Investment Outlook And Strategy -- 1Q24
What do Japanese wages tell us about the US inflation outlook? And why are equity prices so strong despite negative inflation surprises and rising bond yields?
This quarter we take stock of the market developments year-to-date with focus on inflation and the potential for rate cuts this year. Also, we look at the strong equity market performance and analyze its drivers, as well as their sustainability.
Inflation – Far From Transitory
The most recent readings for headline and core CPI (ex-food and energy) came hotter than expected. At 3.2% and 3.8% year-on-year respectively in February, both measures are still far from the 2.0% Fed target. More frustratingly, however, the February month-on-month numbers saw acceleration versus prior months. The breakdown shows that virtually all of the upward pressure on CPI now comes from services: services inflation was up 5.0% yoy, whereas goods inflation was rather tame. The shelter component of the services index was up 5.7%. Transportation was up a whopping 9.9% yoy yet again, as anybody who has booked a flight recently can tell. So inflation remains stubbornly high and far from “transitory”.
It is probably superfluous to mention that the main cost input for services is (mostly) labor. We are probably seeing the flow-through of the generous wage settlements from last year. With unemployment still hovering at around 4.0% and persistent labor shortages in some industries, that trend is likely to last.
Speaking of labor costs, an interesting data point recently was that Rengo, Japan’s largest federation of unions, has secured for its members wage increases of 5.28% year-over-year, a figure much higher than the 3.8% settlement a year ago. This is also the largest wage increase in 30 years. So what, one may ask? Why does this matter?
The “so what” in the story is that Japan is at the forefront of the global ageing process and is the first country to be experiencing decline in working age population. Put briefly, Japanese workers are slowly disappearing. This
demographic shift and its related wage pressure may ultimately help Bank of Japan achieve its coveted 2.0% annual inflation rate. Beware what you wish for because you may get it.
Back to the US, while the situation here is not nearly as dire in terms of ageing, the US is on that path as well. That is one of the main factors supporting our view that inflation in the coming years will be higher than in the past 10-15 years. You can refer to our “4Q23 Investment Strategy And Outlook” for more details on that here.
Interest Rates – Higher and Longer
All this means, as we predicted last quarter, that rates will not come down as quickly as the market has been expecting and they will not go back to the pre-COVID level. This is the good news. The bad news is that inflation will also be higher, so protecting against it remains of paramount importance to investors. Low yielding bank accounts or annuities will not do the job if one has a relatively long time horizon. So our preference in the fixed-income market is to remain short duration for now as the inverted yield curve offers better opportunities in the front
end of the curve. If we are correct, this will remain the case at least through most of this year.
US Corporate Earnings – We Are The Champions, My Friend
Turning to equities, it has been a stelar start to the year, with the S&P 500 up 7.6% including dividends as of mid-March, and up 25% since the bottom last October. It appears that equities do not care about hotter inflation readings or that bond yields have pushed up to 4.30% on the Ten-year Treasury from 3.88% at the turn of the year. We see two reasons for the S&P 500’s presently nonchalant attitude towards rates and inflation.
The first one is that financial conditions have eased substantially since last October. Goldman Sachs compiles a financial conditions index (FCI) that captures five variables – nominal Fed Funds rate, nominal 10-year Treasury yield, non-financials BBB-rated corporate spreads, equity prices scaled by earnings, and the US dollar trade-weighted exchange rate – to determine the level of the index. Since last October, the index is down substantially (i.e., looser financial conditions), mostly due to the decline in bond yields and the rise of the stock market. Easier money means higher asset prices.
But it’s not just easy money. Corporate fundamentals have been better than expected, which is the real reason giving legs to the market rally: earnings revisions for the S&P 500 index have been strongly up.
Despite all the fears of recessions and slowdowns, the economy has remained strong and corporations are making hay while the sun is shining, i.e., using pricing power to boost revenues while demand is strong. Further, producer prices (PPI) have been growing at a much slower rate than consumer prices (CPI). PPI for final demand goods was up just 1.2% you in February vs. the 3.2% for CPI. In other words, corporate costs are growing at a slower pace than revenues, thus helping margins to expand. This has been the case for more than a year now. Expanding margins go straight to the bottom line, boosting earnings growth. The old adage that stocks follow earnings has played out perfectly well so far.
Is this sustainable? As long as we remain on a (very) gradual disinflationary trend and we don’t get a blowout in inflation readings and/or in bonds yields, the outlook remains benign: corporate earnings will continue to benefit from the CPI-PPI spread and from top-line pricing power. But if for some reason yields start rising again towards the 5.0% level we saw in October of last year, investors will likely revisit the price they are willing to pay for these earnings.
Valuations Matter (Eventually)
To spell it out, what makes us somewhat uncomfortable, despite the positive fundamentals, is the market valuation. At 21.0x 2024 P/E, the S&P 500 index is 15% above its median P/E of 18.2x over the past 10 years. While we would stay invested, from a tactical standpoint, we would rather wait for a pullback to put new money to work. It’s normal for the market to have 5-10% pullbacks each year. After the 25% rally, patience may be rewarded yet again this year.
March 18, 2024
Mihail Dobrinov, CFA
Trimon Capital
