Higher for longer and longer

Inflation’s last mile to 2% remains daunting and GDP growth came in unexpectedly weak last month, prompting stagflation worries (most news counts for “stagflation” since June 2022). The growth picture may be a lot better than the headline number of 1.6% suggests, and inflation may resume its decline once lagging shelter data comes in, but all that remains to be seen, and the market was in a show-me mood in April. The S&P 500 fell 4.1% last month, the second-worst April in 40 years (next to 2012), while Treasuries dropped 2.4%. As worries about stagflation set in, Wall Street strategists increased their cash allocations by 82 basis points in April, the biggest such increase since March 2020. But sentiment is a contrarian indicator, and when it is at or below current levels, equity returns have been higher 12 months later 94% of the time (nice odds). Though higher bond yields and somewhat elevated valuations make stocks vulnerable, the dominance of large, profitable companies suggests the S&P 500 might hold up better in a pullback than in the past. Oppenheimer thinks this is an ordinary bull market correction and expects the picture to improve in June due to seasonality, with the possibility first of another “less-intense” drawdown in the coming weeks. Fundstrat wants to see the S&P rise above 5,123 (we’re there as of this writing) before feeling confident that the low is in place. They add that the latter part of May and all of June tend to be “very bullish” in election years and foresee a broad-based equity rally ahead, helped by a weaker dollar and moderating Treasury yields.

Earnings growth for the Magnificent 7 has bettered the broader market for several quarters, but that is set to change. Expectations are that earnings growth for the other 493 will equal those of the Mag 7 later this year and the other 493 will lead in Q1 of 2025. Broadening is bullish! Through the first four months of the year, the 10 largest companies comprised more than three-fourths of S&P 500 gains. Nvidia alone contributed more than 40% of this, a record for any company during a positive year for stocks. But in April momentum gave way to value—a positive development if it continues, since momentum rallies lack staying power. With inflation sticking around, we shouldn’t count on multiple expansion anytime soon. Fortunately, rising earnings can still power equity gains, with 13% y/y gains in S&P earnings expected this year compared to last year. As goes the Fed, we wait for longer and longer … The current Fed pause has now exceeded 280 days and is the second-longest in data going back 50 years (longest was 2006-07). At this point, as Strategas notes, a Fed cut (whenever it comes) might be a sign of issues showing up. A slowdown in profits? Not yet. Some 78% of S&P 500 companies reporting so far have beat their earnings estimates. And while companies that have missed have been hammered, the market overall remains calm. In fact, it’s been more than a year since the S&P 500 has fallen 2% or more in one day. What could be the catalyst? As noted above, it doesn’t appear to be stagflation. Not earnings. What then? Labor.

April’s was a “Goldilocks” jobs report, a word you’ve seen a lot today. Hiring continued to rise at a rate that can support an expanding economy without the frenetic pace of recent months that fuels inflationary pressures. Wage inflation fell from 4.1% to 3.9%. Professional service payrolls have seen slowdowns, but a “white-collar recession” would be unusual, given the stability and strength seen in education, health care and government employment. The quits rate has fallen to 2.1% but remains within normal levels. Still, the labor market remains tight. Piper Sandler doesn’t see unit labor costs (ULC) and sticky inflation coming down without a meaningful increase in unemployment, which would reduce demand. But Yardeni notes that ULC was up a mere 1.8% y/y in Q1, implying a 2% CPI rate could lie ahead. My travel this week took me to scenic Portsmouth, NH, home of the Portsmouth Naval Shipyard.  Founded in 1800, it is the U.S. Navy’s oldest continuously operating shipyard. Advisors here aren’t interested in my heels, but my credentials. “Only 1% of professionals in our industry have all three, CFA/CPA/CFP,” I was told. They’re worried about a “rich-cession.” One noted a 40ish mid-level executive lost his high-paying job at a New Hampshire headquarters and can’t find work. Another has a $450k salaried NYC client laid off after 30 years. To take away the stress, one plays boccie at the office courtyard during lunchtime, while the other has a second job, owner/operator of a Snow Cone truck, complete with an “adult line.” “You can’t imagine the profit margins!”

Positives

• No hikes = dovish The Federal Reserve met and kept rates unchanged. The Fed reaffirmed its confidence that current rates are restrictive and that the central bank will be able to restore inflation to 2%. In a broadly dovish press conference, Powell noted that he expects inflation will come down over the course of the year and that keeping rates steady is more likely than further hikes. As for the neutral rate, once inflation gets to 2%, Strategas sees the central bank looking to place the fed funds rate about 1% above that.
• Perhaps jobs have caught up post-Covid The unemployment rate rose to 3.9%, and payrolls came in short of expectations for April, at 175K but good enough to absorb new entrants into the labor force. While other sectors were mostly on trend, hiring for leisure & hospitality, construction and government all fell sharply, perhaps indicating the post-Covid “catch up” is ending. Average hourly earnings growth at 3.9% was the slowest pace y/y since May 2021. Job openings (JOLTS report) fell to their lowest point in three years, with the ratio of job openings to unemployed at 1.32, near the pre-Covid mean of 1.2. The Employment Costs Index, the Fed’s preferred measure, surprised to the upside but likely due to workers’ wages “catching up” at a lagged rate.
• Imagine these profit margins Halfway through the season, earnings have been impressive. Beats are running at 9.2%, a near three-year high and almost twice the historical average of 4.9%. If this continues, earnings growth is on track to accelerate to 11.8%, driven by a combination of sales growth and margins rising to the highest in almost two years.

Negatives

• Trouble brewing? The ISM’s manufacturing composite fell to 49.2 in April, returning to contraction after briefly moving to growth in March. New orders were the weak spot. As Piper Sandler points out, the ISM data, even in long-term contraction, isn’t a recession indicator. The ISM non-manufacturing composite also declined, falling below 50 for the first time since 2022.
• An unhappy electorate The Conference Board’s measure of consumer confidence declined in April to a reading of 97, its lowest level in nearly two years. Respondents’ assessment of current conditions and expectations for the future both fell, while perceptions of the labor market weakened.
• No wonder we’re in a mood Gasoline started the year at $3.20 but now stands at an average price of $3.73/gallon, and the summer driving season lies ahead. The Energy Information Administration reported that 4-week average demand for gasoline dropped to the lowest level since the 2020 Covid lockdowns. In another indicator of strong pricing, the S&P Case-Shiller 20-City index showed that home prices rose 0.6% m/m in February vs. expectations of 0.1%, while the less-urban FHFA index rose 1.2%. Construction put in place dropped 0.2% m/m in March, with residential falling 0.7% while non-residential rose 0.2%.

What Else

May flowers Does one of Wall Street’s favorite slogans—“Sell in May and go away”—have it wrong? Since 1985, May has been positive 77% of the time. Furthermore, after a positive first quarter and a negative April, May is positive 83% of the time.

Sweet home Per the Wall Street Journal, lawmakers at the federal and state level are calling for legislation forcing large-scale owners of single-family homes to sell off their holdings. The claim is that the spike in home-owning enterprises in recent years has led to higher prices and fewer properties for sale.

The WFH blues MSCI data indicates that $38 billion in U.S. office buildings are at risk of default, the most since late 2012. Also, the payoff rate for commercial mortgage-backed securities, which stood at 90% just three years ago, has fallen to a multidecade low of 35%.