April 13, 2024

A Good Economy May Get Even Better. What That Means for Stocks and Fed Rates.

About the author:  Chris Grisanti is chief equity strategist at MAI Capital Management.

Not so fast, Goldilocks.

The past few months have seen the soft-landing hypothesis surge from behind and overtake recession as the consensus economic outlook. Inflation has receded in the face of the Federal Reserve’s massive assault on interest rates. Yet, paradoxically, employment has remained robust, with lots of new jobs created and layoffs near cyclical lows. Corporate earnings have been reasonably strong.

I know what the Goldilocks deniers are saying right now: Rate hikes don’t work overnight. They take time to stifle the economy. But it has been 700 nights and counting since the first increase, in March 2022. So, maybe Goldilocks deserves to take a bow (a victory porridge?) as the soft landing seems to be all around us, with recession in the rearview mirror.

That said, there’s another alternative, one that is definitely not consensus but seems to be accumulating more and more evidence in its favor. What if the economy—already defying economic theory by surviving in the face of sharply higher rates—is actually getting stronger?

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That’s admittedly an odd thing to posit after two years of interest rate hikes. But as crazy as it sounds, evidence is starting to pile up for the acceleration hypothesis.

First, there are the “big” data points, like unemployment and the stock market. The change in nonfarm payrolls in December’s report was the strongest since September. January’s was even stronger. The stock market, widely seen as a mechanism that discounts future growth, is up over 20% from late October to mid-February.

Other evidence comes from around the economy. After falling for months, the widely followed Citi Economic Surprise Index is up sharply over the past month. The Conference Board’s Consumer Confidence Indicator in January hit its highest reading since the end of 2021.

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Perhaps most significant, the rate of growth in average hourly earnings, which had fallen along with inflation, has risen for the past two months and is now back up to 4.5%. This is where wage growth was in September. It’s also well above the Fed’s comfort zone.

Even the most negative data points have started to turn upward. The ISM Manufacturing PMI Index has shown manufacturing activity contracting, since about the start of the Fed hikes, but has markedly improved recently. January showed the index’s best reading in more than a year. Banks’ willingness to make loans, as measured by the Federal Reserve’s Senior Loan Officer Opinion Survey, has gone from abysmal to merely crummy. Both of these measures are still weak, but the point is they are materially better than they were three months ago.  
Investors ought to pay attention to how these disparate shoots grow.

The possibility that the economy is actually accelerating is both outside of consensus and quite important. Events that combine those two qualities can have a big impact on the market, with additional repercussions for everything from Federal Reserve policy to presidential election results.

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The prospect of as many as four Fed rate cuts has been the source of much of the market’s optimism since October. But why would the Fed add the stimulus of rate cuts to an already accelerating economy? 
Worse, the rationale for cutting was that inflation was finally subdued, but a strengthening economy puts that into question. An economics professor might put it like this: An economy already at full employment, plus a soaring stock market, plus rising average hourly earnings, ought to make for tens of millions of happy consumers. They in turn would continue to buy everything from airline tickets to new homes, even in the face of higher interest rates. Inflation, while not inevitable, sure seems like the natural end result. Seen in that light, the 3.9% rise in core consumer prices in January begins to make sense. 

What does all this mean for the equity market? It might not be all bad. Along with a strengthening economy, and maybe an increase in inflation, should come stronger corporate earnings. (They are reported in nominal, not real, dollars and are thus aided by inflation).

It’s impossible to know whether the market’s greed for rising earnings growth will overcome its fear of rising inflation. But it’s likely that investors’ expectations for lower interest rates are too optimistic.

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Portfolios holding large cash positions in expectation of a recession need to adjust to an environment that professionals under the age of 40 have never seen: a robust economy with higher long-term interest rates and a Federal Reserve that is constantly on the watch for inflation flares.

In such a world, the market can continue to show upward momentum, but that will come with higher rates than expected, which in turn, will have consequences for stock performance. Individual companies can’t depend on free money to bail them out of poor decisions, and balance sheets will matter more than they have in a generation. Management acumen will have to make up for the loss of the tailwind of low rates and high multiples. Some managements will come up short.

So, no more Goldilocks, please! But better than a fairy tale might be a stock market where company fundamentals finally matter, and high-quality securities analysis is back in demand. 

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