The Great Stay

This week took me to the Philadelphia “suburbs” of Wilmington, Delaware, and Marlton, New Jersey, where I met with mostly skeptical advisors. One is worried about a recession, another about the lofty market and another thinks that this market is “smoke and mirrors.” Too much exuberance for these veterans—at a nearby law firm a 25-year-old associate was hired for a bloated $150k salary, only to get poached by a work-from-home $225k offer in New York!  Another complains, “I couldn’t get someone to sell any Nvidia if I tried!” And election discussion is heating up. An advisor’s elderly client wants to sell her house before the election as she fears the wrong candidate will win. What do all these concerns have in common? Inflation. The CPI came in high for both January and February. Unemployment is low, the well-off have excess savings, and the less well-off have the willingness and ability to borrow. Ergo, prices rise. In the latest CPI, core services were up 5.2% year-over-year vs. core goods down 0.3%. Supercore services (ex-shelter) were up 0.5% on the month after an 0.8% gain in January. This services inflation may be taking a toll on retail spending (more below), unless you’re that WFH NYC attorney! This seems to be mainly a U.S. problem. Services inflation is dropping faster in emerging markets than developed markets and Europe is doing better than the U.S. Strategas computes a “Common Man CPI” that focuses on necessities rather than more fanciful purchases. It has been higher than headline CPI (and a wage index) for most of the last three years.

My Greater Philly advisors wondered if the market isn’t too frothy. Not by the standards of the Dotcom bubble, it isn’t. The S&P 500 had a 45 P/E multiple in 2000; it’s at 21 now. The Nasdaq’s P/E spiked to 200 back then vs. 30 today. Other reasons given for skepticism include the yield-curve inversion and, of course, inflation. But Covid has quirky effects—remember that phantom recession in 2022?—and the yield curve’s inversion appears to be another one. As for inflation coming down, that’s the big if, but there are reasons to see that happening as well (more below), which is not to say it’ll be smooth sailing. Evercore ISI says that correlations this low have always been followed by a market correction, and momentum is at an extreme—at the 99.8 percentile, by J. P. Morgan’s estimate. On the other hand, Strategas points out that overbought conditions can last longer than you might expect. They expect to remain bullish until Treasury yields rise. Besides, new all-time highs are historically not a time for bearishness. Hopes for eventual (but ever-receding!) rate cuts undergird the market outlook together with the underlying strength in the economy. While returns for at least four of the Magnificent 7 remain strong, a welcome broadening has continued. Both the Value Line Index and the equal-weighted S&P 500 marked new highs last week. Corrections are always hard to predict, and this market has already been full of surprises. Even if there is a correction, what about the year as a whole? We’ve just had four straight positive months. Fundstrat notes that November-February have all been positive 16 times in the last 90 years. Whenever that’s happened, the median return from March to the end of December has been 15% and none of these years has seen a loss. Decent odds!

Labor supply should remain abundant thanks to immigration and rising productivity, and it could surprise to the upside due to participation gains and automation, among other factors. Accordingly, payroll gains tell us little about inflation right now. Instead, the question is whether or not the labor supply is tight enough to drive up wages. S&P 500 sales growth, which had fallen all the way to 1.7% last year, has recovered to the middle of its typical 2-7% range. We may be in the early stages of inventory restocking as well. For now, the labor market appears to be strong and less tight. The quits rate, a leading labor market indicator, is at 2.1%, down from its early-2022 peak of 3% and in-line with its longer-term average. Median wage growth has been fairly sticky, at 5% vs. 3.7% in 2019, but that may change for the better. Per the NFIB, small business intentions of increasing pay fell dramatically in February to the lowest level since early 2021. A restoration of calm in the labor market suggests lessening upward pressure on wages moving forward. The Fed would love this. It would be an elixir for earnings at a time when pricing power is disappearing. Earnings beat expectations in the fourth quarter. For that to continue, increases in the cost of labor will likely need to slow. Perhaps this will play out in the second half. The Great Resignation is yesterday’s news. Now we have a labor market where companies are reluctant to lay people off and workers are reluctant or unable to leave for something better. Great Resignation, Great Snesignation! Welcome to the Great Stay.

Positives

Back in the saddle Global growth picked back up after a sharp slowdown late last year, according to UBS estimates. Whereas growth fell to a 1.6% annual rate last November, that figure now comes in at 2.7%. Perhaps this portends improving conditions in several stagnant major economies.

Housing logjam breaking up? Mortgage applications rose 7.1% last week, the second such increase in a row. The average rate for a 30-year fixed mortgage dropped 18 basis points to 6.84%.

The weather ate January’s production but not February’s Industrial production rose 0.1% in February, while manufacturing output increased 0.8%. Both figures came with downward revisions to January’s numbers with signs the rough weather at the start of the year dampened activity more than once supposed. Auto production rose above 2019 levels and business equipment increased 1.7%. The New York Fed’s volatile Empire State manufacturing survey, however, slid further into contraction.

Negatives

The rising cost of living rises February’s CPI report came in just above expectations, at 3.2% headline year-over-year. Some culprits, such as used cars, may be headed lower. Services and shelter, in particular, have proved sticky. Producer prices shot up as well, rising 0.6% on a headline basis for the month. Much of this, however, was due to energy, so the PPI report may not be a big factor in the Fed’s deliberations. Nonpetroleum imports increased at a moderate 0.2% in February.

The less resilient consumer Retail sales rebounded somewhat in February. The total was less than expected, though, and January’s figures were revised lower. Building supplies and autos saw strong gains. Meanwhile, the University of Michigan reported consumer sentiment is off just slightly thus far in March. Inflation expectations were unchanged at 3% one year out and 2.9% over the longer term.

Peak pessimism? Small business optimism declined per the NFIB, marking 26 straight months that optimism has been below the long-term average. A mere 5% of respondents thought this was a good time to expand operations, and a minority expected the economy improve.

What Else

Make politics boring again The Biden Administration called for a 25% wealth tax on those with $100 million or more. While it would be significant if it were to pass, presidential budget promises of this kind—especially during an election year—are more messaging than realistic policy.

This could save the day Productivity rose 2.6% year-over-year in the fourth quarter. As Evercore ISI points out, this rate, together with a population rising by 1% per year, implies that GDP could grow 3.6% per year without adding to inflation. 

Topsy turvy The 2/10 year yield curve set a new record for longest inversion at 421 days. Taylor Swift’s “Anti-Hero” was at number one on Billboard when this run started. When has the yield curve gotten it wrong? In 1966-67 the curve inverted without a recession ensuing.