Investment Insights 

 — Steve Orr 

Not so fast

Peak news for perhaps the entire quarter last week. Fed and Treasury announcements, peak earnings season and a puzzling jobs report pushed bad news off the front page. After plenty of back and forth (say “volatility” to impress your friends), rates were largely unchanged and, stocks, well, it depends. Mega Caps like the Dow Industrials and S&P 500 posted a fourth straight week of gains. The Industrials hit a new all-time high Thursday and the 500 intraday Friday. Small company stocks and Emerging Markets cannot seem to get out of their own way and continue to drift sideways.

Now for the sort-of-bad news. We maintain our belief that if the Fed needs to cut short-term interest rates, it will take its time and push the bulk of its cuts to later in the year. Recall around Thanksgiving last year, the Fed narrative was “higher for longer” to kill inflation. Abruptly, for reasons not apparent, at the December meeting the narrative changed to “lower sooner.” The Fed began to lay the groundwork for shifting to a rate cutting stance. Last Wednesday’s press release and Chair Powell’s press conference moved the needle slightly in that direction.

Leaving rates unchanged since last July, Fed Funds remain in the range of 5.25% to 5.5%. With inflation easing into the low 3% range, real returns on cash are near 2%, a historically rare level.  In its press release, the Committee formally removed the bias toward higher rates and set the stage for future reductions. Powell tried to calm any excitement by explicitly stating that rate cuts are not imminent. If Lee Corso were with Powell, he’d grab the mike and say, “No so fast, my friend.” Stock investors like lower rates because valuations are improved, and companies can lower their borrowing costs.

The logical next question is: When will the first cut happen? On average, the time between the last hike and the first cut is around 11 months. From last July to May sounds about right. Futures markets, who have consistently bet wrong on cut timing, are pushing for May 1 or at worst June 12. 
Regardless of the time between Fed rate actions, the Fed historically has not reduced short-term rates until the annualized growth rate of nominal gross domestic product falls below the Fed Funds rate. Nominal GDP is reported by the Commerce Department in actual dollars. Most readers are familiar with “real” GDP, which is just nominal GDP minus inflation. We are not going to get into a debate over which inflation rate to use in the analysis. We would point out that nominal GDP grew last quarter at a 5.8% annual rate. With Fed Funds averaging 5.33% right now, that test has not been met. Waiting for the nominal GDP rate to fall below Fed Funds implies that the Committee is waiting for the long-expected slowdown in economic growth.

Really?

We admit to being taken aback at Friday’s January jobs report. Nonfarm payrolls in January rose a net 353,000 versus an estimated 185,000, a surprising beat. Private and manufacturing payrolls also had sizable jumps. The unemployment rate from the Household survey held steady at 3.7%. We will dig into the numbers in the coming week. Note that recent payroll reports have had a 50% or less response rate, necessitating model estimations by the BLS.

Regardless, continued job growth and very low unemployment means the economy will continue to expand. Long-term trend estimates of U.S. growth center around 2%. That is half the country’s growth rate of 30 years ago, thanks to a federal debt burden greater than the size of the economy. Job gains averaging 230,000-plus this year as they did last year would place GDP above trend for 2024. If that proves to be the case, then there is no path to a slowing “soft landing” economy. If the economy posts a 2.5% or higher growth rate this quarter, Wall Street will be covered in “no landing” headlines as the economy shifts from second into third gear. 

And finally

Low unemployment, above-trend growth and slowly improving sentiment means the Fed can afford to wait on rate cuts. These conditions also help company earnings. We are now halfway through fourth quarter earnings season. Last week, more than 120 S&P 500 companies reported; another 100 report this week. The big news centered around five of the seven “Magnificent 7” stocks that are the largest components of the S&P 500. Five of the seven handily beat estimates led by Amazon, with a very impressive 25% beat on earnings. Analysts had expected earnings per share of 80.5 cents but were handed a late Christmas present of $1.009 per share. The stock rose 16% over Thursday and Friday. A sixth, Apple, beat estimates but gave a downbeat estimate on unit sales. The last of the group to report will be Nvidia, on the 21st.

The impressive results at the top of the index helped pull year-over-year earnings to a positive 2.6%, according to FactSet. We expect that result to be chiseled lower in the coming weeks, as not all of the energy (-27% so far) and materials companies (-23% with 14 of 28 firms) have reported.

Big tech was last week, and this week’s theme is Industrials. Caterpillar, BorgWarner, Carrier, Linde, Lilly and Cummins have our attention for manufacturing and healthcare. Analysts had been lowering full-year projections for earnings, and we are curious to see how last week’s big beats from the tech world helped. More coming.