March Investment Comments
The S&P 500 closed above 5,000 for the first time in history on February 9. The index has risen more than 50% since the end of 2019. The Russell 2000 index of smaller companies has only slightly underperformed the S&P over the past month. The persistent rally finally broadened out.
Valuations are stretching, though. According to FactSet Earnings Insight, authored by John Butters, the S&P’s estimated forward P/E ratio has risen to 20.3, above the 5-year average of 18.9. With three quarters of the S&P having reported fourth quarter earnings, the composite Q4 growth rate for earnings stands at 2.9%. That modestly lags consumer price inflation over the same period, meaning the purchasing power of corporate earnings remains in modest decline. Markets look ahead, suggesting improved earnings growth will be necessary to justify the optimism baked into current valuations.
Buyers appear very enthusiastic about the U.S. economy’s potential to find a higher gear as the Federal Reserve pivots toward future rate cuts. With CPI inflation moderating, it looks like nearly a foregone conclusion that we have reached the peak of the tightening cycle. Stock market bulls eager for the cuts to begin were not deterred by hawkish commentary from Fed Chair Jerome Powell following January’s Open Market Committee meeting. Powell stressed that it is too soon to declare victory against inflation and also reiterated the Fed’s commitment to reducing inflation to 2%. There are many reasons why the Fed would like to cut rates as soon as possible. For one thing, its own income statement has swung down approximately $200 billion annually, from producing nearly $100 billion profits annually over the past ten years to a similar-sized loss as reported by Nick Timiraos of the Wall Street Journal. Whether the Fed earns an accounting profit or a loss is only really important as an indicator of overall system health. It can stem the losses by reducing both the sum total of its liabilities and also the rate of interest it pays on them. It has made progress, which is most evident in the falling utilization of reverse repurchase from banks. Since peaking at $2.4 trillion in 2022, banks have lowered the sum total of their excess cash parked overnight at the Fed to about $600 billion. This is excellent progress, although the U.S. Treasury is currently undoing some of the Fed’s good work by expanding the money supply. More on this later.
The bond market has been less exuberant than the stock market, perhaps taking Powell’s measured statements at face value. The CME’s FedWatch Tool recently predicted 1.5% worth of rate cuts in 2024, likely starting in March, but now only predicts closer to 1.0% in total, with no cuts starting until June. The 5-Year Treasury yield has risen from a low of 3.80% to 4.27% recently. Yields on Treasuries of all terms have mostly moved higher in parallel, and the yield curve remains quite flat except for some inversion at the very front end while the Fed holds overnight rates above 5%. Junk bonds, which represent a sort of intermediate asset between equities and Treasuries, have been stable as the pressure from higher prevailing risk-free rates has been offset by investors accepting lower premiums. Bulls are charging into junk bonds. The difference in premiums between junk and Treasuries, called credit spreads, has returned to the low end of the range in place since the financial crisis of 2008-9.
Economic performance remains resilient. January’s Employment Report told a story of stable headline unemployment of 3.7%, with some very small deterioration in the average underlying quality of jobs, especially as jobs in energy production were replaced by retail and healthcare, which tend to pay less. Average hours worked dropped 0.6%. Meanwhile, the advance Q4 GDP report estimated real economic growth at a solid annualized rate of 3.3%.
The optionality to respond with rate cuts should the economy sputter means the overall picture looks bright and, we might dare to say, relatively predictable as long as inflation continues to behave. There is no real reason to doubt that recent disinflationary trends will continue except to say that the fundamental drivers of inflation in recent years remain somewhat of a mystery. Given lingering uncertainty around inflation’s causes, it is rational to be a bit paranoid, considering that inflation seems like the main danger to the economy at present, beyond the usual tableau of the unforeseeable.
January’s CPI statistic came in above expectations, driven especially by housing and medical care costs. The CPI is potentially subject to some of the same uncertainties that have made many financial datasets hard to interpret since the beginning of the pandemic. The main problem is how to tease out baseline trends versus short-term volatility. When Powell made his infamous “inflation is transitory” gaffe nearly three years ago, his fundamental mistake was attributing too much inflation to supply chain disruptions while underestimating how much money was suddenly chasing goods in an economy that only grows productively at a rate of about 2% annually, at best. When money growth outpaces productivity growth persistently, inflation ensues. Pandemic stimulus and its attendant money supply expansion did not politely wait around for fiscal and monetary policies to revert to pre-pandemic norms. People spent the money!
Speaking of fiscal policy, Federal deficits are running at over 5% of GDP. It would require meaningful tax increases or spending cuts to stop that from increasing further in coming years. Who wants to preach fiscal discipline in an election year, or ever really? The Treasury has been reducing the average term on its outstanding debt, with over one-third of total debt maturing within twelve months. One interpretation is that the Treasury is betting big on the consensus opinion that tame inflation will bring down future financing costs. Whether this decision proves wise only time can tell. Its own actions, however, create some marginal upward pressure on inflation. The closer a debt instrument comes to maturity, the more it acts like cash. More short-term government debt in the system means more cash-like assets competing for goods.
The most reasonable base case calls for solid economic growth buttressed by falling interest rates. Valuations are the only major impediment to owning equities under that scenario. Stock pickers have some control over the valuations they buy and continue to hold—index investors not so much. When picking stocks, it is dangerous to assume that a high valuation implies equally high quality. Wise investors use their own judgment, and they diversify because judgment can never be foolproof.
Miles Putnam, CFA®