The Consumer Price Index (CPI) was first devised in 1914 to tell the government
how much faster prices were rising in coastal towns where warships were being built. The
idea was that the government would add to the wages of defense workers in such localities
where inflation was rising faster than the rest of the country.
Fast forward to today: stock market seers have disassembled the CPI to support
their own argument that interest rate cuts are going to occur sooner rather than later. They
do this by creating a “Core” CPI that excludes the cost of food and energy. The rationale
is that these two components are the most volatile. Excluding them makes the remaining
categories more representative of long-term trends.
There has even been floated a new “Super Core” CPI that excludes housing cost
along with the two aforementioned categories. Using the same rationale, Wall Street bulls
want us to believe that these three areas will deflate back to their prior level of costs on
their own volition.
The problem is that in the real world people have to eat, drive and have some means
of shelter. Excluding these categories from the CPI will not stop their corrosive effects
on the budgets of consumers. Since the CPI is supposed to reflect consumer inflation,
cherry-picking which categories you want to include is not only self-serving but also
misleading.
The pressure on the bull case on Wall Street is real. Corporate profits were up 22.6% in
2021 and only 9.8% in 2022.The full year 2023 numbers will be out later this quarter. It
is not expected to equal profit growth in 2022.
A recent study, carried out by the Federal Reserve in June 2023, indicated that
approximately 40 percent of the growth in profits over the past seven years can be
attributed to the decrease in interest rates and corporate taxes.
Jerome Powell, the Chairman of the Federal Reserve who is the final arbitrator of shortterm
interest rates, has refused to go along with the Super Core CPI parlor game. Powell
in essence said that we are committed to getting inflation down to two percent or less per
year and will not reduce interest rates until the same happens counting all categories.
The Fed prefers to use the Personal Consumption Expenditure (PCE) index, which
is broader than the CPI. This index, published quarterly, showed inflation up 2.6 percent
on an annual basis as of December. This is still above the Fed’s own goal of 2 percent.
Looking ahead, the index of wages has been just ahead of the CPI. This means that
most workers do not sense getting ahead of inflation with good reason. This is also why
there is so much dissatisfaction with the economy in terms of the upcoming elections.
While Biden did score gains for union workers, he perhaps would have gotten more credit
if he worked to increase the minimum wage, which is $7.25 per hour and has not been
raised since 2009. While few workers earn the minimum wage, it is estimated that workers
currently need to earn over $17 an hour to buy what $7.25 did in 2009. If this increase
were done in stages out to 2028, about 19 percent of workers would be positively affected
by an average of $3,100 per year.
Rate cuts will also affect the amount of foreign buying of US Treasury securities.
If the US Treasury yields were to decline to a point where foreigners decide not to buy. A
lack of foreign buying would require interest rates to go back up to a rate that would attract
new buyers. This could undo the salutary effects of a lower-rate Fed policy. It will also
drive home the fact that we are no longer in control of our finances, given our expenditure
deficits and dependency on foreign buyers for our debt.
In fact, we could have a situation where short-term rates go down while long-term
rates go up. This would be a source of concern since longer-term rates dictate the cost of
mortgages and longer-term corporate investments. Investing short-term is a risk since
spiking short-term interest rates can destabilize both government and corporate balance
sheets.
Bottom line: expect no reduction in interest rates until closer to the second half of
the year, if then. At the time of this writing, interest rates on ten-year Treasury Bonds
yields 4.08 percent. The projected ten-year inflation rate is 2.2 percent. An after-inflation
return of less than 2 percent on a ten-year bond is about normal in terms of postwar history.
Compared to the last 10 years it is fantastic. If such a real return becomes the norm going
forward, stock prices will have to be adjusted, along with net government spending and
other asset classes.
The Economy
Economic activity continues its gradual slowdown. While employment is
advancing and wages are getting a bit stronger, employers are showing signs of backing
away from additional job commitments. Layoffs have been announced almost entirely in
the tech and white-collar sectors. Still, most employers expect a headcount by year end to
be unchanged from the start of the year. This means that the layoffs are being offset with
different skill sets or in different geographic locations.
Overall, the forecast is for slower economic growth this year compared to 2023.
Employment will remain tight as the number of people retiring exceeds the number
entering the workforce by almost 2:1.
Interest Rates
Interest rates are expected to remain high, both as the result of Fed policy as well
as the erosion of collateral values in commercial real estate. In 2025 there are an estimated
$2.5 trillion of commercial real estate loans that will come due. If property cannot be
appraised at a level to cover the loan balance either additional funds will be required to
reduce the amount of debt to be refinanced or the loan will go into default. This is expected
to put a lot of downward pressure on commercial real estate prices.
Inflation
Inflation is impacted by ongoing tight labor markets and events abroad. Shipping
is being disrupted on a scale not seen since the pandemic. Both political parties are talking
about tariffs on imported goods, which would be passed on in the form of higher prices.
The Federal Reserve goal of 2 percent or less inflation remains out of reach.
The Stock Market
The performance of stocks continues to be more concentrated in fewer names. Last
week, almost the entire gain in the Standard & Poors 500 was the result of a 20 percent
jump in Meta Platforms (nee Facebook).
Concentrated markets do not have a history of ending well. The key question is how
much of the rest of the market will decline with the largest 7 stocks when the time comes
for their re-evaluation.
Warren M. Barnett, CFA
February 12, 2024
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