Pay Attention

August 29, 2024
Dow: 41,335

We are talking to Jerome Powell, not our readers and friends.

For a good number of months, and a good number of FOMC meetings, it has been all about inflation, inflation, inflation, and very little about the other part of the mandate for the Federal Reserve, maximum employment. The Federal Reserve was right to focus on inflation, and slay that dragon, before turning their attention to other matters. Inflation has finally begun another leg downward after bouncing around the low 3% level for most of this year. Based on the readings for the last few months, it should continue to trend towards 2%.

Hopefully this has given the Fed the ability to focus on the rest of the economy and not just inflation. We think they are now paying attention to unemployment, wage growth, commercial real estate values, productivity, and industrial output. This should make it easier for the Fed to cut rates more quickly in response to any economic weakness if inflation concerns are in their rear-view mirror. The new normal expectation for rate cuts is at least one per meeting for the foreseeable future. We feel comforted that both the stock and bond markets have those expectations as a backdrop. All in all, we think this makes it less likely that the Fed will miss early signs of a slowdown because they are too focused on the 2% inflation goal.

Both unit labor costs and average hourly earnings have been trending downward; the belief that employees would demand that employers compensate them for past inflation losses seems to have passed. Overall GDP growth has been running at a strong 3%. All of these are good signs so far, with inflation moving lower while the economy is still showing strong growth. Our concern is that Fed policy operates with a lag. We hope it is not the case, but they may find that they kept rates too high for too long, even as they begin cuts. Our concerns will ease if the economy stays resilient through the Fall as the Fed begins to cut rates.

Fixed income returns have bounced to very attractive levels as interest rates have begun to fall across the curve in anticipation of Fed rate cuts. After rising through the first four months of the year, rates have moved lower and are now below where they stood at the end of 2023. This move should help provide a tailwind for the economy and the bond market, and slightly eases our concerns about valuation levels in equities.

As we have emphasized in many client meetings, the S&P 500 Index is now much more of a growth stock index because tech stocks occupy the largest six positions in the index and make up almost 30% of the total market value of the index. Growth stocks are far more sensitive to changes in the expected trajectory of their growth or earnings since future earnings account for a large part of their valuation. When price/earnings ratios are high, as they are now, there is little patience for companies that don’t beat their earnings and revenue targets. Even though earnings reports have been above expectations for the second quarter, and the stock market is near all-time highs, we would not be surprised if the market moved sideways for a while.

This is not to say that equity allocations should not be maintained, as we haven’t found the person who can predict future moves. But certainly, expectations for future earnings have continued to increase, and the valuation levels on those future earnings (P/E ratios) have also increased. Even if the market moves sideways, it gives time for future earnings growth to bring the valuation level on the market down. That sets up a future move upward.

 

 

 

Random Thought: “Your time is limited, so don’t waste it living someone else’s life” -Steve Jobs

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