Charts for the Week
Corporate Profits | Unfazed by the Fed thus far
March 3, 2024
The Fed’s preferred PCE inflation metric continued to tick lower in January. Thus, even while policymakers hold their target fed fund rate steady, monetary policy is continuing to tighten as falling inflation pushes the real, inflation-adjusted fed funds rate higher. Using Core PCE as the measure of inflation, the real fed funds rate has now swung eight percentage points over the past two years from negative 5.5% to positive 2.5%.
So far that big change in interest rates has not served as much of a headwind for corporate profitability. Indeed, many companies have gotten a boost from the additional interest income on their cash holdings. In the fourth quarter of last year, profits for companies in the S&P 500 came in largely as anticipated, and expectations for earnings growth this year remain robust at more than 12%. While companies with higher debt levels have seen interest expenses start to rise, the increase has been relatively modest.
A return to a more historically normal interest rate environment will be a long-term drag on profit margins, which have benefited from falling rates for decades. In the short term, however, the bigger risk to corporate profits from tighter monetary policy is not higher interest expense, but a slower economy that could make it difficult to achieve lofty growth expectations.
Bubbles | Turning future returns into past returns
February 26, 2024
Stock markets across the globe are hitting new all-time highs. Even Japan’s stock market reached a new record high after more than 34 years of languishing below its 1989 bubble peak. Japan is an example of how the herd can push stock prices to such heights that decades of future returns are squeezed into a short period of time.
Investor enthusiasm last week was fed by “the most important stock in the world”, Nvidia, reporting another quarter of astounding growth. Nvidia appears to hold the key to unlocking the door to the magical AI future, and it is taking full advantage of the moment. While Nvidia is likely to continue to be a highly successful company, it will be challenging for its stock to offer investors good long-term returns at its current valuation. (Although, over the short term, bubbles can inflate longer and higher than imaginable.)
The current AI mania echoes the excitement surrounding the internet at the turn of the century. At that time, Cisco was the indispensable stock that for a few months in 2000 surpassed Microsoft as the most valuable company in the world. While Nvidia is a different juggernaut in many ways, Cisco still offers a cautionary tale for any stock that flies too close to the sun as it remains nearly 40% below the high it reached 24 years ago.
The Fed | Facing a tougher road ahead
February 19, 2024
CPI inflation was slightly higher than expected in January. While the Consumer Price Index is not the Fed’s preferred inflation metric, the inflation report still led investors to lower their expectations for rate cuts this year to be largely inline with the 0.75% reduction in the overnight fed funds rate that policymakers have forecasted. Inflation continues to head in the right direction, but the pace of progress has slowed.
Just as the initial decline in inflation has been relatively painless, so has the Fed’s efforts to normalize its balance sheet from the extreme measures taken during the pandemic. Other than the quickly extinguished fire of a few large bank failures last March, the Fed has successfully shrunk its balance sheet without disrupting the financial system. However, the road there might be about to get tougher as well.
Since the bank failures last year, total bank deposits are up, and bank reserves at the Fed have increased even while the Fed’s total assets have declined by more than $700 billion. The increase in bank reserves (which are a liability on the Fed’s balance sheet) is thanks to the rapid decline in the amount of money that the Fed borrows primarily from money market funds. But that bucket is almost empty as money market funds swap back into holding US Treasury bills with slightly higher yields, so further quantitative tightening will likely entail a resumption in the decline of bank reserves (just as the Fed is trying to wrap up its emergency lending program initiated in response to last March’s turmoil).
While normalizing bank reserves should not in theory cause problems, the Fed has placed itself in uncharted territory with unknown hazards. Once money market funds stop lending the Fed money, policymakers may start to step more gingerly on the long path back to a normalized balance sheet and slow the pace of quantitative tightening.
Recession | Now unexpected
February 12, 2024
Last week, the S&P 500 notched another up week (the 14th in the past 15) and cruised past the symbolic 5000 level to a new all-time high. The rally remains highly concentrated in the mega cap stocks, but it is still indicative of a growing sense of insouciance – a feeling that is echoed in the debt markets.
Credit spreads in the corporate debt market are at a historically low level and falling. If investors were fearing any economic weakness, credit spreads would at least be ticking slightly higher. And while banks remain cautious in their lending, the number of banks continuing to tighten lending standards is dwindling – which is typical when the economy is coming out of a downturn, not headed into one.
The lack of a recession last year surprised many. If a recession were to materialize this year, it might surprise even more.
Strong jobs report | Have we reached nirvana?
February 5, 2024
For the second week in a row, the government reported unexpectedly strong economic data. In January, employers were estimated to have added 353,000 new jobs, the estimated payroll gains in December were revised higher to 333,000 and the unemployment rate remained at a low 3.7%.
With inflation seeming to also be in full retreat, the economy appears to have reached nirvana (low inflation, low unemployment, solid growth, high government deficits, low personal savings, historically normal interest rates, record stock prices, record house prices, no pain). However, the headlines belie the government statisticians’ struggles to gauge the true state of the economy on the other side of the pandemic wildness. The same report that showed payrolls growing at a steady rate also showed the total number of hours worked barely changed from the previous year. And the accompanying household survey of individuals continues to show much slower job gains than the survey of employers and an increasing number of people who wish they were employed.
The numerous discrepancies in the economic data are indicative of potential rumblings underneath the surface that at least caution against claiming enlightenment too soon.
GDP | Too good for rapid rate cuts?
January 29, 2024
Last year, the economy was supposed to weaken and potentially tip into a recession. Instead, economic growth accelerated (at least based on current GDP estimates). Real GDP adjusted for inflation increased by 2.6% in 2023 as consumer spending remained resilient in the face of waning pandemic savings, higher interest rates, and the restart of student loan repayments. Economic growth last year was also greatly supported by the federal government which ran an abnormally large budget deficit equal to nearly 8% of GDP.
