this suggests economic recovery is ending or even that growth will stagnate. It means we are in a transition phase, a period of heightened uncertainty. With equity prices high, a little disconcerting news sends prices down. The next real positive is third quarter earnings season. That may be a mixed bag for each company depending on the impact of supply chain disruption, input costs, and inflationary pressures. Already several large companies have reduced forecasts and September isn’t half over yet. That’s not a good sign, at least for the near term.
I want to end with a brief comment on the California recall election. While Governor Newsom survived handily, there were no winners. The fact that there even was a recall effort tells one of the state of voter dissatisfaction. Governor Newsom and supporters had to spend $83 million just to survive. He survived not because voters felt he did a good job. He survived because the alternatives appeared to be even worse. The leading opponent, the one likely to be the next governor if the recall effort succeeded was a staunch conservative talk show host, not a particularly appealing option in a liberal state like California. On the other hand, liberals and progressives shouldn’t walk away with the wrong message. Californians didn’t like the way Newsom handled the virus, didn’t like his arrogance, and didn’t like higher taxes. Californians are moving away in droves seeking a better lifestyle, better working conditions, and less expensive homes. At the same time Democrats in the Senate debate how much higher they can push taxes, and how many new entitlement programs they can put into place.
No one can question the worthiness of pre-school education or community colleges, but one must consider the costs. Federal spending was 21% of GDP in 2019. It is likely to be about 26% this year. The full Democratic agenda will move that higher. The costs of new entitlements will come at the expense of private sector growth. It isn’t for me to take sides on this debate, but Congress needs to understand what they are doing. The current way of life in Washington, that one party molds a huge spending package, allows very limited debate, with no input from the other side, and then votes quickly isn’t responsible. The current package, announced within the past few days, will be moderated some. Once new entitlements are put into place, no one is going to take them away. Should the current package pass, free pre-school, free community college, and paid medical leave are here to stay. The result will be an explosion in debt to over $40 trillion by 2030, double what it was early in the Trump administration. With interest rates near zero, the cost to service the debt can be handled today. what happens if interest rates rise again? The answers are obvious and not particularly pleasant. In our economic world, nothing is free. Someone eventually must pay the bill.
Today, Prince Harry is 37. Tommy Lee Jones is 75.
James M. Meyer, CFA 610-260-2220