Mr. and Mrs. Federated Hermes

Off this week to the secluded, gorgeous, bastion of genteel golfing, Pinehurst, N.C., for an annual meeting and one of my largest audiences each year. Pinehurst Resort, America’s largest golf resort, is adding its tenth 18-hole course, just in time to host the 2024 U.S. Open. Walking through the lobby for my speaking time, I spied two possibly baby boomer gentlemen, dressed for an outing—one sporting a complete USA flag design (head to toe), the other a black outfit with a large orange daisy pattern, reminiscent of the ’70s. They missed my comparison of current days to the inflationary ’70s, delivered to a mostly millennial audience. I couldn’t help but raise my voice into a working mic when sharing the “shocking” 10-year debt increase forecasted last week by the nonpartisan Congressional Budget Office. But who cares? Risk assets have held up remarkably well to the massive repricing by the Fed and ECB—high-yield spreads and the S&P are trading in line with early May 2022 levels, when futures were pricing a Fed terminal rate of 3% (vs. 5.5% today). J.P. Morgan cites three drivers of this resiliency: 1) the equity risk premium has remained positive, serving as a shock absorber to tightening; 2) credit stress has been contained because so many corporate and household borrowers locked in low fixed rates before 2022 (5% of mortgage borrowers carry variable loans, vs. roughly 40% before the global financial crisis); and 3) there still is a lot of excess cash in the financial system.

Indeed, the massive monetary overhang from the unprecedented pandemic response—Piper Sandler estimates some $4 trillion of what it calls “legacy liquidity” is still sloshing around the system—may be vastly underappreciated. While M2 is now contracting at its fastest rate in at least 70 years, its disinflationary effects are being muted by the fact that it soared 25% in ’20 (the most since World War II) and 12% in ’21 (the most since ’76 outside of ’20’s spike), years in which nominal GDP rose “only” 12% and 7%. If monetary policy works with “long and variable” lags, as the father of monetarism Milton Friedman put it, and nominal GDP never fully responded to the surge, Deutsche Bank wonders if nominal growth might stay elevated for longer? The answer could determine if sticky prices (more below) stick around for months or quarters to come. Signs of higher for longer are everywhere. In fed futures, in macro data (more below), in Treasury yields (the 10-year breached 4% this week, and the 2-year neared 5%), and overseas, where the 10-year German Bund hit a cycle high of 2.75% (vs. 0.03% just a year ago). In more than 20 countries, 2-year sovereign yields are now trading at new cycle highs.

Higher for longer means inflation’s drag on margins and profits should intensify. Acceptance of higher prices is starting to run thin, according to guidance this week from major retailers. But with Wall Street coming off its worst earnings season since 2009 (more below), Street estimates are a still elevated $222 vs. Q4’s annualized run rate of $213.8, according to FactSet. With U.S. and global short rates and bond yields increasing, and the dollar resurgent, Piper Sandler wonders if EPS will even bottom this year. While nominal revenues are still 13% above their pre-Covid trend, real revenues are back to trend (up just 2.1% y/y in Q4) and stalling, with nominal compensation up 7.7%. As real revenues continue to deteriorate, compensation (employment times wages) should follow, as it always does. My Pinehurst comments were very well received, but no questions—until afterward. An advisor said his clients ask, “Why should we invest in any equities?” given the current environment. Another, insisting that his comment was not meant to be political, says his liberal friends believe the Biden administration spent to increase debt knowing in the next term, taxes will be raised to pay for it all. “It was all part of the plan.” And a first for me—a gentleman approached the stage I was sharing with my affable colleague, asking if we were man and wife. “God, no!” I blurted. “Why this man could be my much younger brother!”

Positives

• Good news is bad news February services ISM was flat vs. January’s big upside surprise but beat consensus on strength in new orders (the highest since November ’21) and employment (its best reading since December of that year). S&P Global’s separate services PMI also surprised.
• Good news is good news National home prices declined a sixth straight month, dropping y/y price appreciation to 4.65% from a peak 21.4% last April, according to the S&P/Case Shiller survey. FHFA prices also fell more than expected in December, while more recent median home sale price data from Redfin showed prices below where they were a year ago for the first time since 2012.
• Housing isn’t collapsing Despite struggles due to higher mortgage rates and elevated prices, residential construction employment continues to make all-time highs and is now well above levels last seen at the peak of the housing bubble in ’06. The surprising resiliency reflects the market itself, with the 529K multifamily housing starts in ’22, the largest annual total in 36 years and up 14% from a robust ’21. Sales show signs of turning, too, with January pending home sales surging 8.1% to August ’22 levels.

Negatives

• Sticky inflation After months of declines, Manheim’s used-car price gauge is rising again—up 4% the first half of February to 38% above pre-pandemic levels, and now down just 12% from its Covid peak, vs. an 18% trough at year-end ’22. Elsewhere, ISM manufacturing prices hit a 5-month high and overseas, France and Spain CPI unexpectedly popped, helping push core eurozone CPI to a record high.
• Uh-oh Revisions sharply lowered Q4 nonfarm productivity and drove unit labor costs higher, pushing annualized costs to 6.3%. Goldman Sachs upwardly adjusted its wage tracker, too. Elsewhere, 4-week average jobless claims fell to a 5-decade low (’70s redux?), and Conference Board’s “jobs plentiful” rose a second straight month. All higher-for-longer catalysts.
• Worst earnings season since the global financial crisis Q4 EPS contracted 2.4% on a 5.9% increase in revenues, a 1.9% rise in buybacks and a 10.2% contraction in margins. Earnings topped estimates by just 1.2%, vs. a long-term average of 4.8%. Ex-Big Tech, EPS growth was a more robust 5.7%, but still trailed EAFE’s 8.5% increase.

What else

WFH fad isn’t fading The return to office rate is faltering at 50%, with more and more owners and lenders coming to realize the robust return to the office they had hoped for isn’t likely ever to materialize. Commercial real-estate services firm Cushman & Wakefield projects the U.S. will end the decade with a record 1.1 billion square feet of vacant space, compared with 688 million in 2019.

Close enough for government work The Fed’s Summary of Economic Projections, in a back-of-book discussion of forecast uncertainty, shows 70% confidence intervals for median FOMC forecasts. (Big enough to drive a truck through, Bank of America jokes.) To wit, by year-end, the unemployment rate may rise to between 3.5% and 5.7%, PCE inflation between 1.8% and 4.4% and the funds target rate between 3.9% and 6.3%.

With dividends, you get paid whether the market is up or not Notwithstanding last year’s bear market, S&P 500 dividends grew to a record high of $562.9 billion.

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