Onward and Upward!

Stocks continue to grind higher with the major market indices finally eclipsing previous records set back in September, 2018. There could be several factors contributing to investors’ newfound bullishness, but we think the foundation of the recent strength could be data signaling both strong economic growth and waning inflation. This combination can be highly potent. Strong economic growth usually leads to strong growth in corporate earnings – the lynchpin of higher stock prices. And the recent trend toward lower inflation is likely to make the Fed highly reticent to resume its interest-rate increases and bond sales. What’s not to like? That is, unless the markets are misreading something.

Let’s start with inflation. In the chart below it is easy to see that inflation has cooled in recent months. Growth in employment costs (Average Hourly Earnings and the Employment Cost Index) is still growing at a solid pace, but the other three price gauges (which all exclude highly volatile food & energy prices) have dropped below the Fed’s inflation target of 2%. This decrease in inflation, or disinflation, has provided cover for the Fed to maintain its “patient” posture following the turmoil in the financial markets in the fourth quarter of 2018. In isolation, the inflation data would strongly suggest that the Fed is done with its interest-rate increases for the foreseeable future. And because low interest-rates have been the lifeblood of the stock market, the bullish reaction to the recent inflation data makes sense.

  Sources: Bureau of Economic Analysis and Bureau of Labor Statistics 
But there are a couple of things this data does not consider.  First is the rapid inflation in asset prices, including stocks, bonds, and commercial and residential real estate.  Here are the pertinent questions: 1) Should asset prices be considered by the Fed and others in evaluating the level of inflation in the economy?; and 2) if so, will high asset prices cause the Fed to become more hawkish and raise interest rates (or forego interest-rate cuts) in order to avoid the formation of asset bubbles?  Our long-held belief has been that asset prices should be considered in the formation of monetary policy because frothy asset valuations raise the cost of saving for retirement – especially for the middle class – by lowering expected future asset returns.  And because saving for retirement is one of the largest expenses for middle-class folks, it’s hard to argue that it should be ignored in policy-making.  Prior Fed regimes have been highly reluctant to base monetary policy on asset prices.  Will Jerome Powell’s tenure be different?
The second issue is the breakdown in inflation, which has pretty consistently shown that prices for non-discretionary goods and services are growing faster than prices for more discretionary goods and services.  This dichotomy has policy implications because the issue of economic inequality is getting more and more attention, and this attention will only intensify in the months leading up to the presidential election next year.  Will growing economic inequality influence the Fed’s actions?  If so, will the central bank lean more dovish so as to perpetuate recent middle-class wage gains, or will it lean more hawkish so as to reduce inflation in the non-discretionary goods and services that disproportionately affect middle-class Americans?  These are difficult questions, and I don’t have the answers.
The second factor driving stock prices, in my opinion, is better-than-expected economic growth.  The Bureau of Economic Analysis reported last week that GDP grew 3.2% in the first quarter, far surpassing the consensus estimate and earlier estimates that had been as low as 0% at one point.  But as you’ve probably heard by now, the headline growth figure of 3.2% far overstates the underlying strength in the quarter.  In the chart below, we show the breakdown of contributions to the 3.2% growth.  The light blue bars represent the combined contribution from Personal Consumption Expenditures (consumer spending) and Private Fixed Investment (business and residential investment).  You will see that the contribution from these two vital categories, which together make up about 85%-86% of GDP in any given year, has been decreasing since the second quarter of 2018.  In the 1Q18, the contribution from these two categories was just 1.1%.  Where did the rest of the growth come from?
  • Net Exports (exports minus imports) contributed a huge 1.0%, due largely to an idiosyncratic increase in exports and decrease in imports resulting from the trade wars.  Due to the fact that Net Exports are a drag on GDP growth in any given year, nobody should expect that this category will be a sustainable source of GDP growth (yes, even with better trade agreements!);
  • We also got 0.65% from an increase in inventories, which will eventually have to be worked off before additional inventories can contribute to future GDP growth;
  • And finally, we saw a 0.4% contribution from State & Local Government spending.  This category is generally a very small contributor to GDP, so we should consider this growth an anomaly as well.

Source: Bureau of Economic Analysis
What’s the lesson from all this?  My conclusion is that since the GDP strength was quite obviously anomalous, investors are placing much more weight on the recent decrease in inflation.  In other words, investors are not bidding up share prices in anticipation of a surge in corporate profits due to a strengthening economy.  Rather, investors are encouraged that lower inflation and continued subdued economic growth will keep the Fed on the sidelines and translate to lower-for-longer interest rates.  Persistently low rates are good for share prices.