Investment Insights

 — Steve Orr 

Nothing

The spring of everything; the spring of nothing. March and May printed new all-time highs for multiple stock indices. Treasury bonds made another run at 5% but did not get there. No changes in short-term rates. Since May 21, stocks have been flat at best, and bonds are unchanged. The NASDAQ, Dow Industrials, Transports, dollar, copper and crude oil are all lower. No change at the top of the stack, but plenty going on down in the basement. What gives?

Earnings for one. The final reading on the first quarter’s earnings growth was 6% year over year. NVIDIA accounted for nearly 40% of the rise in earnings. Energy, healthcare and materials sectors all fell by 25% or more over 2023’s first quarter. Anything tech- or internet-related saw earnings increase 25% to 40%. Wall Street consensus forecasts are for earnings to rise 10% this year over last. We would love to see that come to pass: $244 in S&P 500 earnings times 21.6 multiple equals an index value of 5,246. That’s roughly where we are today. Next year’s forward estimate of $270 times today’s 21.6 P/E multiple gives 5,832, or roughly 11% above today’s level. We would be very happy with back-to-back 11% return years.

But what of the present? The spring of nothing has come around as an increasing number of stocks rolled over from recent highs and traded lower. Call it post-earnings fatigue, “buy the rumor, sell the news,” what have you. Management reports and conference calls separated the good from the questionable. Good: discounters like Walmart and high-end retail like Abercrombie & Fitch. Not so good: Target and Kohls. While everybody was celebrating the end of the school year, retailers, manufacturers and national numbers painted a slowing picture of economic growth. 

Next up

The Fed has declared themselves “data dependent.” This is Wall Street code for “we wait for economic numbers.” Consumer prices and employment numbers are backward looking – month ago “has beens.” We find it better to listen to our clients and the regional Federal Reserve bank surveys. The most recent Dallas Fed survey of manufacturers’ comments included such gems as: 

• Demand feels more robust right now than at the beginning of the year. We are still battling cost inflation on raw materials.
• Orders are down approximately 10%.
• Things seem to be slowing down in our manufacturing sector.
• We are still trying to find competent people who want to work. The biggest problem is turnover of new hires. Long-term employees are stable. Young people do not want to work. (Ed: ouch!)¹

Next up for the data-dependent folks are the S&P Purchasing Manager Indices and ISM surveys of manufacturers. The headline surveys and new orders slipped further into contraction last month. ISM Prices Paid index did come down slightly but is still in expansion mode. Like the consumer price index, it shows prices are still rising, just not as fast as a year ago.

Job openings fell for the fifth straight month in April, suggesting employers are pulling back on growth plans. May unemployment and non-farm payrolls are coming out later in the week. We expect the Household Survey unemployment rate to stay flat at 3.9% and the net payrolls gain to slide to a six-month low of 170,000.

All fodder for the Fed to consider at next week’s regular FOMC meeting. No change in short-term rates is expected now or at the July meeting. There are some wagers placed on the Fed cutting rates one-quarter point at the September meeting. We would think the next two monthly payroll and CPI reports would have to be pretty weak to justify a September rate cut.

We do expect the Fed to lower the number of rate cuts it expects from three to two this year. We think the right number is zero, but doubt the Fed wants to shock Wall Street with that large of a change. 

Lower growth

Earnings at least are out-pacing the overall economy. GDP growth last quarter grew at a 1.6% annual rate in the Commerce Department’s first estimate. The headline was well below analyst estimates of 2.5%. But, that 0.9% difference was net imports dragging down the GDP calculation. It reminds us of the first two quarters of 2022 when inventories and net imports lowered reported growth. Government and consumer spending were on the lighter side last quarter. Year-over-year GDP growth notched a still-respectable 3% growth. No stagflation or recession in the data or headline.

A better measure of what is happening in the U.S. is the GDP series “Real Final Sales to Domestic Purchasers.” This series focuses just on activity inside the U.S. As long as it and a couple of other series stay above 2% growth, we should stay out of a recession. Last quarter’s report of 3.1% shows the economy rumbling along in second gear. 

Ceiling

One area of growth the bond market did not like was Core PCE. The Personal Consumption Expenditure measure of inflation continues to drift lower at a 2.7% year-over-year rate. What unsettled the bond market last week was the past three months’ reading of Core PCE rolling higher at a 4.4% rate. That and other inflation readings have pushed the 10-year Treasury over four-tenths of a percent higher this month. Two-year Treasurys are back knocking at the 5% door, returning to last October’s levels.

Where do rates go from here? The 10-year Treasury generally has a yield close to nominal GDP. At the moment, 10s trade around 4.65%, making them expensive relative to nominal GDP growth of 5% to 5.25%. Pushing rates above 5% would require surprising economic growth at home and abroad. Some combination of cheaper crude, lessening global tensions and massive stimulus in Europe and China would also be on the growth menu. Odds? Pretty low.

Cutting rates by a full percent would help the mortgage market, among others. Persistent inflation is staying the Fed’s hand from cutting short-term rates. How else to get rates lower? Possible drivers could be rapid escalation of the Middle East conflict and/or recession in the U.S. Steady 3% domestic GDP slowing to 2.2% in the middle of this year puts small odds on a big rate drop. We think rates stay in a third of a percent up/down range for the balance of the year, waiting on the election. The yield curve should Bear Flatten slightly as long rates rise. Upward momentum in rates relies more on continued borrowing by the administration than great growth in the economy. After the new Congress is seated, we may get a better idea if austerity or continued wonton spending will rule D.C. In short, second gear economy will not let rates fall; second gear economy will not push rates much past a 5% ceiling.