August Investment Comments
Since early 2020 the economy has undergone a series of shocks. First came the Covid-19 pandemic, which continues to impact the economy more than three years later. Next came the war in Ukraine, impacting global oil and wheat markets.
Most recently the emergence of Generative Artificial Intelligence (GAI) is a technological development that some have said could be as profoundly positive as the invention of the internet, mobile devices and cloud computing. Only time will tell if GAI lives up to the hype, but these shocks have brought tremendous volatility to the economy and financial markets.
Unprecedented monetary and fiscal support in response to the pandemic has brought elevated inflation. Since March 2022, the Federal Reserve has been pursuing monetary tightening, resulting in the fastest pace of rate hikes in U.S. history, eleven separate increases bringing the federal funds rate to a range of 5.25%-5.5%. The Fed is attempting a soft landing for the economy, raising rates just enough to slow growth without causing a recession.
But what is the definition of a soft landing? In the past 75 years, every time the three-month moving average unemployment rate has increased 0.5% or more the economy has experienced recession (known as the Sahm Rule). In his March 2022 news conference, Fed Chairman Jerome Powell cited three times in history—1964, 1984, and 1994—that the Fed has been able to tighten monetary policy without increasing unemployment, successfully executing a soft landing. However, the only widely agreed-upon soft landing was engineered in 1994-1995 by then-Fed Chairman Alan Greenspan. Hard landings are much more likely, as in each of the years 1970, 1974, 1980, 1990 and 2008, when inflation was running higher than 5% Fed overtightening led to a recession.
The odds that the Fed might pull off a soft-landing this time around are increasing. Inflation as measured by the Consumer Price Index (CPI) registered 3.0% in June, down substantially from the peak of 9.1% one year ago. The drop in the price of oil resulted in a gallon of gas falling from over $5.00 last summer to $3.54 now. However, the contribution from falling energy and some food price decreases is set to fall out of the index next month as core CPI, excluding food and energy, rose at a still high 4.8% in June. The market has rallied on the belief that inflation is falling back to the Fed’s 2.0% target, but this enthusiasm might be short-lived.
Or maybe it won’t. We have discussed previously that much of the increase in core inflation can be explained by the shelter component of the CPI which makes up over one-third of the index. Shelter costs moved up 7.8% in June, contributing over 70% of the increase in the CPI when excluding food and energy. Shelter costs are measured by “owners’ equivalent rent of residences”, an approximation of cost increases for homeowners, and “rent of primary residences”, reflecting rent increases. These measures increased 7.8% and 8.3%, respectively, in June. However, their calculation is subject to substantial smoothing that acts with a lag and is now overstating current housing inflation, likely dramatically.
As an example of how much the overstatement might mean for shelter costs, apartmentlist.com, a nationwide website of over five million apartments and rental properties, compiles the Apartment List National Rent Index (ALNRI), an estimate that strives to capture actual rental increases nationally. Its July report showed rent increases peaked in 2021 at 17.8%, just as the rental component of the CPI was heating up. In June 2023, the ALNRI was flat year over year, a sharp contrast to the 8.3% increase for the rental component of the CPI.
In further good news, the report goes on to explain that annual rental growth will likely turn negative in the months ahead as vacancies are high and new apartment supply is set to come online.
Progress on inflation doesn’t mean the Fed is out of the woods. Interest rate increases slow the economy with a lag, and the risk of overtightening given these lags is evident in the historical record.
Recent economic data looks strong. The Atlanta Fed estimates that GDP will grow 2.3% in the second quarter, a slight acceleration from the 2.0% rate of Q1. The employment market continues to chug along, with 209,000 jobs added in June and unemployment falling to 3.6%. Average hourly earnings grew 4.4% in June, matching previous gains in April and May and representing the first real wage gains since 2021.
Even so, the employment market is showing some cracks, as the number of people working part time because they can’t find full-time work jumped by nearly half a million in June. The labor force participation rate remains below the February 2020 pre-pandemic level of 63.3%. Initial applications for unemployment benefits, a proxy for layoffs, are up about 20% since the start of the year. At the start of recessions, the employment market can fall off quickly, and these cracks bear watching.
The stock market has had a great year from the combination of GAI excitement, moderate economic growth, falling inflation and the belief that the Fed is close to ending interest rate increases. The S&P 500 is up over 20% since its low last October but has followed a strange path to get there. In the year to date through May, the seven largest tech companies in the U.S., most of whom are associated with GAI, drove a 9.7% increase in the market-cap weighted S&P 500.
However, the rest of the market didn’t participate as the equal-weighted S&P 500 fell 0.6%. Since May the gap between the two indexes has narrowed, with the market-cap weighted S&P 500 through mid-July up about 17.5% and the equal-weighted S&P 500 up about 9%. This narrowing has occurred as investors have pivoted to companies expected to benefit from a moderately growing economy with falling input costs that can expand profit margins.
However, the market may be ahead of itself as earnings remain under pressure. According to FactSet’s Earnings Insight published on July 7th, earnings are expected to sink 7.2% for the second quarter, the third straight quarter of contraction. Revenues are expected to fall 0.3%, the first decline since the third quarter of 2020. Sharp declines for the energy and materials sectors are the main culprit behind the revenue and earnings shortfalls.
As is typical of optimistic analysts, third and fourth quarter earnings are projected to grow 0.3% and 7.8%, respectively, while full year 2024 rachets up 12.4%. The combination of this year’s market advance and expected earnings growth has left the forward P/E multiple 18.9, above the average of 18.6 and 17.4 for the past 5 and 10 years, respectively. The market’s valuation is even richer in a world where investors can earn more than 5% on safe, short-term Treasuries compared to almost nothing as recently as early 2022.
While financial markets have been volatile since the pandemic, equity investors in stocks who stayed fully invested have made money. As always, picking growing companies at reasonable valuations is eventually rewarded.
Daniel J. Boyle, CFA