Even with the economy seemingly running hot, the Fed’s preferred PCE inflation metric continued to trend downward, and annualized 6-month PCE inflation is now tracking right at the Fed’s 2% target. Accordingly, investors’ expectations for more Fed rate cuts this year have swung back up despite the strong GDP report, and the overnight fed funds rate is once again anticipated to be below 4% by the end of the year based on fed fund futures.
It would seem unwise for the Fed to start lowering rates with economic growth accelerating. However, when Fed policymakers meet in May, annual PCE inflation could be tracking near 2% if current trends persist, providing them with sufficient rationale to start lowering the fed funds rate at that time. How quickly they reduce short-term rates will likely depend on the true strength of the economy. Certainly not all the data is as rosy as the estimates of GDP growth suggest. Even evident in the GDP numbers are the low personal savings rate and high government deficits which raise questions about the sustainability of the recent strong expansion. If the economy does continue to motor along, investors’ expectations for rate cuts are unlikely to be met, but that would not be an altogether bad thing.
Stocks | All-time high with "cash on the sidelines"
January 22, 2024
Last Friday, the S&P 500 Index hit a new all-time high for the first time in more than two years; however, most stocks remain well below their highs reached in 2021. The new year has brought a resurgence of the mega cap trade as the largest stocks have pushed higher while the rest have pulled back slightly.
One thing that some point to as potential fuel for a broader rally this year is the cash investors have stashed away in money market funds. As the Fed lowers interest rates and the odds of a recession recede further, the hope is investors will reallocate their money market fund holdings into stocks.
One problem with the cash-on-the-sidelines theory is that in practice the cash is always on the sidelines. If someone buys a stock, someone else is selling it, and the cash the buyer had now resides with the seller (on the sidelines).
To the extent there has historically been a drawdown in money market assets, it has not occurred until there has been a significant decline in stocks and the Fed is near the end of aggressively cutting interest rates. Even then individuals’ total holdings of cash and fixed income securities have remained steady or continued to trend higher.
While there is no practical reason for a high level of money market assets to support the stock market, like any market theory if enough investors come to believe that it is a bullish signal, then it can become a self-fulfilling belief (at least for a while). But if the market rally does continue and broaden, it will more likely be because of improved fundamentals and will likely also be accompanied by higher money market assets, not lower.
Inflation | Progress slows but expectations do not
January 15, 2024
The headline Consumer Price Index (CPI) reported an uptick in annual inflation to 3.4% in December. Ever since hitting 3.0% last June, improvements in CPI inflation have stalled. Annualized 6-month inflation is now higher than it was a year ago for the first time since inflation peaked in the summer of 2022. Nevertheless, investors expect inflation to steadily decelerate towards 2% this year.
Despite CPI inflation failing to make progress in recent months, the Producer Price Index (PPI) continues to show reduced wholesale price pressures, and the Core Personal Consumption Expenditure (PCE) price index, the Fed’s preferred inflation metric, appears to be on a promising trajectory back to 2%. As a result, investors are now anticipating the Fed to cut its target overnight fed funds rate seven times this year to around 3.6%. As fears of the Fed keeping interest rates higher for longer have receded, the yield curve has once again become more inverted with the short-term Treasury rates now about 1.5 percentage points above the 10-year Treasury yield.
Investors have been waiting for the Fed to pivot for a long time. The yield curve has been inverted for 15 consecutive months and is poised to exceed the modern-day record of 17 months reached in the late 70s and early 80s when the Fed was battling double digit inflation. Fed policymakers will provide an indication at their next meeting at the end of January as to whether investors have once again become too hopeful for lower rates.
Source: YCharts, https://www.zillow.com/research/data/, https://fred.stlouisfed.org/, AOWM Calculations
Labor Market | Signaling strength and weakness
January 9, 2024
The labor market is a good indicator of where the economy is but not necessarily where it is going. In that regard, the economy is still in good shape. The unemployment rate remained at a historically low 3.7% in December and employers added 216,000 jobs based on initial estimates. Claims for unemployment insurance are also offering hopeful signs that the labor market is slowing without stalling.
However, there are also less-hopeful signs in the data. The number of individuals unemployed increased 10% last year. Job openings continue to decline, and individuals are less confident about leaving their jobs. Payroll growth is decelerating, and the data continues to be revised lower each month. And the canary-in-the-coal-mine that is temporary workers continues to decline.
While the good news should not be discounted, the odds of a more significant slowdown remain higher than normal if for no other reason than a $28 trillion economy is challenging to precisely manage despite policymakers' best intentions.
Source: YCharts, BLS, Federal Reserve, AOWM Calculations
23/24 | The year that was and the year to come
January 2, 2024
Last year exceeded even the optimists’ expectations. Inflation retreated largely as anticipated while the economy remained surprisingly strong and unemployment stayed low. The growing hope that inflation will be tamed without a recession fueled a strong year for stocks, especially mega cap growth stocks, with the S&P 500 up 24.2% (26.3% with dividends). Most stocks significantly lagged the headline index yet had a good year nonetheless with the equal-weight S&P 500 up 11.7% (13.7% with dividends).
One of the few things that didn’t exceed expectations was corporate earnings which weren’t as good as analysts had projected at the beginning of the year; however, they rarely are and were still far better than they could have been if the economy had slipped into a recession as many were predicting.
In general, the outlook for the year to come is similar to what it was a year ago – moderating inflation, slowing yet positive economic growth, and decent (if not spectacular) market returns. The odds of a recession have declined but likely remain higher than the stock market would suggest. Investor sentiment has swiftly swung carefreely positive as the set up for stocks in 2024 appears promising. Such an overwhelming consensus can be its own cause for caution.