November Investment Comments
Judging solely by the U.S. stock market, economic conditions could hardly be any better. Year to date, the S&P 500 is up more than 22%. Investors may be taking their cues from economic data suggesting a desirable “Goldilocks economy,” one that is neither too cold nor too hot. Economists forecast U.S. Gross Domestic Product to be up about 2.5% for 2024. Inflation has been gradually ebbing.
Underlying statistics paint a murkier picture. Manufacturing has been in a recession for most of the past two years, and new factory orders continued to decline in August. The Institute for Supply Management’s Purchasing Managers Index showed continued contraction into September. The weakness is largely due to high interest rates that reduce demand for big-ticket consumer and industrial goods like cars, appliances, and factory machinery. The Federal Reserve’s goal in hiking interest rates in recent years was to slow down the economy by making large items more expensive to finance. Demand for services, about 80 percent of the economy, continues to rise steadily.
The U.S. consumer continues to give off mixed signals. Consumer confidence surveys point to a steady decline over the past couple of years. Yet, retail sales have been generally favorable. Adjusted for inflation, however, sales are actually down over the past year. Low-income and lower-middle income consumers are struggling with high costs for basic items and surging rent. Services are more than offsetting weak goods purchases, propping up GDP.
High interest rates held back demand from factories and consumers, which not surprisingly impacted job growth. The workforce has grown faster than the number of new jobs, causing the unemployment rate to rise from a low of 3.4% in April 2023 to 4.1% in September 2024. This trend doesn’t portray economic vigor.
Uneven demand and higher unemployment prompted the Federal Reserve to announce a “recalibration” of its monetary policy at its September meeting, cutting interest rates for the first time since 2020. While fighting inflation had been its previous focus, it is now giving equal weight to combating unemployment. Stable prices and low unemployment comprise the Fed’s “dual mandate.”
No sooner did the Fed cut rates than the economy post unexpectedly strong job growth of 254,000 jobs in September compared to the 12-month average of 203,000. Then the September inflation report showed no further progress on price increases. These datapoints suggest an economy that might be too warm to be considered the “Goldilocks economy” that got stock investors excited. You wouldn’t know it from stock prices, however, that remain on an upward trajectory.
Bond investors are better economists than most stock investors. They have to be in order to be successful. Bond investors are generally entitled to a fixed interest payment plus are turn of their principal. Their only jobs are to make sure the borrower pays and to accurately calculate what those streams of payments are worth. Higher inflation would likely lead to higher interest rates and a lower present value for those payment streams. It is not surprising, therefore, that investors pushed long-term interest rates higher following news of stronger job growth and no further progress on inflation.
The 10-year Treasury began the year yielding 3.88%, somewhat below the 2-year Treasury which yielded 4.25%. This “inverted” yield curve suggested an elevated risk of recession. In recent months, the yield curve has regained its typical upward slope. The 10-year Treasury peaked in late April at 4.70% and fell to 3.60% around the time of the Fed’s September announcement. Since then, it has bounced up to 4.10%. The 2-year Treasury is more sensitive to short-term rates set by the Fed. Its rate peaked at just over 5% in late April, fell to 3.6% around the time of the Fed’s announcement, and has since popped up to around 4%.
The Fed sets the Fed Funds rate, the interest rate banks use when lending short-term money to each other. Beyond that, interest rates are determined by the market, i.e. by the forces of supply and demand. The bond market is telling us that interest rates might not fall as rapidly or as far as stock investors appear to believe. That should be a cautionary sign.
But what if the data everyone depends on isn’t as accurate as investors believe? We have been tracking revisions to job growth statistics since the beginning of 2023. Job growth numbers are subject to revision for two months following the initial release. If the data were reasonably accurate, one would expect upward revisions half the time and downward revisions half the time. However, in the 19 months we’ve been monitoring these numbers, 79% of the data has been revised downward.
Inflation numbers are also not as absolute as one would like to believe. The largest single component of the Consumer Price Index (CPI) is the imputed rental value of one’s home – a made-up number imagining people were renting the home they own. As of September, inflation rose 2.4% over the past year, 3.3% excluding food and energy costs. However, the CPI would have been up just 1.4% excluding this flawed imputed rental value figure.
There is a good chance that the Fed may see through the uneven job and inflation data and continue cutting interest rates. If so, stock investors’ optimism may be well founded after all. However, valuations are elevated, so some degree of caution is warranted. Weak economic growth in much of the rest of the world may be causing investors to gravitate toward U.S. stocks. We believe in the importance of selecting individual stocks of companies that produce sales and profit growth while selling for reasonable valuations. Owning quality growth stocks is especially important during periods of uncertainty, a characteristic in abundance given the interest rate outlook, a soon-to-be decided election, and a volatile world situation.
Scott D. Horsburgh, CFA®